Q: I don't see where the $109,400 is on the statement on Slide 15.

A: The $109,400 is classified on Page 16 in the financial Statements of the City of Calistoga as a "Transfer" from Governmental Activities to Business Type Activities.

Operating revenues for Governmental Activities in the absence of grants, contributions, and transfer was $1,434,505 of Charges for Services, $8,215,757 of General Revenues, and the $109,400 add-back transfer out of General Revenues from Governmental Activities to Business Type Activities.

Course overview: Fund Accounting and Municipality Analysis: Part II of II

 

Q: How can you tell when a municipality's pension liability is getting too large for them to handle? Are there red flags or a rule of thumb?

A: There is no given "Rule of Thumb." However, a practical approach is to review the municipality’s enterprise-wide Statement of Activities over the past two or three years and determine if the Change in Net Assets is deteriorating, stable, or improving.

There is a continuing concern about the extent of municipalities’ unfunded pension liabilities and whether they are sufficiently large and threatening to cause severe debt service problems. GASB 68 and GASB 71 attempted to clarify the computation and presentation of unfunded pension liabilities, but there is considerable controversy about the proper discount rate to use for future pension obligations and the proper rate of return to use on investment of pension assets. As a result, think tanks, such as the Brookings Institution, have suggested that the best approach to assessing the severity of pension obligations is an assessment of a municipality’s income statement – or Statement of Activities – over time to determine its prospects for covering all costs, including annual pension expense and debt service.

The key to any practical assessment is use of the enterprise-wide financial statements for a municipality, which are reported on an accrual basis according to GAAP. The use of fund accounting statements requires numerous adjustments to approximate a cash flow statement that allows assessment of a municipality’s ability to meet all operating costs, as well as pay its debt service as scheduled.

Q: We have bonds where we have a pledge of dedicated tax revenues. The bond resolution indicates that P&I payments are payable prior to the payment of any operating expenses. Our analysts are looking at the debt service in relation to the specific dedicated tax revenues (prior to operating expenses). We have a school district that had decreases in net assets every year and almost no real liquidity. Given the bond terms, how realistic is this situation? How much confidence should the dedicated tax and priority over operating expenses provide?

A: A few comments and questions to consider.

If the school district has diminishing operating cash flow, that should be of concern.

The bond's payment priority appears to be a subordination clause. Whether the district honors the clause will only be apparent after the fact.

If all bond interest charges are met without delay, that is good news. However, does the district have a short term credit line and is it using it more as time passes? If so it may be relying on short term debt to service long term debt.

Are there any funds transfers to the school district from other funds and business operations controlled by the associated municipality? (Assuming the school district is not a stand alone entity.)

Finally, all of the above is further complicated since the financial data is usually stale by the time it's public.

Course overview: Fund Accounting and Municipality Analysis: Part I of II

Q: Shouldn't leverage have increased with unfunded pension liabilities on the balance sheet?

A: The definition of leverage can cause a problem. For a commercial business, leverage is, in general, liabilities divided by net worth. Low leverage is desirable since there are more assets to cover the liabilities in the event of default and liquidation.

In this instance, leverage is defined as assets divided by liabilities. The higher the leverage ratio, the greater the asset coverage and the less the risk. If the leverage ratio decreases, it means less assets available to cover every dollar of liabilities. For Calistoga, reporting unfunded pension liabilities dropped the leverage ratio from 2.67 to 1.98, signaling greater risk, i.e., fewer assets to cover each dollar of liabilities.

Q: The last chart statement pointed out lower interest rate environment over the period and reduced principal which shows less need to borrow.

A: A very good observation.

In 2011, the 20-year municipal bond rates varied between 4.75% and 5.50%. In 2015, the rates had dropped to roughly 3.25% at the lower end of the range to 3.85% at the upper end - 150 to 165 basis points difference. This period would obviously translate to lower debt service per dollar of debt.

Course overview: Fund Accounting and Municipality Analysis: Part II of II

Q: Is it correct to say that if debt service is met under fund analysis, it would be even stronger under enterprise analysis?

A: Not necessarily. Some of the fund amounts may be actually greater than their cash counterparts and could lead to an inflated estimate of cash available for debt service. But funds flow statements, if properly adjusted and assessed, can usually indicate whether sufficient cash flow is available to service debt.

The key question is whether the "near cash" amounts in any funds account will turn out to be actual cash, such as property taxes due in the near term that may not actually materialize.

Course overview: Fund Accounting and Municipality Analysis: Part I of II

Q: What are the typical sources of grants and capital contributions and how reliable are they?

A: The primary source of municipality grant and contributions is the federal government.

The federal government provides state and local governments grant funding for a wide range of public projects and policies, such as health care, transportation, income security, education, job training, social services, community development, and environmental protection. Federal grants account for about one-third of total state government funding, and more than half of state government funding for health care and public assistance.  Congress plays a central role in determining the scope and nature of the federal grant-in-aid system, the amount of funding involved, and disagreements over the appropriate role of the federal government in domestic policy generally and in its relationship with state and local governments.

Accordingly, it is necessary to pay particular attention to ever changing Congressional legislation regarding grants and contributions that may affect municipalities in your geographical area.

Course overview: Fund Accounting and Municipality Analysis: Part II of II

Q: Will we be covering (today or next week) the various Development Agencies as they are a part of a city government? These entities request loans to fund their development activities. Thank you.

A: Neither Part I nor Part II specifically addresses the assessment of a Development Agency within a municipality.

However, in assessing a municipality, we cover the financial presentation of governmental activities and business-type activities. Governmental activities are invariably presented by use of fund accounting while business-type activities are presented using accrual accounting. As we have seen and will see, the process of analysis differs using statements prepared on a funds basis or prepared on an accrual basis.

Almost invariably, a Development Agency within a municipality will present the results of its operations using fund accounting. In Part II, we explore in much more depth how to use funds statements to properly assess a governmental division's or department's operations. Therefore, we would apply the same techniques to financial statements for a Development Agency whose operating results are presented separately using fund accounting.

Course overview: Fund Accounting and Municipality Analysis: Part I of II

Q: Poll Question 4 mentions net pension liability on the fund accounting balance sheet. I thought net pension liability is never included on a fund accounting balance sheet, whether it is payable in the next 60 days or not. So, if net pension liability is due in the next 60 days, I could expect to find it in the balance sheet? Thank you.

A: In theory, yes. If any liabilities within the net pension liability is due and payable withing 60 days, it would be included on a fund accounting balance sheet. Note, however, that the “Net Pension Liability” reported in the “Governmental Activities” column in the Statement of Net Position on Page 15 records $6,641,154 for this line item as “Noncurrent Liabilities”. That, in turn, suggest that no amount in that net balance will be paid down in the coming period. As a result, we would not expect to see any of the $6,641,154 on a strictly funds accounting balance sheet.

Page17 provides a strictly funds accounting balance sheet for Governmental Activities. Note that no amount is recorded on this balance sheet under “Liabilities” since all liabilities on this balance sheet are due to be paid down in the very short tun.

If a “Net Pension Liability” balance were allocated between “Current Liabilities” and “Noncurrent Liabilities” on Page 15, we would expect some of the current balance to be recorded on the strictly fund accounting balance sheet on Page 17.

Course overview: Fund Accounting and Municipality Analysis: Part I of II

Q: Do the financial statements for municipalities typically break out the financial performance of each individual fund, or do they just show the summary statement of all the individual funds?

A: It depends on the quality of the financial statements of each municipality.

In the case of the City of Calistoga California, the audited statements include a Supplemental Section containing a Schedule of Revenues, Expenditures and Changes in Fund Balances Budget and Actual for Non-Major Governmental Funds.

However, for many smaller communities with lesser quality financial statements, one would need to consult with management in order to obtain financial information broken down by each individual fund.

Course overview: Fund Accounting and Municipality Analysis: Part I of II

Q: The Napa Valley had those horrific fires last year, which impacted a lot of wineries.

A: You are absolutely correct in your observation, which points to the fact that with all loans in all industries we must be cognizant of the current facts concerning the financial and economic conditions which surround each industry.

Q: Is municipality analysis similar to that of schools and school districts?

A: In general, yes, especially if the records are kept and presented using fund accounting. But if institutions use not-for-profit accounting, the statements can be quite similar to standard business-type accrual financial statements.

Q: Do you offer a webinar on school financials?

A: At this time, we don't offer a course on assessing schools. However, the material contained in our Not-for-Profit and two Fund Accounting webinars should provide you with a good financial analysis methodology to analyze the financial statements for a school or school district.

We also offer a couple of specific comments here - see Q#3 and here - see Q#4.

Course overview: Fund Accounting and Municipality Analysis: Part II of II
 

Q: What is the restatement line item on the statement of activities?

A: A footnote on page 48 of the financial statements reports the following adjustments to fixed asset values, which caused a restatement:

“Effective with the City’s reporting for the current fiscal year ended June 30, all capital asset balances were reviewed, inventoried, and audited. For governmental activities, the effect was a decrease in total assets of approximately $24.5 million to the prior fiscal year balance. For business type activities, the effect was an increase in total assets of $20.2 million, offset by an increase in related accumulated depreciation of $14.9 million, resulting in an overall net increase of approximately $5.3 million.”

Q: If a bank finances equipment for a municipality (or state university), how may a bank confirm the interest portion of payments received are exempt from Federal Tax?

A: The best source of information should be the municipality that would be able to provide documentation and evidence to the effect that interest payments are exempt from federal taxation. If a question remains, however, it would be wise to ask bank counsel to review all relevant federal statutes to determine the tax-exempt status.

The same procedures apply to determining whether interest expenses payments are exempt from state taxation.

Q: It would be good to learn more about GASB 68 and its effect on the financial statements. We understand it is a liability (or can be). How do we work that into our financial analysis when determining cash flow and ability to repay debt? It is the big elephant in the room and we want to make sure we are properly assessing it when considering a loan to a municipality. Perhaps you cover (or can cover) this more in Session II.

A: GASB 68 is fairly straight-forward in terms of concept but considerably complex in the implementation details.

The most practical suggestion we can offer is to always check to assure that it has been fully implemented and embedded in the comprehensive financial statements you use for assessment. Whether it was properly implemented is a different issue that depends on the competence of the accounting firm following the implementation guidelines issued by GASB.

In effect, GASB 68 moves the unfunded pension liability from the footnotes to the balance sheet and, in theory, makes analysis less complex and ambiguous. I'm attaching an overview of GASB 95 prepared by a Michigan firm. The first several pages / slides can be quite helpful.

We touch on GASB 68 and GASB 71 very briefly in Fund Accounting: Part II. Our objective is to highlight the objectives and results of their implementation rather than to explore either in detail.

Q: In fund accounting, is there a defined maximum number days to be considered "near cash"?

A: Fund accounting, or modified accrual accounting, has a current period focus.

Only current revenue, current expenses, current assets, and current liabilities appear on the financial statements. In practice, this means that tax revenues are classified as revenue only if they can be collected – considered measurable and available – within a short period of time such as 60 days.  Depending on the situation and past experience, the “near cash” period of time may be more or less than 60 days, which means that there is no maximum number of days that defines “near cash”. An amount that is measurable, available, and collectible is “near cash”.

Further, governmental fund financial statements do not include long-term assets or long-term liabilities. As a result, a balance sheet for a government fund – as opposed to a balance sheet for a proprietary fund – does not include fixed assets. Nor does it include long-term liabilities, such as post-retirement benefits.

Given no fixed assets on the balance sheet, a government fund statement of revenues, expenditures, and changes in fund balance does not include depreciation expense. But if a governmental fund purchases fixed assets in a period, the full amount of the purchase will be reflected as a capital outlay in a current expense category on the statement of revenues, expenditures, and changes in fund balance, i.e., on the income statement.

Q: Is it fair to say that most grant funds are earmarked for particular projects and, thus, excluding them from the analysis merely negatively skews the results since we are not taking out related project expenses that are tied to those grants?

A: Yes, your point is certainly valid in many instances. However, in other cases, grants may be used for general purposes per donor stipulations.

But excluding grants and outside contributions allows us to determine the extent to which a municipality is dependent on outside sources of financing to operate and pursue its objectives. In general, we tend to feel better if a municipality can self-fund via taxation, fees, and charges for its operations and, therefore, does not have to depend on decisions by outside agencies and parties.

Q: On page 18 of the slides for Fund Accounting II (determining profitability without outside support for government activities) it shows the transfer of $109,400 being subtracted out of operating expense. Why is it coming out of operating expenses; would think it would need to come out of revenue. Further, in the town I am working on I have a positive number - meaning they got money from business type activities. So, where do I add this number back?

A: In putting together the information on Slide 17, we considered the $109,400 transfer from governmental activities to business-type activities as an expense. It's recorded as negative revenue in the amount of $109,400 on page 16 in the financial statements. What that really means is that the City transferred $109,400 of its revenue to some other entity - in this case to business-type activities. Such a transfer is really an expense.

An alternative approach would be to increase $10,584,548 by $109,400 to $10,693,948 and, therefore, increase operating income net of grants, etc. by $109,400 to $9,759,662 but then to leave operating expenses at $7,082,522. The difference between these two amounts remains at $2,677,140, which is operating profit net of grants, contributions, and transfers. Under this approach, the operating profit % would change slightly to (($9,759,662 - $7,082,522) / ($9,759,662)) = 27.43%. The difference in the operating profit % is negligible - 27.74% vs. 27.43%.

Note, too, that in computing profit and profit margins for business-type activities, we did not include the $109,400 transfer to those activities from governmental activities. The operating revenue included $8,220 from unrestricted investment earnings but not the $109,400 transfer from governmental activities. So, in the case you cited, remove the transfer to government activities as a revenue source for governmental activities but then reduce business-type activities expenses by the amount of the transfer. Governmental revenue will be less by the amount of the transfer, and business-type expense will be less by the amount of the transfer.

Q: On page 21 of the slides for Fund Accounting II (determining cash flow of governmental activities) the interest expense is not the same on the income statement (on page 21 of City of Calistoga statement) and the cash flow statement (on page 22 of City of Calistoga statement)

A: Page 21 in the Calistoga financials is the 2015 income statement for business-type activities and page 22/23 is the cash flow statement for business-type activities. 2015 interest expense on the income statement is reported at $613,988. Interest expense on the cash flow statement is reported at $622,782. The difference is $8,794, which reflects the fact that the City paid down $8,794 of accrued interest payable in 2015. The combination of interest expense for the year - $613,988 - and the reduction in accrued interest payable on the balance sheet - $8,794 - totals to the cash interest expense reported on the cash flow statement on page 22 - $622,782. We didn't provide you with the 2014 financial statements, so you would have no way of computing the change in the accrued interest payable account.
 

Q: Our institution has two ways we can spread municipalities.  One way is to spread the statement of net assets and statement of activities.  This is a quick and easy way to spread, and is somewhat similar to how we spread any company (since it is on an accrual basis). 

We also have a spreading template we use which breaks out the governmental activities separate from the proprietary activities.  Regarding the government activities, we always spread the general fund separately, we break out the spread of other major funds, and then we generally group other minor funds together.  Regarding the proprietary activities, we generally spread each fund separately (if there are not too many).  So needless to say, there is a lot of detailed spreading involved, and a detailed spread results from this.  This template also allows (and requires) us to spread the various adjustments in order to reconcile back to the statement of net assets and to the statement of activities.    

Within our credit department, we spread using the latter approach.  This is a more difficult to study and understand.  Sometimes lenders will question it, e.g., when they don’t see LTD listed.    If you could only pick one of the above two approaches regarding how we spread, which would you choose? 

A: Here are some general thoughts about assessing municipalities or assessing any other entity that reports financial results using a combination of accrual accounting and fund accounting.
 
1. Examine and spread the enterprise-wide statements, if they exist, because the resulting UCA cash flow statement can be so helpful.  It can indicate whether the municipality ran a financial surplus or experienced a financial deficit/requirement for the year, which is simply good initial information to have at hand.  You might find, too, that even if a municipality ran a financial surplus, which appears to be the case for Chambersburg, it still might increase short or long-term debt outstanding.  If it did so, it likely points to financing needs for one of its business enterprises or for a specific fund.
 
2. Spread the individual business enterprises since their results should be reported on an accrual basis and pay special attention to the resulting UCA cash flow statement.  That statement will identify a) the borrowing causes, if any, for each business enterprise, b) the source of cash to service enterprise debt, c) the financing requirement or surplus per business enterprise, and d) the source of cash to meet an enterprise financing requirement.
 
3. Disregard the fund balance sheets for the most part since they only include assets and liabilities that are near cash, i.e., due within 90 days or payable within 90 days although the "near cash" time span may vary by accountant and by specific accounts.  All long-term asset accounts and long-term liability accounts are removed from a fund accounting balance sheet.
 
4. Use the fund accounting income statement if you can find footnotes that identify a) fixed asset spending buried in the expense accounts and b) debt repayment that is also buried in the expense accounts.  If you can identify fixed asset spending from footnotes to the financial statements - and such footnotes frequently exist - you can reclassify fixed asset spending in setting up an approximate UCA cash flow statement.  The same applies with respect to debt repayment.  Footnotes should identify the amount of principal debt repayment buried in some expense account.  We need to identify it and reclassify it.
 
The fund accounting income statement, after reclassification, does approximate a true cash flow statement.  As a result, if you can find the hidden information about fixed asset spending and term debt repayments, you can structure a quasi-UCA cash flow statement.  That, in turn, allows you to determine if the fund in question was compelled to borrow money and, if so, why.
 
All of this is a lot of work, which I readily admit.  But one thing I've noticed in my career is that consolidated statements - such as enterprise-wide statements - frequently mask real problems lurking below the surface.  That forces an individual examination and assessment of all relevant business or proprietary enterprises and all relevant funds.  A problem in one business enterprise or fund can cause real difficulties that may be hidden by a high level review of the enterprise itself.

Q: Can you go over the financial impact that natural disasters such as the Northern California fires would have on a municipality's financial outlook?

A: Such natural disasters result in a range of expenses from fighting the disasters to rebuilding infrastructure after the disaster. If the municipality, such as Santa Rosa or Calistoga, California, were left to its own resources, it could not meet the first responder and firefighting expenses let alone provide for disaster relief and infrastructure rebuilding.

The key issue in such circumstances is the amount of aid available from non-profit organizations, such as churches and charitable organizations as well as from state and federal government to meet the immediate cost of the disaster as well as the future rebuilding costs.

Note the impact of the Northern California fire on Calistoga's tourism, which per Slide 38 is critical to its finances. Calistoga largely escaped the fire damage but the impact on tourism in the region is likely to be severe.

Q: What are potential pitfalls of focusing the credit analysis of a municipality solely on unrestricted funds/activities?

A: A sole focus on unrestricted funds could miss some potential cash inflow that would be released in the future (temporarily restricted funds) and, in the process, represent an increase in cash flow.

As with any industry, however, it is always wise to fully analyze a municipality using a Standard Analytical Process:

1. Assess “profit”, assess revenue sources, assess funds flow and cash flow, peer into the future, identify challenges, as well as assess possible resolutions
2. Use management’s discussion, footnotes, and supplementary schedules which contain good, and, frequently invaluable, sources of information

Q: Other than asset/liability leverage ratios, what are some other industry prevalent financial ratios?

A: Debt service coverage ratios are always helpful – on for business type activities, one for governmental funds, and one for total enterprise. But at end of the day, it all comes down to sufficient cash flow – today and tomorrow.

Q: Can you please confirm that non-depreciable assets are land only.

A: Yes, land is a non-depreciable asset. Most other assets are subject to depreciation, unless they have been wholly depreciated.

There may be an exception, however, for infrastructure assets (roads, bridges, etc.) as municipalities are unique in that they have these infrastructure assets.

Infrastructure assets do not have to be depreciated and may instead use a “modified approach” if the following two conditions are met:

1. They are maintained at (or above) the condition established and disclosed by the government agency, and
2. They are managed as follows:

• A current inventory of the infrastructure assets is maintained.
• An assessment of the infrastructure assets’ condition must be performed and reported on using a scale of measurement at least every three years.
• The amount needed to maintain and preserve the infrastructure assets in the specified condition is decided on annually.

The idea behind using the modified approach is that if infrastructure assets are being so well maintained, they really don’t depreciate in value.

If the modified approach is used, any additions or improvements made to the infrastructure assets that increase their capacity or improve their efficiency should be capitalized. All other expenditures made for these assets should be expensed as incurred.

If at any point the requirements for using the modified approach are not met then the assets should be depreciated on a prospective basis.

Q: Where do we find the $10,584,548 in accrual revenues recorded on Slide 44?

A: The accrual revenues of $10,584,548 on Slide 44 is sum of a) “Charges for Services” of $1,434,505, b) “Operating Grants of  $760,212, c) “Capital Grants” of $174,074, and d) “Total General Revenues and Transfers” of  $8,215,757 on Page 16 in the City of Calistoga, California financial statements.  

The cash revenue number comes from Page 18 at Total Government Funds of $10,784,897.

Q: Do you think there might be time to address some of the industry standard ratios for municipal analysis? Also, what are the good and bad values for those ratios, i.e., debt per capita?

A: Because municipalities can vary so greatly in terms of Governmental and Business-Type activities, it is difficult to suggest industry standards.

The standard approach to credit analysis should guide us. That is, review profitability and cash flow by product line and by the whole enterprise. Identify the soft spots or areas of concern and failure. Match debt service to existing and projected cash flow by source of cash responsible for service debt.

Debt per capita is useful as is income per capita. But in the final analysis it gets back to existing and projected cash flow available to service debt.

Q: Why does the cash flow statement not add back the pension liability?

A: For the Governmental Funds Flow statement all cash and near cash expenses (such as pension expense for the period) are included. For Business-Type activities, note the pension expense adjustment ($430,456) which includes changes in pension liabilities that had a cash dimension.

Q: Is the City of Calistoga writing a check for $9MM at the end of the year? What happens when you overfund the pension liability?

A: Over or under funding is determined by the present value of all future pension expenses measured against the present value of all resources set aside to meet those expenses.

If pension liability is overfunded, it means that the present value of resources to meet expenses exceeds present value of all future pension expenses. No check is written if over funded. It is a good financial position to be in, yet not many municipalities enjoy that luxury.

Each year, the City of Calistoga uses existing pension resources to meet annual pension payments. If those liabilities are underfunded, it means the City will run out of resources before it can meet all future pension payments year by year.

Q: Why are hotel taxes not related to Business-Type activities? If hotels are empty you do not collect occupancy taxes.

A: The City of Calistoga does not own and operate the lodgings; they just collect tax from the hotels. Therefore, these financial activities fall into governmental activities. If the City owned and managed the lodgings, it would be different matter.

Q: What is the best schedule(s) to use for determining an annual cash flow coverage ratio?

A: Unfortunately, there is no cash flow statement for enterprise-wide activities. Consequently, one must break cash flow down by the government fund responsible for paying debt or by the Business-Type activity responsible for paying debt as we demonstrated for the City of Calistoga.

Q: My team and I are still a bit confused regarding the modified accounting presentation of the City of Calistoga Balance Sheet (Government Funds) – on page 18 of the handout.

Specifically, it was said in the presentation that this Governmental Funds accounting was “near cash flow,” or roughly that which was coming due in 60 days. As such, if I look at principal and interest ($136,994 & $205,649, respectively) what do those numbers take into account? Is it only the principal and interest that had “recognition events” with the past 60 days? In addition:

• Would a line of credit (LOC) that is maturing or renewing in ten months be reflected in the interest portion?
• Would a real estate note coming due for renewal in one month be reflected differently in this statement than one coming due in two years?

On a larger scale, how can I attempt to reconcile these numbers with the normal notes to the financial statements, which show debt service obligations broken out by year?

A: In response to your questions, let’s first review 2015 debt service for Governmental and Business-Type Activities for the City of Calistoga, California.

Governmental Activities Observations (using the funds flow statement on Slide 54)

• $3,179,180 cash and near cash available to service debt
• 2015 debt service of $342,643 or $136,994 + $205,649
• $2,836,537 cash and near cash remaining after debt service
• Conclusion: City paid debt service from cash flow

Business-Type Activities Observations (using the cash flow statement on Page 22 of the handout)

• $792,508 cash flow available to service debt
• 2015 debt service of $1,242,351 or $622,782 + $619,569
• $449,843 cash flow shortfall after debt service
• Conclusion: City used existing cash balances and transfers from governmental funds.

The overall 2015 debt service was principle repayments of $759,776 and interest expense of $825.218 for total debt service of $1,584,994.

A reminder or two before responding to each of your questions. A funds flow statement – a Government Funds Statement of Revenues, Expenditures, and Changes in Fund Balances - is a quasi-cash flow statement for the period in question that captures all receipts and expenditures over the period. The funds flow statement will include various expenses that are excluded from the accrual Statement of Activities, such as principal repayments and capital outlays. Under accrual accounting, principal repayments and capital outlays are recorded on the balance sheet.

The principal and interest payments reported on page 18 of the handout represent cash or near-cash principal and interest payments for 2015. The interest payment of $205,649 is slightly greater than the $202,958 accrual interest expense reported on the Statement of Activities on page 16 of the handout. In effect, the City paid more on a funds basis than it recorded as interest expense for the period on an accrual basis. In that $205,649 funds flow amount may be an amount due and payable very shortly after the close of the financial year and, therefore, counted as near cash.

An LOC maturing within 10 months would not be included in the interest portion. A line of credit that did mature and pay down within 2015 would be included in the principal amount reported on the funds flow statement. Further, a real estate note coming due for renewal in one month or in two years would not be reflected in the principal amount since renewal implies no cash outlay. If a principal pay-down amount were scheduled for one month after the end of the financial year, it would likely be included in the reported principal amount for the year, although accountants may differ in their approach to future payments with a specific payment date. Near-cash normally applies to receipts and expenditures that could be received or spent at any point in the near future but have no specified receipt or expenditure date.

With respect to reconciliation, there should be a perfect match between principal and interest payments for business type activities, since those activities are reported on an accrual base. That is, the footnote information about future principal and interest should be reflected in the financial statements exactly, barring any adjustment to existing term debt repayment provisions.

With respect to interest-bearing debt for which government funds is the obligor, footnote information is provided on an accrual basis. But actual payment reported in the Statement of Revenues, Expenditures, and Changes in Fund Balances is on a funds or near-cash basis. Therefore, actual payments of interest and principal may vary from those stated in the footnotes. In general, the differences should not be significant.

In theory, a prior year enterprise wide balance sheet should provide interest-bearing debt due and payable in the present period. In the case of the City of Calistoga, the balance sheet account in question is “Bonds, leases, agreements, notes and certificates due in one year.” The amount recorded for 2014 should be captured in the 2105 financial statements. However, it is usually difficult to precisely reconcile the amounts for two reasons.

• First, future lease payments reported in the footnotes frequently do not break out the interest and principal portions year-by-year.
• Second, the amount of principal repayment reported on the funds flow statement for Governmental Activities may differ from the accrual amount reported as part of interest-bearing amounts do on the enterprise wide accrual balance sheet.

Nonetheless, we recommend reading the footnotes very carefully to identify all interest-bearing debt repayments due in the coming year and years. Further, to actually identify debt payments for a year in question, use the funds flow statement for Governmental Activities and the Statement of Cash Flows for Business-Type Activities.

Q: What information should be included in a credit proposal for a new loan? Spread of both District wide statement and general fund? Cash flow for both or just one?

A: We recommend beginning with the Enterprise Wide Statement, based on accrual accounting, to obtain an overview of performance in general and by individual units within the district or municipality.

Then focus on the fund or business-type activity that represents the source of cash to service debt for the credit request in question. Examine especially the funds flow statement, if the repayment source is a fund, and adjust it to approximate a UCA cash flow statement that identifies Business or Net Cash Income and Cash after Debt Repayment.

There may be material differences between the performance of the enterprise and a specific fund, e.g. the enterprise may appear robust with sufficient cash flow while the fund may reflect cash flow problems. Or, vice versa. If the specific fund has problems, then the enterprise may be compelled to provide financial support via loans or allocations in order for the fund to meet its debt service.

Q: What are the differences in looking at financials for a city versus a school?

A: The financial statements of a municipality are similar in respect to format and terminology to those of a school district. However, there are numerous differences in terms of sources of revenue and array of expenses.

Similar to a municipality, the annual report of a school district consists of three parts: Management’s Discussion and Analysis (MD&A), the basic financial statements, and required supplementary information.

The basic financial statements include two kinds of statements that present different views of the district:

1. The first two statements are government-wide financial statements that provide both short-term and long-term information about the District’s overall financial status.
2. The remaining statements are fund financial statements that focus on individual parts of the District, reporting the District’s operations in more detail than the government-wide statements.

A municipality usually has a greater array of revenue sources and a greater array of expenses while a school district is largely dependent on shared municipal, county, and state tax revenues as well as operating grants and charges for services. Expenses for a district usually consist of instruction, pupil transportation, and school lunch programs.

The key in every instance is to carefully identify revenue sources and assess their sustainability and sufficiency going forward, in addition to controlling expenses to match that revenue.

Q: With regards to what should be analyzed and included in a credit proposal, is there a certain part of the analysis that could be excluded for a small commercial loan and, if so, what part (maybe analyzing the general fund since it only makes up a portion of the district wide)?

A: It is possible to exclude broader analysis but it is usually important to avoid skipping any portion of the financial statements.

One may find, for example, going back to Question 1, that the district as a whole is facing financial and cash flow problems while the school, for example, is not. Yet, in the sense of global cash flow, the district's problems may divert cash from the school's fund to meet its general debt service needs. As a result, the specific fund in question may come up short.

Q: When looking at the Enterprise Wide Statements, do you include Component Units? The statements I am looking at include Governmental Activities, Business Type Activities, and then a Total and another column for Component Units.

A: GASB 14 provides guidance about whether Component Units should or should not be included in enterprise wide statements.

GASB Statement No. 14 states that the financial reporting entity consists of (a) the primary government; (b) organizations for which the primary government is financially accountable; and (c) other organizations for which the nature and significance of their relationship with the primary government are such that exclusion would cause the reporting entity's financial statements to be misleading or incomplete.

Further, as defined in GASB Statement No. 14, component units are legally separate organizations for which the elected officials of the primary government are financially accountable. They may be a governmental organization (except those that meet the definition of a primary government), a nonprofit corporation, or a for-profit corporation.

A primary government is financially accountable for a component unit if:

1. The primary government appoints a voting majority of the organization's governing body.
2. The primary government is able to impose its will on that organization.
3. There is a potential for the organization to provide specific financial benefits to, or impose specific financial burdens on, the primary government.

In the event the component unit is excluded, then you'll need to assess the component unit separately using their set of financial statements that should be separated from the enterprise wide statements.

Q: Would I determine debt service obligations (annual P&I) for the government wide entity by looking at the government wide statement of net positon only? Am I missing something by ignoring the Statement of Revenues (government funds on page 18)?

A: The enterprise wide statements will normally provide interest-bearing amounts due in the next period for both governmental and business-type activities. But check the footnotes, if available, since some amounts due in the next period might be short-term lines of credit so classified by the accountant.  

In addition, footnote information may spell out more precisely both next period debt repayment and associated interest expense.

Q: We are in the process of spreading a governmental agency and our financial spreading software does not have a template for government accounting (fund accounting). Do you have a template we can use to compose the UCA or can you direct us as to where we might be able to find one?
 
A: We don't, unfortunately, have a fund accounting template. On Slide 54 in today's slide deck was an example of how to approximate a UCA cash flow statement by adjusting a funds flow statement. Perhaps that illustration or example could be helpful. You might also review the written solutions for the exercise. The illustration about using a funds flow statement to approximate a UCA cash flow statement begins on page 8.

Q: In New York state and, perhaps, in other states, Villages are separately governed political subdivisions, but part of the Town. General Funds and Highway Funds are both segregated into an "A" Fund and "B" Fund. The "B" General Fund and "B" Highway Fund are described as "Part-Town" activities or outside Village activities. When analyzing a borrowing request for a Town project, i.e., a Highway Garage and Salt Barn, how should the apportionment of revenues and expenses between the "A" Funds and "B" Funds for debt service requirements to be viewed?

A: Match the debt service associated with the Town request with the array of Town funds, which would exclude funds specified for the Village, assuming that Town is the obligor. However, you might engage in a bit of "global" cash flow analysis by combining all Village / Town funds and matching these amounts against all Village / Town debt service. In a pinch, one fund would undoubtedly lend to the other.

Since this is specialized lending pertinent to New York state, we highly recommend you consult with a municipal attorney familiar with New York municipal lending.

Q: Does GASB 68 require disclosure of anticipated cash payments/draws on the pension obligation over a pre-determined time period, for example 20-30 years?

A: GASB 68 places emphasis on the present value of pension obligations for each employee from the point at which he or she becomes pension-eligible to projected retirement. To our knowledge, there is no requirement to report anticipated draws from the point of retirement but, rather, to estimate the present value of all anticipated cash pension obligations up to the point of retirement.

If there are no unfunded pension liabilities, the implication is that the municipality can and will meet all pension pay-out obligations to the last estimated date of pension payments in the future. If there are unfunded pension liabilities, every responsible municipality will estimate the future point at which available assets will be exhausted in honoring pension claims and payments. Therefore, regardless of GASB 68, responsible municipalities will generate internal estimates of future dates at which assets reserved for pension pay-outs are exhausted.

In effect there is no pre-determined time period for running pension payout projections. The time period is set by the all the relevant factors, including life expectancy, that result in an estimate of the present value of unfunded pension liabilities.

Note, too, that municipalities must re-estimate unfunded pension obligations every two years to accommodate any required adjustments to their assumptions in arriving at estimates of the present value of unfunded pension liabilities.

Q: In reference to Poll Question 4, where is does the $374,154 figure come from?

A: Poll Question 4 reads as follows:

Calistoga, California’s 2015 fund accounting balance sheet recognized $374,154 of Accounts Payable, rather than $389,341 under accrual accounting, since only that amount was due and payable in the next 60 days.

• Agree.
• Disagree.

The correct answer is “Agree”.

Page 15 of the City of Calistoga, California’s financial statements shows the Enterprise-Wide balance sheet for Governmental Activities where, on a GAAP basis, accounts payable are $389,341.

Page 17 of the City of Calistoga’s financial statements shows the Governmental Funds balance sheet on a fund accounting basis of $349,130, but to that number we must add Advances from Other Funds of $25,024, for a total of $374,154.

Q: Will you please explain exactly what the deferred inflow of resources (pension) refers to?
A: A deferred inflow of resources (pensions) is likely pension payments received in one year that exceeds the amount required given the pension payment schedule for employees and employers. It is a one-time adjustment like deferred revenue, and, as such, is an actual receipt of cash to be recognized over time on an accrual basis.

GASB (Government Accounting Standards Board) Statement 63 provides the definitions of a “deferred outflow” and “deferred inflow” and introduces some name changes to accommodate for addition of these new elements of the balance sheet. This statement differentiates between an asset and deferred inflow, and a liability and deferred outflow. In short, governmental utilities will need to assess every item they are currently calling an asset and liability, and determine which definition each item meets.

Deferred outflow of resources is defined as the consumption of resources that is applicable to future reporting periods that will be reported in a separate section after assets.

Deferred inflow of resources is defined as acquisition of resources that is applicable to future reporting periods that will be reported in a separate section after liabilities.

Under GASB Statement No. 68, the following amounts related to pensions should be recognized and classified as either deferred outflows of resources or deferred inflows of resources accordingly:

• Differences between expected and actual experience in the measurement of the total pension liability.
• Changes of assumptions or other inputs.
• Net difference between projected and actual earnings on pension plan investments.
• Changes in the employer’s proportion and differences between the employer’s contributions (other than those to separately finance specific liabilities of the individual employer to the pension plan) and the employer’s proportionate share of contributions.
• Contributions to the pension plan from the employer subsequent to the measurement date of the collective net pension liability and before the end of the employer’s reporting period should be reported as a deferred outflow of resources related to pensions.

Q: What credit metrics do you normally look at for a municipality?

A: In today’s Fund Accounting: Part I session we developed a basic understanding of the following:

• Fund accounting.
• The differences between fund accounting and business accounting while focusing on revenue recognition and expense matching.
• The format of fund accounting financial statements analytical content of fund accounting financial statement.

In our next session on Fund Accounting: Part II on May 12, 2016, we conduct a credit review and assessment of two municipalities – Calistoga, California and Central Falls, Rhode Island – with emphasis on addressing four fundamental issues:

• Borrowing causes.
• Cash repayment sources.
• Risks to repayment.
• Mitigants to the repayment risks, if any.

In very general terms, the metrics we use in establishing the risk profile of a municipality are quite standard, i.e., ratio and cash flow analysis that accommodate the terminology of municipality financial statements and reporting formats.

October 22, 2015

Q: Is fund accounting also used by non-profits?

A: No. In general, not-for-profits use a slight variation of accrual accounting in which financial statements are prepared in accordance with GAAP (Generally Accepted Accounting Principles) and FASB 117, which establishes standards for general-purpose financial statements provided by a not-for-profit organization. The terminology is different but the financial statements closely follow those prepared solely under GAAP.

Q: Why don't the business activities break out the related interest expense?

A: This is a function of the accountant's decision in preparing the enterprise wide financial statements. If interest expense relatively small, it is likely buried in aggregate account for business activities. Note, however, that interest income is broken out in individual accrual financial statements for business activities.

Q: Does the fund accounting income statement cover year to date information or just income and expenses for 90 days?

A: The fund accounting statement covers a full year but includes only cash or near cash events. Near cash means something converted to cash within the next 90 days.
 

April 23, 2015
Q: Are income and expense allocated to the proper year in fund accounting (excluding tax receipts received for the following year)?

A: Given the nature of fund accounting, recognized revenue and expenses may be somewhat out of step with the year in which revenue and expense events took place. Recall that accrual accounting records a transaction when it occurs, while fund accounting records transaction when it is cash or near cash. Hence revenue and expenses recognized under accrual accounting may be more or less than fund accounting revenue and expenses.

To compute the exact cash flow in a given year, it is necessary to have the accrual financial statements for two years (because a balance sheet only records the results of a given day, two balance sheets and one income statement are required to calculate a cash flow). The resulting cash flow statement can then be compared to the accrual statement for that year.

Q: What are your thoughts on municipalities using tax anticipation notes on a regular basis?

A: Using tax anticipation notes on a regular basis is fine if a) the municipality has track record of properly estimating future tax receipts and b) the funds raised by the notes are used for operational needs.

Q: Is the net change in fund balance on the governmental funds the same as the financing requirement on the UCA cash flow?

A: No. The net change in fund balance is the surplus or deficit for the governmental fund for a given period. On the surface, it would seem that a fund surplus for a given period would reflect a financing surplus since fund accounting is based on all cash or near-cash receipts and expenditures for a given period. And vice versa, a fund deficit would, presumably, reflect a financing requirement, since all cash and near-cash receipts failed to cover all cash and near-cash expenditures.

The problem is that a fund accounting statement of revenues is not a true cash flow statement, since the near-cash revenues and expenditures may or may not materialize. The UCA cash flow statement, on the other hand, is a true cash flow statement, compiled from two accrual balance sheets and the associated accrual income statement. We can identify with assurance the financing requirement for a fund only if we can construct a UCA cash flow statement for it. By so doing, we would confirm or refute the implications about a financing surplus or requirement from the change in a fund balance.

Q: Since benefit payments are made monthly, why wouldn’t a portion of that be shown on the funds statement?

A: The portion due and payable in the near term, e.g., within a 60 day period, should indeed be reported as a liability on a government funds balance sheet. In the case of West Linn, any such amounts may have been included in the accounts payable and accrued expenses account.

However, given the nature of fund accounting, those obligations due and payable beyond the near term would not be recorded on a government funds balance sheet. For example, post-employment benefits recorded as long-term liabilities on an accrual balance sheet would not be reflected on a government funds balance sheet, since they are due and payable beyond the near-term.

Q: I read recently that governments have to now record all pension payables. What were they doing before?

A: Under fund accounting, obligations due and payable beyond the near-term, e.g., beyond 60 days, would not be recorded on a government funds balance sheet. Those obligations may be recorded in a footnote to the comprehensive financial statements.

However, in June 2012, GASB issued a statement requiring governmental entities that provided defined benefit plans to recognize their long-term pension obligations. Such obligations should already be recognized in the enterprise-wide financial statements prepared on an accrual basis. Given the GASB statement, these obligations will be recorded on the appropriate government funds balance sheet for those entities whose financial reporting year falls after June 15, 2014.

November 18, 2014

Q: When you are looking at unrestricted funds vs. cash on the balance sheet - does the cash on the balance sheet need to cover the restricted funds prior to be available for use of the unrestricted funds?

A: It is usually most helpful to measure cash and marketable securities against operating expenses rather than relate them to restricted or unrestricted funds.

If information exists about the nature of the restricted funds, e.g., cash contribution designated for fixed assets, it makes sense to measure cash and equivalents against restricted funds to estimated cash balances available to meet expenses.

In order to specifically determine the amount of unrestricted cash for a given date, it would be necessary to confer with management concerning the amount of total cash that is permanently or temporarily restricted.

Q: Why do some entities charge depreciation against net assets?

A: Most assets are depreciated in non-profit accounting. However there are exceptions.

As with for-profit accounting, nonprofits are required to record the purchase of long-lasting, substantial property and equipment (such as computers, vans, buildings, etc.) as assets in the financial records and to charge a portion of the cost of those items in each year in which they have a useful life. This process is called capitalizing and depreciating fixed assets. While all businesses, including nonprofits, are required to record depreciation of assets, some assets in the nonprofit sector receive special treatment.

Due to the nature of certain non-profits, some long-term assets are not eligible for depreciation and are not recorded as assets in the financial statements. Certain works of art, historical treasures, historical buildings, libraries and general items placed in museum collections are exempt from being depreciated. If sold, the proceeds from these items do not have to be recorded as revenue.

October 23, 2014

Q: What would cause the restatement of assets?

A: There was a long running embezzlement by the former chief financial officer that was ultimately discovered, and that caused previous year’s financial statements to be restated.

Q: How did you choose the City of West Linn, Oregon as our example?

A: The City of West Lynn, Oregon seemed representative of the times. The city was beginning to feel a slight pinch from economic uncertainty, and the financial statements were particularly good, which helps greatly in conveying the major points of the webcast.

It was also interesting, in retrospect, that the financial statements appeared so clear and useful in the follow-on period of city turmoil involving a long-running embezzlement scheme by the former chief financial officer.

Q: Are there any special considerations for collateral with a municipality?

A: Yes. Frequently a municipality cannot pledge taxpayer assets, i.e., cannot offer collateral that an outside lender can attach. Because of the unsecured nature of municipal financing, proper credit underwriting by the lender becomes critically important.

Q: Would it be an acceptable credit decision based on 2013 YE financials if the entity states they do not have fiscal YE 2014 company prepared statements?

A: It may be an acceptable credit in that case. In the case of dated year-end financial statements a positive decision would depend on the analysis of the last last set of financial statements, a review of the current year’s budget and internally prepared interim financial statements as well as a review of financial trends coupled with the overall local and national economic outlook. Unfortunately, municipal statements are always late by six months or more.

April 24, 2014

Q: What is unallocated depreciation?

A: Unallocated depreciation is listed under Governmental Activities and means that depreciation expense for the year has not been matched against specific fixed assets but, rather, lumped together and added to existing accumulated depreciation. Depreciation expense for the year, however, may be allocated at a later time.

Q: What, if any, meaning can you take from transfers from governmental and business activities?

A: Transfers usually represent short term quasi-loans between governmental activities and business enterprise. Transfers are made from the operation with a cash flow surplus to one with cash flow deficits or needs, in general. The municipality must ensure that no funds are transferred which are temporarily or permanently restricted.

Q: Which statement is used for spreading and financial analysis for municipalities?

A: The statement depends upon your software. If you have a municipality format, it will indicate specific statements. Otherwise use only the accrual statements, i.e., the enterprise wide and business-like activities statements, since the fund accounting statements are only partially complete. An additional problem with spreading fund accounting statements is classification issues, e.g., all fixed asset spending is recorded as an expense, all debt repayments are recorded as an expense, and so on. Consequently, reclassification of activities using fund statements for any spreading purpose becomes critical to the final results.

Q: How was the embezzlement accounted for and in which statement?

A: It is unclear how the City of West Linn accounted for the embezzlement in its financial statements. In October 2006, the City released a forensic report that provided considerable details about the embezzlement, including the manner of embezzlement, the dollar amount involved, and some of the municipal accounts used to facilitate the embezzlement. The report did not suggest or indicate accounting entries to report the embezzlement, which took place over a five-year period.

In the 2007 Annual Financial Report, there is no reference to the embezzlement except in a footnote on page 43. The footnote mentions that the embezzlement impacted the General Fund, but the City could not identify all specific General Fund accounts that were impacted. Further, the footnote provided information about the City’s continuing attempts to recover some of the embezzled funds from various sources, including the embezzler and a former auditor’s insurance carriers. However, the extent of possible restitution could not be estimated.

In reviewing the 2007 Statement of Revenues, Expenditures, and Changes in Fund Balances for the General Fund, it is likely that the City would use a Contingency expense account to record the cost of the embezzlement if it were to restate prior years. The offsetting entry would be to the cash account in the General Fund. However, there is no indication that the City did, or would, restate prior years, perhaps because the cost of doing so would far exceed the benefit of more accurate prior statements. In addition, there is no indication it reported any dimension of the embezzlement in the 2007 Annual Financial Report.

However, if and as it recovers embezzled funds, it likely would credit a miscellaneous revenue account and debit its cash account.

If you wish to read more about the embezzlement, please click here.

Q: On the “Enterprise-Wide” financial statement you pointed out municipalities may list an asset called “Capital assets not subject to depreciation” and I was curious if you had some examples of what that may include?
 
A: Land is not subject to depreciation, so capital assets not subject to depreciation would be such assets as parks, open space, etc. owned by the municipality.

December 5, 2013
Q: What is the difference between general obligation (GO) bonds and full faith and credit obligations?

A: General obligation bonds are paid from the general fund, as a rule, by a municipality or by a governmental jurisdiction that has taxation power. Such bonds carry the implicit or explicit full faith and credit guarantee of the municipality, which means the bonds will be paid as scheduled using all the municipality's taxing resources to do so. With respect to cash sources of repayment, municipalities generally generate the necessary cash via tax receipts while states may use appropriated funds that include cash sources other than tax receipts.

There are two types of municipal bonds – revenue bonds and general obligation bonds. Revenue bonds are associated with business-type activities, and the cash sources of repayment come from the fees charged by these types of activities.  As noted above, the cash sources of repayment for general obligation bonds are generally the tax receipts of the municipality.

General obligation bonds are considered to be relative safe investments because the full faith and credit of a municipality stands behind them.  General obligation bonds typically have high bond ratings than revenue bonds based on a municipality's power of taxation.  That is, because of a municipality’s option of raising tax rates or levying new taxes in order to meet its obligation to bondholders, the bonds are considered safe investments. However, events since the Great Recession suggest that there are very real limitations on municipalities’ ability to raise taxes sufficient to meet debt service obligations on general obligation bonds.  In fact, business-type enterprises within a municipality may have equal, if not superior, ability to raise fees since the services they provide give them considerable leverage over pricing.

October 24, 2013

Q: A recent municipal credit we analyzed showed only 79% of the pension liability was funded. How does this compare and what can they do to close this gap?

A: Unfunded pension liabilities are a major problem across the country for several different types of businesses, including municipalities.

The funding gap varies widely from municipality to municipality, and it is very difficult to generalize, other than to say it appears to be a pervasive issue of varying severity. In many cases, unions have been able to negotiate pension programs with municipalities that simply cannot be sustained.

To close the gap, an entity needs to renegotiate their obligations or find more lucrative investments. The latter is virtually impossible in today's environment.

These unfunded pension liabilities will continueto be an issue that must be closely observed.

Q: Can you provide us with "industry averages" for churches and/or religious organizations? The ones we have seen seem outdated.

A: Shockproof! Training does not collect that information.  You might find some help with the RMA Statement Studies, but perhaps the best avenue to pursue is a Google search.  If you do so, you will likely find that individual states provide the most useful information.

Q: The adjustments from fund accounting to accrual assume there is only one fund, correct? Is there a way to make these adjustments when there is more than one fund?

A: The adjustment from fund (or modified accrual) accounting to accrual accounting for Governmental Activities includes all funds within those governmental activities.

The accounting statements for Enterprise-Wide Activities, Business-Type Activities, and Fiduciary Activities are only completed on the accrual basis, and, therefore require no conversion.

As stated in the webcast, the Enterprise-Wide financial statements are the most useful for financial analysis because they include the entire municipality on an accrual basis.

August 13, 2013

Q: In assessing credit risk for municipalitieswhat are several key metrics to focus on to determine credit risk when evaluating municipalities for loan worthiness, e.g., debt coverage, per capita revenues versus per capita debt, national averages or metrics to benchmark municipalities for comparison? I need several key metrics to support the credit analysis and credit decision for the municipality sector.

A: As we summarized in the webcast, the issues and analytical process listed below represents an effective approach to assessing the credit quality and repayment prospects of a municipality:

Fundamental Issues

1. Why does the municipality or business-type activity need the money?
2. How do we get repaid?
3. What are the risks to repayment?
4. What are the mitigantsto the risks, if any?

Analytical Process

1. Begin with a higher level overview by reviewing and assessing all municipal management discussions and comments.
2. Identify the current change in net assets – “profit” or “loss” for the period – and the recent trend in the change in net assets.  A positive net change is a positive indicator while a negative net change is a negative indicator pending an assessment of the reasons for the change.
3. Examine movements in revenues and expenses for government activities and business-type activities and identify reasons for current and prior changes in net assets, i.e., in the “profit” or “loss” of the municipality.  In the process, peruse and assess budget vs. actual information that provides helpful insights into areas of flexibility or rigidity. A downward trend in positive net changes or an upward trend in negative net changes is a red flag that require comprehensive assessment.
4. Examine movements and trends in sources of taxable revenue and identify, if possible, delinquency rates for each revenue source.  Decreases in the sources of taxable revenue and increases in delinquency rates by taxable revenue source are red flags, which require a solid understanding of the reasons for such trends and events and an assessment of their likely future course of events.
5. Examine the composition of net assets and identify status and trends in unrestricted assets measured against total net assets and against operating expenses.  Decreasing unrestricted net assets relative to total net assets and operating expenses represents a red flag, which requires an assessment of the reasons for such trends and an assessment of their likely future course of events. 
   In addition, it is critical to determine the extent to which unrestricted net assets are in the form of cash.  Obviously, the greater the cash percentage of unrestricted net assets, the greater the municipality’s ability to service its interest-bearing debt in the event operating cash flow fails to do so.
6. Examine movements and trends in total municipal debt measured against population and against assessed value of property within the taxable domain.  Increases in total municipal debt relative to both population and assessed property values represents a red flag, which require an assessment of the reasons for such trends and an assessment of their likely future course of events.
7. Examine movements and trends in debt coverage for government activities and for business-type activities.  Decreases in debt coverage ratios – particularly if the coverage ratio falls below 1.00 – demands an understanding of the reasons for such trends and events and a thorough assessment of likely future movements in debt service coverage.
8. Using a Statement of Cash Flows for business-type activities, determine if business-type activities generated sufficient operating cash flow to service interest-bearing debt.  A deficit at Cash after Debt Repayment indicates that the business-type activity was unable to meet its debt service from business cash flow and, therefore, requires a thorough analysis and assessment of the reasons for the deficiency along with an assessment of the prospects for improvement.
9. Using a funds flow statement for government activities, adjusted by footnote information or information in supplementary schedules, determine if government activities generated sufficient funds (near cash) to service interest-bearing debt.  A deficit at Cash after Debt Repayment indicates that the business-type activity was unable to meet its debt service from business cash flow and, therefore, requires a thorough analysis and assessment of the reasons for the deficiency along with an assessment of the prospects for improvement.
   If a deficit does exist at Cash after Debt Repayment for either business-type or government activities, the relative amount of unrestricted net assets in the form of cash comes into play as a secondary source of interest-bearing debt service.  Such a source of debt service is, of course, highly temporary in nature since the primary and sustainable source of cash for debt service must be cash flow from business or government operations.
10. With respect to projected results and debt service prospects, review and assess larger economic dynamics such as local jobs and employment status and trends, changes in per capita income, and so on.  Give special attention to unfunded retirement benefits, which are usually identified in the footnotes.  (This is becoming a critical issue.)  Use projected budget revenues and expenses vs. last actual revenues and expenses (if the information exists) and identify likely projected debt service relative to available cash resources.
    A deficit at Cash after Debt Repayment indicates that the business-type activity will be unable to meet its debt service from business cash flow and, therefore, requires a thorough analysis and assessment of the reasons for the deficiency along with an assessment of the prospects for improvement, if any.  If there are no realistic prospects for improvement, the lender must realize that the source of cash to service debt will likely be additional interest-bearing debt.
11. Discussions with management (if possible) to confirm or refute observations and anticipated financial results.

May 30, 2013

Q: What is the contingency line item on the income statement?

A: Contingencies are an expenditure line item, referring to unexpected expenses. The city has provided for unexpected expenses in the amount reported – a slush fund, in effect, if they need to spend the money.

As we noted in the webcast, the City of West Linn, Oregon eliminated the budgeted contingency expense for 2009 because actual revenueswere considerably less than actual revenues for that year according to the General Fund budget included within the financial statements.  

Q: Why is there so much emphasis on cash debt service for municipalities instead of on an accrual basis?

A: The emphasis on cash debt service is important for any type of loan in any industry precisely because accrual net income does not repay loans.  Cash repays loans. Accrual net income or profit is simply a proxy for cash flow, and we must consider the cash flow impact of the balance sheet in conjunction with the cash impact of the income statement for a given year.

Q: Of note, Moody’s and Standard &Poor’s always rate General Obligation bonds better than revenue bonds.

A: Conventional wisdom does, indeed, give the nod to General Obligation bonds, but, in actual fact and in tough political times, it may be far easier to raise water and sewer fees and rates than to raise taxes in general. We tend to see that everywhere in the wake of the Great Recession.

Q: Your water and sewer will be shut off faster than they can collect delinquent taxes through foreclosure, correct?

A: You are absolutely correct.  Foreclosure proceedings can take forever while water and sewer services can be ceased in short order upon non-payment of fees.

Q: What number should we use for an "EBIDA" in calculating a DSCR?

A: It depends on the perceived volatility of the revenue stream of the municipality, but the ratio should cover debt service by 1.25 at a minimum for a very stable and conservative borrower.  However, a much better debt service metric is actual cash flow coverage since cash repays loans and not accrual income.

Q: Can you remind us how to calculate the numerator for the debt service coverage ratio for a municipality?  In addition, how would we calculate a global DSCR for a municipality?

A: Two excellent questions.  Since these are complex issues, it might be most helpful to refer you to a recent paper we drew up to address such issues, using 2008 and 2009 excerpts from the City of Calistoga’s Comprehensive Annual Financial Reports.  In the webcast, we focused only on 2008, but we have added some comments and observations using 2009 data as well.

You’ll note that there is no simple way to compute a global DSCR – on either a cash or accrual basis – because of information limitations.  In this respect, it may be most useful to compute DSC for governmental activities and a separate DSC for business-like activities.

Q: What is the proper way to handle capital outlays in calculating DSC?    

A: Use the generic approach in computing or establishing a DSC ratio.  That is, identify the cash available for servicing debt and divide that amount by debt service for the period.  Capital outlays play no direct role in the computation of a DSC.  However, the debt service requirements associated with capital outlays play a prominent role in a DSC computation.  The objective of a DSC – past or present – is to identify is the borrower had, or is likely to have, sufficient cash flow from operations to meet all debt service requirements, including those requirements associated with capital outlays.

Q: Is it generally true that a city can pull from the Enterprise Revenues, such as Water and Sewer, to fund shortfalls in the General Fund?

A: Yes, it happens all the time in the form of transfers or some similar account as long as the funds are unrestricted. In theory, all amounts borrowed will be repaid in the next period.

Q: I can only speak for the State of Louisiana, but if ad valorem taxes are not paid, the taxing entity can sell enough of a portion of the property to pay them to cover the debt service.  And if this isn't possible, the state steps in as a final measure of security to get these paid

A: Very good observation. Similar arrangements likely exist in virtually all municipal jurisdictions and will certainly vary widely as well.

Q: How do we get $1,080,960 in net revenue when the total net change in assets for primary government was $901,900?

A: The $901,900 change in net assets for the City of Calistoga results from the positive change for governmental activitiesof $1,140,989 less the negative change of $239,089 for business-type activities, i.e., the government made money and business-type activities lost money.The net result was accrual "profit" for the enterprise of $901,900.

Q: For the City of Calistoga, the reduction in capital grants in business type activities offsets the rise in grants for government activities. Overall grant income appears down by roughly $286M in 2008?

A: You are absolutely correct. On a net basis, capital grants are down in 2008 asbusiness grants fell more than governmental grants increased.

Q: What are compensating absences and are they considered debt?

A: Compensating absences are amounts due employees for vacation or sick leave they, the employees, have yet to take. It is money the municipality owes employees – a contingency, in effect.

May 2, 2013

Q: Why would you "want to always be repaid from cash flow from operations" when you could be repaid from specific unlimited tax revenues?

A: For municipalities, recurring tax revenues fall in the category of "cash flow from operations". We certainly do not want our debt to be repaid from other sources, such as from additional long-term debt, which would mean that tax revenues were insufficient to meet debt service.

Q: What would be considered good/bad/average for unrestricted net assets/net assets for a church?

A: You might want to measure unrestricted net assets against overall operating expenses. There is no good rule of thumb, but we can feel more comfortable as the ratio increases above, say, 25% – assuming we can identify unrestricted net assets as cash or equivalents. The threshold level depends, in part, on the volatility of the overall revenue stream of the organization.

Q: Does new debt show as income on the fund statement offsetting some of the capital expenditure (capex)?

A: New debt that is incurred in the period is a cash inflow, which does, indeed, serve to offset capital spending for that same period. How it is reported may vary by municipality.

Q: On the statement of activities (accrual accounting) Capital Grants and Contributions are recognized as revenue.  However, these revenues are typically reserved for specific capital projects (Capital expenditures).  Since the capital expenditure would not be included in the expenses under accrual accounting methods, would the net revenues stated in the statement of activities not be over-stated due to the lack of capital expenditures being expensed on that statement?
 
For Example in your example of the City of Calistoga: Capital Grant and Contributions amounted to $702,629.  However, the capital expenditures (outlays) are only reported on the statement of Governmental Fund Statements under modified accrual accounting, or on the statement of cash flows for the proprietary funds under accrual accounting.

A: Please click here for a series of comments about fund accounting and debt service, along with 2008 and 2009 excerpts from the City of Calistoga's Comprehensive Annual Financial Reports.  In the Fund Accounting webcast we focused only on 2008, but we've added some comments and observations using 2009 data as well.  

(You've raised an excellent point about identifying the actual amount of cash available to service interest-bearing debt for both governmental funds and business-type activities.)

January 23, 2013

Q: When assets are restricted for capital projects, are the types of projects usually identified in the endowment or is it up to the Mayor/City Council to approve?

A: Restricted assets may very well be a function of one or both funding methods.Contributors or donors of funds may specify their use completely and/or themunicipality may create and fund the project and, therefore, specify how funds are used.

Q: In Indiana, we do not get the modified accrual accounting statements.  So, we frequently use CTARs (Comprehensive Town Annual Reports).  Can you offer tips on analyzing municipalities if you do not get the fund accounting statements?

A: As you may recall from the webcast, when an institution receives audited financial statements from a municipality that are based upon both accrual and modified accrual accounting.  Our recommendation is to concentrate your analysis on the enterprise-wide statements which are completed on an accrual basis. This is done because the enterprise-wide statements give the lender the most comprehensive view of the financial condition of the municipality. Please keep in mind that only the governmental fund activity financial statements are done on a modified accrual (fund accounting) basis.

Therefore, provided the Comprehensive Town Annual Reports (CTARs) you receive are both comprehensive and completed on an accrual basis, they should be sufficient to analyze the financial condition of a municipality.

Question & Answer Fund Accounting: Part II of II
November 1, 2012

Q:  As part of your due diligence in reviewing municipalities, would you require copies of grant contracts or annual contributions from government agencies, or just ask question of the municipality?  

A:  We would rely on the financial statements prepared by qualified accountants to determine the level of grants and contributions for a given year.  It is their job to prepare financial statements in accordance with Generally Accepted Accounting Principles (GAAP) and the Government Accounting Standards Board (GASB).

However, we certainly should speak with the officials of the municipality concerning their opinion on the source and sustainability of governmental grants and/or contributions in the current and future years.  This is important because of the economy’s likely impact on government grants and contributions as a revenue source for municipalities. 

Questions & Answers  Fund Accounting: Part I Webcast - October 18, 2012

Q:  For deferred revenue, you said it "can" be converted into cash in 60 days.  Does it matter if it "can" be or "will" be?

A:  Yes.  It does matter if the amounts can be converted to cash.  Funds flow is almost cash flow but not quite.  The deferred revenue – receivables – must still be converted to cash.  So a funds flow statement is only an approximate cash flow statement.

Q:  Why are prepaid expenses included under fund accounting but not under accrual accounting?

A:  Prepaid expenses are included under both accrual and fund accounting. All current asset slides we use show the same entry for both fund and accrual accounting, e.g., Slides 48 and 53.

You may be referring to Slide 50 where we show that in fund accounting under net assets, prepaid expenses are considered restricted funds because the cash payment has already been made.  

Q:  Are capital outlays only considered expenditures when they are funded by internal cash, or also when they are funded with debt?

A:  The manner in which capital outlays are funded how does not matter.

What matters is whether they are accounted for under fund accounting or accrual accounting. Under fund accounting, they are expenses. Under accrual accounting, they are long term assets subject to depreciation.

Q:  On transfers, are organizations typically restricted from making any transfers to / from the General Fund?

A:  This really depends on internal policies. Temporary transfers are very common.  However, longer term transfers may require city council or voter approval as well as ensuring that donor requirements are met.

Q:  If capital grants were included in the statement of activities on the enterprise-wide financial statement, would you recommend they be excluded from a cash flow analysis?

A:  No.  If they are actually cash inflows, they should be included in the cash flow statement in the year they were received.  However, in looking forward be very careful to determine if they are, in fact, sustainable or are one-time events.

Questions & Answers, Fund Accounting II, July 26, 2012

Q: If we are providing a loan for water meters, will the source of repayment be revenues received from the water services first and then the secondary source of repayment would be the unrestricted funds?

A: Yes. You will be providing financing for proprietary (or business-type) activities, and the revenue source for that debt will be revenue (service charges) from water services. In addition, unrestricted funds could be used for debt service, if needed.

Q: Are the governmental budgets fixed or variable? Can they decide not to fund capital projects?

A: Most municipalities may take a few months to adjust the budget from a preliminaryone to a final one, but, once finalized, it should remain fixed. Usually, at each town or city council meeting, actual operating performance to date will be compared to the final budget, and changes will be made, where possible, in revenue and/or expenses to bring the current year’s operating performance in line with the final budget.

One of the decisions that municipal management must make during a given year is to cut expenses (including capital projects) if it appears that projected revenuestreams seem optimistic compared to budgeted revenues.

Questions & Answers, Fund Accounting I, July 11, 2012

Q: What or why was the $5MM in Restatement on the City of West Lynn 2008 Statement of Activities - do you look at this?

A: You should always explore restatements, unless the results are immaterial.

In this instance, refer to page 48 and the Restatement section, which points out that governmental activities and business-like activities' fixed assets were audited and adjusted accordingly. The net result was a $19 million decrease in net assets. In addition, it may be necessary to speak with city officials to get more information on the reasons for the restatement.

The real issue in this case is the implications, if any, for debt service in the coming year, and there appear to be none with the City of West Lynn.

Q: We are looking at lending to some municipalities at this time.   The most recent financials we have are FYE 6/30/11 which is over a year old at this time.    Most of the time they refer us to a  2011-2012 budget that is not consolidated. Can we rely on this?  Do municipalities prepare any internal financial statements (before these get audited)?

A: During each year, usually monthly, city or town finance staff usually prepare financial statements for the city/town council.

Consolidated financial statements can be misleading if the various governmental activities and business entities cannot shift cash around from a cash surplus unit to a cash deficit unit.  Therefore, you need to get the budget for the governmental fund or activity that will be the obligor of any financing you are considering.

These operating statements are directed toward control over revenues and expenditures in the primary operating funds. The budgetary operating statement, which includes revenues and expenditures that are compared with the final revised budget and changes in fund balance, is most commonly used. A budgetary operating statement should be most useful to city council members, particularly during the year, because it compares budgeted revenues with actual revenues and budgeted expenditures with actual expenditures. This kind of statement allows council members to monitor overspending and to determine if revenues are being received as projected.

Three years of prior audited financial statements when combined with the above analysis of the budget to actual interim financial statements should provide a lender with sufficient information to make a loan decision. Of course, the lender would also want to discuss the overall analysis with the borrower to ensure that all questions and/or discrepancies are properly answered and understood.

In addition, as a really rough indicator of a city's likely problems, check the foreclosure rate in its taxable domain.  For example, the two most recent bankruptcies - Stockton and San Bernadino - both had exceptionally high foreclosure rates.  Such rates imply a steep fall-off in tax revenues and collections and imply real cash flow difficulties.

Fund Accounting II Webcast May 9th 2012

Q. What is the difference between an original budget and a final budget?

A.    An original budget is the budget of record at the beginning of the financial year, which represents the municipality’s best estimate of revenues for the period and approved expenses based on the revenue estimates.  A final budget represents the last in a series of adjustments and changes to the original budget – and successor budgets – as events change over the year, e.g., revenue projections fall short of original projections, which forces changes in expenses and so on.  

Q. From the West Linn case, I missed where the $175,000 debt reduction and $168,136 interest expense came from in the General Fund.

A. Under the “General Fund” column on the Statement of Revenues, Expenditures, and Changes in Fund Balance on page 26 in the Basic Financial Statement, a line item for “Principal” indicates a $175,000 payment and a subsequent line item for “Interest” records a $168,136 payment.

Q. How much due diligence should we be doing on pension plans?

A. In short, as much as possible.  There are two fundamental issues. The first is whether pension fund assets can produce the rates of return necessary to match projected pension payments as they come due and payable.  Historically, municipalities have assumed an average 8% rate of return on such assets, which is extremely optimistic in this very low interest rate environment.  A more conservative and realistic assumption about future rates of return may indicate a rather severe shortfall between obligations and assets available to meet the obligations.
In addition, there is the question of the composition of pension fund assets.  If the majority is presently in Greek government bonds – as an extreme example – then we should have considerable concern about the course of both market value of the assets and actual rates of return on those assets.

Q. Is there value in testing debt service by application of total EBITDA to principal and interest payments?

A. There is if EBITDA is cash EBITDA rather than accrual EBITDA. Since governmental activities are recorded on a funds basis – cash or near cash – it should be possible to estimate cash EBITDA for each governmental activity, especially with liberal reference to information in footnotes and supporting schedules.  Further, since the business-like activities record operations on an accrual basis and provide a statement of cash flows as well, it is possible to identify cash EBITDA for these operations.   At that point, we could conceivably roll up the various EBITDAs and apply them to total principal and interest payments.

Questions & Answers, Fund Accounting I Webcast, April 26, 2012

Q: When funds are released from restrictions (from temporarily restricted to unrestricted), is it safe to assume that there will be an equal amount of expenses that offset the funds released?
 
A: Yes, the release of temporarily restricted funds and their associated expenses are virtually one and the same thing. When the funds are spent as directed, the restricted use ends, in effect, and the funds are released from their restrictions.
 
Q: Where do the Union Church financials fit into the three types of accounting funds (Government, Proprietary, and Fiduciary)?

A: The Union Church financials are similar to proprietary (or business type) accounting in that it is accrual accounting according to GAAP and FASB 117.  Proprietary accounting is prepared according to GAAP but formatted according to GASB standard formats.
 
Q: I am reviewing a set of financials for a city which have fund transfers, and I am having a difficult time following the destination of those funds transfers. Where should I look for that information?
 
A: Look for the transfers in the Statements of Revenue, Expenditures, and Changes in Fund Balance (or Net Assets) where the transfers to and from various funds are located. You may also match inflows/outflows in other governmental or proprietary funds.

It may be very hard to identify outward transfers that go to third party entities rather than to funds within the enterprise itself.  In all cases, when in doubt check the notes to the financial statements and/or confer with the appropriate municipal official(s).

Q: Page 29 in the slides refers to $21,187,428 in accrual revenues. Where is that dollar amount on page 24 of the financial statements? I found the $20,205,043 accrual expenses but not the revenue.

A:  On the Statement of Activities for the City of West Lynn, Oregon (page 24 of the financial statements), under Program Revenues, Charges for Services for Governmental Activities are $8,790,380 and Operating Grants and Contributions for Governmental Activities are $4,126,676. In addition, Governmental Activities tax revenue located on the line entitled Total General Revenues and Transfers are $8,270,372.

The total of these three revenue sources is $21,187,428 which represents the total accrual revenues for Governmental Services.

Q: Our institution has two ways we can spread municipalities.  One way is to spread the statement of net assets and statement of activities.  This is a quick and easy way to spread, and is somewhat similar to how we spread any company (since it is on an accrual basis). 

We also have a spreading template we use which breaks out the governmental activities separate from the proprietary activities.  Regarding the government activities, we always spread the general fund separately, we break out the spread of other major funds, and then we generally group other minor funds together.  Regarding the proprietary activities, we generally spread each fund separately (if there are not too many).  So needless to say, there is a lot of detailed spreading involved, and a detailed spread results from this.  This template also allows (and requires) us to spread the various adjustments in order to reconcile back to the statement of net assets and to the statement of activities.    

Within our credit department, we spread using the latter approach.  This is a more difficult to study and understand.  Sometimes lenders will question it, e.g., when they don’t see LTD listed.    If you could only pick one of the above two approaches regarding how we spread, which would you choose? 

A: Here are some general thoughts about assessing municipalities or assessing any other entity that reports financial results using a combination of accrual accounting and fund accounting.
 
1. Examine and spread the enterprise-wide statements, if they exist, because the resulting UCA cash flow statement can be so helpful.  It can indicate whether the municipality ran a financial surplus or experienced a financial deficit/requirement for the year, which is simply good initial information to have at hand.  You might find, too, that even if a municipality ran a financial surplus, which appears to be the case for Chambersburg, it still might increase short or long-term debt outstanding.  If it did so, it likely points to financing needs for one of its business enterprises or for a specific fund.
 
2. Spread the individual business enterprises since their results should be reported on an accrual basis and pay special attention to the resulting UCA cash flow statement.  That statement will identify a) the borrowing causes, if any, for each business enterprise, b) the source of cash to service enterprise debt, c) the financing requirement or surplus per business enterprise, and d) the source of cash to meet an enterprise financing requirement.
 
3. Disregard the fund balance sheets for the most part since they only include assets and liabilities that are near cash, i.e., due within 90 days or payable within 90 days although the "near cash" time span may vary by accountant and by specific accounts.  All long-term asset accounts and long-term liability accounts are removed from a fund accounting balance sheet.
 
4. Use the fund accounting income statement if you can find footnotes that identify a) fixed asset spending buried in the expense accounts and b) debt repayment that is also buried in the expense accounts.  If you can identify fixed asset spending from footnotes to the financial statements - and such footnotes frequently exist - you can reclassify fixed asset spending in setting up an approximate UCA cash flow statement.  The same applies with respect to debt repayment.  Footnotes should identify the amount of principal debt repayment buried in some expense account.  We need to identify it and reclassify it.
 
The fund accounting income statement, after reclassification, does approximate a true cash flow statement.  As a result, if you can find the hidden information about fixed asset spending and term debt repayments, you can structure a quasi-UCA cash flow statement.  That, in turn, allows you to determine if the fund in question was compelled to borrow money and, if so, why.
 
All of this is a lot of work, which I readily admit.  But one thing I've noticed in my career is that consolidated statements - such as enterprise-wide statements - frequently mask real problems lurking below the surface.  That forces an individual examination and assessment of all relevant business or proprietary enterprises and all relevant funds.  A problem in one business enterprise or fund can cause real difficulties that may be hidden by a high level review of the enterprise itself.

Q: On slide 65 the line item "Fixed Asset Spending" reads $3.2MM; On the Income statement on page 26 of the financials, Capital Outlay reads $1.6MM. Why don't these numbers correspond? How is the difference derived?

A: Given information in a Capital Asset footnote on page 40, which is not part of the background materials for Fund Accounting I, fixed asset spending is the sum of a) $475,941 of land and easements and b) $2,759,462 of buildings and improvements, vehicles and equipment, and infrastructure. The sum of those two is $3,235,403.
 
The rough cut cash flow statement on Slide 65 begins with total funds revenue of $19,066,406 on page 26 in the West Linn financials and reduces that by the total of all expenditures, which is $19,396,284.  From the expenditures, we remove a) net transfers of $7,606, b) land and easements of $475,941, c) other fixed assets of $2,759,462, and d) scheduled long-term debt repayment of $670,000.  The result is an estimate of Net Cash Income on the UCA cash flow statement of $3,583,131.
 
Next we reduce Net Cash Income by $670,000 for the scheduled long-term debt repayment.  In effect, we reclassify that cash outflow.  Then we reduce the resulting Cash after Debt Repayment by total fixed asset spending of $3,235,403, which gives us a $322,272 financing requirement.
 
The capital outlay amount of $1,611,978 differs from total fixed asset spending of $3,235,403 because of classification decisions in the fund accounting statement.  The differnce between the two amounts - $1,623,425 - represents fixed assets of one sort or another that are buried in the expense categories of a) general government, b) cultural and recreation, c) public safety, and d) highways and streets on the government funds statement on page 26.
 
Absent the footnote information on page 40, we would have no way of properly identifying fixed asset spending.  The moral of the story, however, is to recognize that fixed asset spending  may differ from capital outlays by a considerably amount, which we noted on Slide 63.  It is essential to get the fixed asset spending amount right if we wish to construct a useful approximation to the UCA cash flow statement using funds accounting information.

Questions & Answers, Fund Accounting II, December 7, 2011 

Q: What do you consider to be sufficient documentation to support a municipality’s response that grants are sustainable?

A: One should look for confirmation that the grantor has confirmed a multi-year series of grants; otherwise consider grants a single year event. In addition, evidence to support any grant as "sustainable" must be persuasive.

This information may be included in the Notes to the Financial Statements or through conversations, supported by documentation, with a municipality’s management officials.

Q: When looking at DSC, you did not mention warrants, compensated absences, etc. Should these be considered when looking at DSC?

A: You should include any warrants or compensated absences, which are liabilities, only to the extent they are going to be expensed in the coming period if you are calculating a projected DSC. This calculation requires considerable judgment and information from the government entity.

If these liabilities were expensed during the period covered by the financial statements, they would already have been expensed and would be reflected in the change in net assets for the period. In this case these expenses would already be included in an historical DSC calculation.

With respect to warrants, it does not seem probable that any local government or hospital would issue warrants, which are securities that entitle the holder to buy an underlying stock of the issuing company at a fixed exercise price until the expiry date.

Q: What are pension trust funds funded by?

A: Pension funds are commonly run by a financial intermediary for a company or a municipality and its employees, although some larger corporations operate their pension funds in-house. Pension funds control relatively large amounts of capital and represent the largest institutional investors in many nations.
 
These assets are usually funded by a combination of short and long term assets, such as money market funds, T-bills, municipal and corporate bonds, as well as equities.

It is critical, however, to understand the composition of the assets supporting pension obligations and how vulnerable they are to economic cycles. In addition, it is necessary to determine if the fund assets are sufficient to match future pension fund obligations. This gap, known as unfunded pension liabilities, is gigantic, by most estimates in the $3 trillion + range.

The level of pension funding for a municipality or company can usually be found in the footnotes of the financial statements.

Q: Is it safe to say that the General Fund is the sole fund that represents the risk when lending to a Municipality?  In my experience, I've seen the General Fund account for about 70-90% of district-wide revenue, but on the General Fund balance sheet, it usually only accounts for 20-30% of district-wide assets (since it does not contain any fixed or long term assets).

A. In many instances, this may indeed be true.  In the two municipalities we used in the webcast, revenues from governmental activities accounted for roughly 78% of all revenues for West Linn, Oregon but for only 60% for Calistoga, California.  In general, the General Fund dominates all other funds.  However, if the municipality includes substantial business-type activities, the relative importance of the General Fund may well decrease. 

Q: In terms of a debt service coverage ratio, the General Fund typically does not have any long-term debt or even any short-term debt and therefore typically has no debt service coverage ratio. Should debt service ability (EBITDA) / (CPLTD + Interest Expense) be calculated with emphasis on the district-wide financials?

A.    Definitely.  All governmental funds and business-type activities are really like divisions within a larger enterprise.  Cash moves back and forth depending on which divisions is running a cash flow surplus and which is suffering cash flow problems.  Note the frequent variances in net transfers from governmental activities to business-type activities and vice versa.  Therefore, it makes sense to approach any debt service estimate on an enterprise wide basis.

Q: What is the difference between general obligation and full faith and credit bonds?

A. In practice there is little difference.  Both reflect a municipality’s pledge to honor its obligations.  However, a general obligation bond is more specific in that it usually includes a pledge to levy property taxes, if necessary, to meet debt service requirement.  No such specific pledge is included in a full faith and credit bond.

Q: In addition to my debt service coverage concern, often I have school districts ask for a State Aid Note. The General Fund typically will show the liability on its balance sheet since it is short term and, therefore, I can calculate some sort of debt service coverage ratio. However, when a school district asks for a bus fleet loan (installment loan), the General Fund may show the principal and interest expense on the income statement, but the asset value of the buses and the corresponding liability will not be on the General Fund balance sheet. So in essence, when I risk rate the General Fund, in my experience, it can be different based on the type of commercial loan requested. Agree?

A: The debt service ratio computations should be conceptually similar.  In one instance, the debt service refers only to interest expense and, in the other, to the sum of interest expense and scheduled long-term debt repayment.  In either case, the numerator would be cash or near-cash available to service debt.  If the principal balance were identical for a short-term note and a long-term installment, the debt service ratio would be greater for the short-term facility than for the long-term facility.  However, if you supplement a debt service ratio as a measure of risk with a leverage ratio, then you would need to identify the long-term asset and long-term liabilities in constructing the leverage ratio.   The comprehensive statement of net assets will include all long-term assets and liabilities for governmental activities.

With respect to the numerator in debt service ratio computations using General Fund information only, note that the statement of revenues, expenditures, and changes in fund balances allows you to use near-cash amounts in computing cash available for debt service.  Referring to this statement for Calistoga, California on page 15 in its Comprehensive Annual Financial Report, the amount of cash available to service debt in 2008 was total governmental funds of $8,812,271 less total governmental expenditures (excluding debt service and capital outlays) of $6,652,711.  In effect, the municipality had $2,159,560 of cash or near-cash available to meet 2008 debt service of $391,762 – a coverage ratio of 5.51.

Yet this debt service coverage ratio is really misleading since it does not include business-type revenues, expenses, and debt service requirements.  You might consider a debt service coverage as really having three components – one for governmental activities, one for business-type activities, and one that applies to the enterprise as a whole. The enterprise debt service ratio may be more appropriate since municipalities are generally able to transfer cash back and forth between different “divisions”.

Q: In Pennsylvania we have the Government Unit Debt Act, by which the court can require the municipality to raise taxes to repay bank debt. Do you have experience with this type of law, and can we rely on it in the future?

A. I have no experience with such a law but, in today’s environment, I would be very reluctant to rely on such a legal provision.  The court may act and direct a municipality to raise taxes, but whether the municipality would do so is another question.  Its political will to act could vary greatly.  And if a municipality did honor the court’s ruling and increase local taxes, there is the issue of taxpayer reaction and their willingness to honor their new obligations.  Further, the municipality may or may not mount a vigorous tax collection effort in the face of taxpayer – and voter - resistance.

Q: Typically I see a portion of the Fund Equity labeled as “Reserved for Debt Service”. Would this number be a legitimate addback to EBITDA (or cash available for debt service)?  Or in particular, if they municipality has set up a sinking fund for debt service.

A: There may a couple of things to do. First, examine the balance sheet and see if there is sufficient cash or short-term investments to cover the amount labeled as the reserve for debt service.  If the amount has truly been reserved, it should be reflected in the cash account.
 
In addition, run a cash flow using unrestricted donations and contributions - some of which should represent amounts released from restriction for the payment of debt service - and see if the NFP did generate sufficient cash in the last historical period to cover its debt service.
 
You could run the numbers forward to project cash available to service debt.  In doing so, you would need information about the amount of funds that would be released in the coming period for debt service.  If there is no cash on the balance sheet, then there will virtually no cash released - unless some unusual circumstances exist.
 
I don't think I would do anything with addbacks or with adjustments to EBITDA.  It all truly comes out in a cash flow statement.

Questions and Answers, Fund Accounting II, February 8, 2011

Q: In California, are municipal workers required to join a union that represents the city?

A: It depends on the contract with the city that will spell out those jobs included and those excluded from public service union jurisdiction. It would be prudent to check with any municipal borrower as to the extent of union membership within their jurisdiction.

Q: How can depreciation be "unallocated"?
 
A; Depreciation could be unallocated between different departments that share fixed assets.  It is also possible that a municipality didn't know how to allocate a block of depreciation between government activities so did not do so.

As an example, depreciation is not required to be included in the direct expenses of the various functions but may be reflected as a separate line captioned "unallocated depreciation" in the Statement of Activities or as part of the general government function. If an entity chooses to use a separate line in the Statement of Activities to report unallocated depreciation expense, it should clearly indicate in the footnotes to the financial statements that this line item does not include direct depreciation expenses of the other functions. Because school buildings often serve multiple functions, many school districts are reporting the depreciation as "unallocated depreciation" for these assets.

Q: What is the difference between an incorporated and an unincorporated municipality?

A: An unincorporated area is a region of land that is not a part of any municipality or legal jurisdiction. An unincorporated community is usually not subject to, or taxed by, a municipal government.  Such regions are usually administered by default as a part of larger administrative divisions, such as a country. On occasion, a municipality may un-incorporate itself if it becomes fiscally insolvent Cabazon, California, for example, did so in 1972.

Q: Where is depreciation expense?

A: Depreciation expense is buried in the general expense categories.  Consequently, it is usually necessary to refer to the notes to the financial statements to identify depreciation expense for Governmental Funds.  For Proprietary Funds and Fiduciary Funds, depreciation expense may be found in the Statement of Cash Flows, if they are provided.

Q: On slide #49, what makes up the $1,080,960 in net revenues?

A: Note 4F lists both the Wastewater and Water Enterprises net revenues. The $1,080,960 is the sum of net revenues of $772,492 for the Water Enterprise and $308,468 in net revenue for the Wastewater Enterprise.  Note, however, that the accountants, and the City of Calistoga, do not precisely define “net revenue”.

Q: Do you know what happened to transient occupancy taxes for 2009 for the City of Calistoga?

A: The transient occupancy taxes for 2009 were approximately $3.2 million, which is down slightly from 2008 transient occupancy taxes of roughly $3.4 million, yet considerably higher than transient occupancy taxes in 2007 of $2.5 million.

Although the city of Calistoga attracts a somewhat upscale client base, at the time a loan decision needs to be made, the financial information will be dated. Therefore, because of the city’s heavy reliance on the transient tax, a worthwhile discussion to have with city officials would be the trend and sustainability of that tax source.

Questions and Answers – Fund Accounting I (January 13, 2011)

Q: How are Fiduciary Funds paid?
A: The short answer is that the funds are paid in accordance with a trust agreement or fudiciary agreement between the trustee and the beneficiary.

Q: Can you please explain why there are capital assets not depreciated?
A: Fund accounting treats capital assets as an expense. Accrual accounting puts capital assets on the balance sheet and depreciates them over the useful life.

Q: Why is there a 60 day window for Fund Accounting?
A: 60 days, perhaps even 90 days, is a standard way of thinking about near-cash, i.e., the receivable will be converted to cash within 60 or 90 days or an accrued expense will be paid out in cash in 60 to 90 days. A footnote might give the definition of "near-cash".

Q: Which statement to you typically prepare first?
A: It depends on the entity. Those that use fund accounting work against a fund accounting budget and those that use business-type budget and accounting would use standard accrual accounting. The enterprise wide statements would be the final roll-up statements.

Q: Is a reconciliation statement prepared as part of the standard statements?
A: There are reconciliation statements but they can be very difficult to understand. See page 27 in the West Linn financial statements.

Q: When calculating the debt service, do I use the entire amount of Net Revenue or is there any amount that needs to be deducted (or added) from the Net Revenue?  The positive net revenue increases the net asset but some of it might be reserved for restricted funds and not available for the debt service. 

A:  A standard debt service coverage definition is as follows:

(Net Income + Non-Cash Charges + Interest Expense – Distributions – Loans to Owners)
————————————————————————————————————
(Interest Expense + Scheduled Debt Repayment)

In this instance, there are no distributions or loans to owners.  Further net income becomes net revenue for the business enterprise or the fund where net revenue is operating revenues and other income sources less operating expenses, which exclude depreciation, debt service, and capital spending.  The standard definition, therefore, reduces to the following:

(Net Revenue + Interest Expense)
————————————————————
(Interest Expense + Scheduled Debt Repayment)

An option is to simply relate net revenue to debt service, which is the definition used by the bond rating agencies.

(Net Revenue)
————————————————————
(Interest Expense + Scheduled Debt Repayment)

In either instance, a critical issue is that of setting the required coverage or risk factor, such as 1.25 or 1.50.  The coverage ratio should properly reflect an assessment of the net revenue’s volatility.  If net revenue were perfectly predictable based on historical performance, we could live with a very low risk factor and coverage ratio.  If it were highly unpredictable, then the risk factor and coverage ratio would increase accordingly.

Further, if you are aware (by reference to the notes to the financial statements or discussions with a particular municipal's officials) of any portion on net revenue not eligible for debt service payments, you should eliminate that amount from you calculation.

There is an important point to keep in mind about debt service coverage for loans to governmental enterprises.  The task is to determine your estimate of the least likely net revenue for the borrower and then assure debt service on your loan does not surpass that amount.  This means, in effect, that the lender must decide the maximum it will lend to a governmental enterprise based on the lender’s estimate of the least likely amount of net revenue available to service the interest-bearing debt.

For example, if average net revenue were $200,000 but the lender estimated that net revenue could fall as low as $160,000, then the lender could establish debt service coverage at 1.25.  That is ($200,000) / (1.25) = $160,000.  Further, the loan amount would then be set so that the debt service on the loan would not exceed $160,000.

There can be great difficulties in attempting to impose debt service coverage on a governmental enterprise that cannot be substantiated by historical performance.  For one thing, it is always unclear if private sector lenders have any sustainable claim on public assets in the event of default and in the event of litigation.  Many legal jurisdictions prohibit private lenders from attaching public assets.  Therefore, it may be wisest to consider all loans to governmental enterprises to be cash flow loans with no supporting collateral.  A lender does not necessarily want a public lawsuit with a cash-strapped municipality or governmental enterprise.

Questions and Answers – Fund Accounting I (September 14, 2010)

Q: How does fund accounting help manage the "business," or is it not designed to?

A: Fund accounting does help manage a “business” because it keeps track of revenues and expenses on a virtual cash basis.  At the end of the day, it is very easy to determine if cash revenues exceed cash expenses and, if not, why not.  In addition, it is fairly easy to reformat a fund accounting income statement to approximate a Uniform Credit Analysis (UCA) cash flow statement. 

Recall in the webcast that we did so by first removing all capital expenditures and debt repayments from the amount of cash or near-cash expenses to arrive at cash operating expenses.  We deducted that amount from cash or near-cash revenue to provide us with Net Cash Income of $3,583,131 (Slide 65).  We then reduced Net Cash Income by scheduled debt repayment of $670,000 to arrive at Cash after Debt Repayment of $2,913,131.  From that amount we deducted capital spending in the amount of $3,235,403 to arrive at a financing requirement of $322,272.  The financing requirement matched the Net Change in Fund Balance from the fund accounting income statement. 

As a result of the reformatting, we clearly see that West Linn was able to properly service its debt from internal cash flow in 2008.  Its small financing requirement was explained entirely by its 2008 capital expenditures that exceeded cash available by $322,272.  Keep in mind, too, that the “business” in this instance is all of the funds, excluding any of the business-type activities.

To reformat the fund accounting income statement, we did need additional information about 2008 capital spending, which was available in the capital assets footnote on page 50 of the comprehensive annual financial report.

As useful as fund accounting statements are to managing a “business”, we also need the accrual financial statements.  We need those statements to understand and identify all capital assets and all non-current liabilities, particularly long-term debt obligations and long-term pension and retirement obligations.  For example, without the accrual financial statements, we could not compute a leverage ratio, which is a critical risk indicator for any type of business operation – public or private.

Q: You mentioned that deferred revenue is not converted to cash immediately, but it is, at times, included on fund accounting balance sheet?

A: On page 32 in the West Linn comprehensive annual financial report, there is a statement to the effect that “…a deferred revenue account arises on the balance sheets of the governmental funds when potential revenue does not meet both the measurable and available criteria for recognition in the current period.  This unavailable deferred revenue consists primarily of uncollected property taxes not deemed available to finance operations in the current period…”   In other words, the city and its accountants have determined that an amount of property taxes due and payable will not be collected in time to help finance operations in 2008 in this instance.  As a result, the city records property taxes receivable on the asset side of its balance sheet with an offsetting entry to deferred revenue on the liability side of its balance sheet.  When it finally does collect the property taxes due, it will decrease the deferred revenue account and classified the cash inflow as revenue for the period.

Q: If "Depreciation Expense" is not included on the Statement of Activities, is it accurate to pull it from the Fund Statements and add into the Statement of Activities in order to arrive at an accurate EBITDA?

A: Depreciation expense is not included on the Statement of Revenues, Expenditures, and Changes in Fund Balance for Governmental Funds because that statement is prepared on a modified accrual (or fund accounting) basis, and, as such, the only transactions that are recorded are those that convert to cash in the very near future.

Depreciation expense is included on the Statement of Activities for Enterprise-Wide activities because that statement is prepared on an accrual basis; however, it may be necessary to review the notes to the financial statements to get the actual depreciation expense if the Statement of Activities does not include expense detail.

EBITDA would be a useful measure if we wished to track its movement from period to period to determine if the fund or funds were becoming more or less “profitable”.  We have the information to do so from the fund accounting financial statements, since the fund accounting income statement includes cash and near-cash revenues and cash and near-cash expenses.  However, we need to remove all interest expenses, debt repayments, and capital spending from the near-cash expenses to arrive at cash operating expenses.  We approached that number in reformatting the fund accounting income statement to reflect the Uniform Credit Analysis (UCA) cash flow statement that was illustrated on Slide 65 in the presentation.  The cash operating expenses on that slide were $15,483,275.  The amount included $626,604 of interest expense as the funds accounting income statement illustrated.  Therefore, cash operating expenses excluding interest expense, income taxes, depreciation and amortization in 2008 for West Linn’s governmental funds was $15,483,275 – $626,604 = $14,856,671.  Since cash and near-cash revenues were $19,066,406, EBITDA for governmental funds in 2008 was $4,209,735. 

Keep in mind that we need no longer use EBITDA as a proxy for cash flow with government enterprises for two reasons.  First, we get a statement of cash flow for the comprehensive enterprise.  Second, we get a near-cash income statement for government funds that can be readily reformatted into a UCA cash flow statement.

Q:  What definition would you recommend for a debt service coverage covenant for LTD?   You answered a question at the end of your presentation that somewhat touched on this.   Could you give me a detailed definition, using the specific “terms” in the various statements that you covered today? 
 
A: A standard debt service coverage definition is as follows:

(Net Income + Non-Cash Charges + Interest Expense – Distributions – Loans to Owners)
————————————————————————————————————
(Interest Expense + Scheduled Debt Repayment)

In this instance, there are no distributions or loans to owners.  Further net income becomes net revenue for the business enterprise or the fund where net revenue is operating revenues and other income sources less operating expenses, which exclude depreciation, debt service, and capital spending.  The standard definition, therefore, reduces to the following:

           (Net Revenue + Interest Expense)
————————————————————
 (Interest Expense + Scheduled Debt Repayment)

An option is to simply relate net revenue to debt service, which is the definition used by the bond rating agencies.

                           (Net Revenue)
————————————————————
 (Interest Expense + Scheduled Debt Repayment)

In either instance, a critical issue is that of setting the required coverage or risk factor, such as 1.25 or 1.50.  The coverage ratio should properly reflect an assessment of the net revenue’s volatility.  If net revenue were perfectly predictable based on historical performance, we could live with a very low risk factor and coverage ratio.  If it were highly unpredictable, then the risk factor and coverage ratio would increase accordingly.

There is an important point to keep in mind about debt service coverage for loans to governmental enterprises.  The task is to determine your estimate of the least likely net revenue for the borrower and then assure debt service on your loan does not surpass that amount.  This means, in effect, that the lender most decide the maximum it will lend to a governmental enterprise based on the lender’s estimate of the least likely amount of net revenue available to service the interest-bearing debt.

For example, if average net revenue were $200,000 but the lender estimated that net revenue could fall as low as $160,000, then the lender could establish debt service coverage at 1.25.  That is ($200,000) / (1.25) = $160,000.  Further, the loan amount would then be set so that the debt service on the loan would not exceed $160,000.

There can be great difficulties in attempting to impose debt service coverage on a governmental enterprise that cannot be substantiated by historical performance.  For one thing, it is always unclear if private sector lenders have any sustainable claim on public assets in the event of default and in the event of litigation.  Many legal jurisdictions prohibit private lenders from attaching public assets.  Therefore, it may be wisest to consider all loans to governmental enterprises to be cash flow loans with no supporting collateral.  A lender does not necessarily want a public lawsuit with a cash-strapped municipality or governmental enterprise.

With respect to examples of debt service coverage requirements and specific terms, we will review these issues in more detail in the Fund Accounting II webcast.  In that webcast, we focus specifically on private lenders’ terms and conditions captured in the footnotes of the comprehensive annual financial statements for West Linn, Oregon and Calistoga, California.

Q: Why are there two types of accounting systems?  Why not consolidate financial reporting for municipalities into a single system? In other words, what was the rationale for setting up two systems for municipal reporting?
 
A: This is an excellent question concerning the present rules for Fund Accounting.

As municipal accounting is presently structured, there is a Government-Wide financial statement which is designed to provide readers with a broad overview of the municipal’s finances. These statements include a Statement of Net Assets (balance sheet) as well as a Statement of Activities (income statement) using the accrual basis of accounting.

However, as you point out, there is also a Governmental Funds statement which is created on a modified accrual (fund accounting) basis and therefore focuses on cash or near cash activities.

There is considerable support for moving totally away from fund accounting to accrual accounting, and using accrual accounting for Business-Type entities is a step in that direction. This movement to accrual accounting is a general step in changing municipalities completely from fund accounting to accrual accounting. Time will tell.