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Government and Not-for-Profit Accounting, Binder Ready Version: Concepts and Practices, 7th Edition Class Notes

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    Chapter 1 Chapter 1 The Government and Not - for - Profit Environment In the first session or two, (after addressing course mechanics – the syllabus, policies, etc.) I present the objectives of the course . I note that my priority ranking of the objectives is likely to be close to the reverse of that of the students. I emphasize that the course will, in fact, prepare students for the CPA exam, but that preparation for the CPA exam preparation is not the course’s primary objective. I then ask the students why we have a course in governmental and not - for - profit accounting when we have no such similar courses for other “industries.” Or, to put in another way, why we have two standard boards – one for government; the other for all other types of entities. In the course of the discussion that ensues, I try to key on the point that a central purpose of accounting is to measure entity performance. In the business sector, the objective of the entity is to earn profit; hence the financial statements focus on profit. Governmental and not - for - profit organizations have objectives other than profit; therefore it would be no sense to focus profitability. I start the discussion by asking the students what they did in the morning right after getting up. For example, using the water, dropping of their kid to school, the road they travelled on, the streets etc – it is all public sector and is part of every facet of their life. I also emphasize the importance of the Public Sector (PS) by showing a video from the AGA that states that the PS is 50% of the economy. Additionally, m ost of you (addressing to the students) can expect to have some involvement with government and no t - for - profit entities during your professional careers, either as a Controller/CEO of a governmental/NFP entity, as a n auditor with a public accounting firm or S tate A uditor, or as an accountant or financial manager with such an entity , be on the Board of an NFP or even hold a public office. I try to convince the students that governmental and not - for - profit accounting is far more challenging than business accounting. In governmental and not - for - profit accounting we face all of the same issues as in business accounting (i.e. many governments and not - for - profits engage in business - type activities), plus many more. Examples:  We have first to determine the objectives of the entity, then measure how well they have been achieved (I engage in a brief discussion of what are the objectives of organizations with which they are familiar, such as a police department or a university).  In making capital budgeting decisions in business, we typically compare costs with benefits – i.e. cash inflows with cash outflows. In not - for - profit organizations the benefits are not easily defined, let alone measured (e.g. what is the benefit of a new fire station?; what is the value of the lives that might be saved?).

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    Comments Page 2 Chapter 1  In assessing the fiscal strength of a business, we focus mainly on the net assets (both tangible and intangible) of the business itself. By contrast, the fiscal strength of a government cannot be assessed by measuring only (or evenly mainly) its own assets. Instead, we must take into account the resources of its jurisdiction – those that it can draw upon if and when needed. These include the assets of its businesses and residents. Thus, we must perform a comprehensive economic analysis. At the same time we must consider the demands that the citizenry will make upon the government. Hence we must also evaluate a variety of demographic, political and social factors. To both emphasize the latter point and to try to put into perspective the role of accounting and financial reporting, I review the file, “A City’s Fiscal Status; A Strategic Analysis.” I ask the students to identify the characteristics that distinguish governments from businesses and use the GASB’s statement of objectives (see computer file) to assure that we identify all the major differences. I then try to show that at least some of these characteristics also apply to not - for - profits. I then ask the students the purpose of a statement of objectives and review the GASB’s objectives. I focus on the first objective (“Should assist in fulfilling government's duty to be publicly accountable and should enable users to assess that accountability”). I ask the students whether they think this objective, including its three sub - objectives, are reasonable. They almost always agree that they are. I then present them with the problem (see computer file “What Number do You Have in Mind?” I call on a student to prepare a statement of activities consistent with the first two sub - objectives (interperiod equity and budgetary compliance). The question arises as to whether the cost of the vehicles should be expensed in the year of acquisition (i.e. consistent with the budgetary compliance objective) or the years of use (consistent with the interperiod equity objective) I assert that this conflict underlies much of the difficulty that the GASB has faced in establishing accounting principles and is the reason why GASB Statement requires, in effect, two sets of financial statements.

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    Chapter 2 Chapter 2 Fund Accounting I begin this chapter by defining a fund and emphasizing that each fund is a separate accounting and fiscal entity that can be defined by the fundamental accounting equation (assets = liabilities + “owners’” equity. Accordingly, I note, the resources and activities of a fund can be described by the same basic statements as those of a business (i.e. a balance sheet, an “income” statement and a statement of cash flows.) I note, however, that the GASB has now distinguished between assets and deferred outflows and between liabilities and deferred inflows. Hence, the basic accounting equation for a government is now: Assets + deferred outflows = liabilities + deferred inflows + fund balance (or net assets) I then discuss the reasons for fund accounting, stressing that it is mainly a control device to assure that governments and not - for - profits comply with restrictions as to the purposes for which resources can be used. I contend that there is nothing inherent in governments or not - for - profits that necessitates fund accounting. I spend the majority of a session reviewing the basic financial statements (government - wide and funds) and the fund structure of a government. I recommend basing the session on the statements of your own city or some other city with which your students can identify (and which can be downloaded from the internet). I then discuss the meaning of “measurement focus and basis of accounting.” I ask the students to take particular note of the types of assets and liabilities in each of the fund types and on the basis of these assets and liabilities to determine the measurement focus and basis of accounting of the various governmental funds. It quickly becomes clear that since the governmental funds include assets other than cash, they cannot possibly be accounted for on a cash basis. But in asmuch as they exclude capital assets (such police cars, buildings, equipment, etc.), they also cannot be accounted for on a full accrual basis. This discussion leads to an explanation of the need for some sort of off the balance sheet records keep track of assets and liabilities that otherwise would be written - off at time of acquisition. Because the form and content of the government - wide balance sheet is similar to that of a business, I spend relatively little time on it. I spend approximately 20 minutes discussing the form and content of the government - wide statement of activities. I try to emphasize that, although it may be in an unfamiliar form, it makes intuitive sense – that is, in the upper portion of the statement we determine the amount that has to be covered by general revenues; in the lower portion we identify those revenues. I go to great lengths to emphasize that the fund structure of a government or not - for - profit is almost never coincident with its organizational structure. Funds are established to account for resources that are restricted for specific purposes, not for organizational units. Hence, the general (or operating) fund, accounts for the majority of transactions engaged in by a government’s operating departments.

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    Comments Page 2 Chapter 2 I then attempt to get the students to understand the relationship between funds. I go over a series of transactions, a couple of which involve two or more funds (See files “Relationships Among Funds”). To emphasize that each fund is an independent accounting and fiscal entity, I assign each fund to a specific student. As I go over each transaction I ask the class to identify the one or more students who are accountable for recording the transaction. Although I focus on the fund statements (and thus on the modified accrual basis), I ask the students for the entries that would be made to reflect the transactions on a full accrual basis. I conclude the sessions on Chapter 2 with a discussion of the reporting requirements per GASB Statement No. 54, Fund Balance Reporting and Governmental Fund Type Definitions .

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    Chapter 3 Chapter 3 Issues of Budgeting and Control I introduce this chapter by telling (somewhat facetiously) the students that much of the material dealt with in this chapter – specifically, that dealing with budgetary entries and encumbrances – is the least important in the text. That is because budgeting entries have no effect on the financial statements and encumbrances have but a minor effect. Nevertheless, both budgetary entries and encumbrances are significant in that they are important control mechanisms. Indeed, insofar as the students work f or government or not - for - profit entities budgetary entries and encumbrances may someday enable them to avoid the consequences, such as embarrassment or even jail tim e (a bit of hyperbole, perhaps) by preventing them from overspending their budgets. Further, the chapter may be of more immediate interest to them in that budgetary entries and encumbrances are given prominent attention on the CPA exam. I begin the substantive portion of the discussion by displaying a budget to actual comparison of a local government. I emphasize the difference between the original budget and the amended budget and point out the reporting objectives (legal compliance; managerial efficiency) that are served by requiring both to be presented. I also point out the key potential differences between legally adopted budgets and GAAP - based financial statements (i.e., basis, timing, perspective and reporting entity). To cover budgetary entries, I go over the transactions on the computer file “Budgetary Entries.” I stress that since the budgetary entries are reversed at year - end, the effect is the same as if the entries had never been made. I also point out that many governments debit or credit the initial budgetary entries to “budgetary fund balance” so as not to contam inate the “true” fund balance (an approach that I personally prefer). To cover the encumbrance entries, I go over the transactions on the computer file, “Encumbrances and Expenditures.” These transactions, along with the resultant end of year financial statements, make the encumbrance process intuitively appealing. As the result of the process, the government, in the first year, orders $6,000 of goods and services but receives and uses $5,000. Accordingly, it charges $5,000 in expenditures but reserves $1,000 of fund balance to accommodate the goods still on order. In the second year, the government receives and uses the remaining goods and services. Although it estimated that the cost would $1,000, it is, in fact, only $950. Hence it charges only $950 in expenditures. Since the $50 balance in the reserve for encumbrances account is no longer required, it is restored to unreserved fund balance. Per the entries (and this point is the most difficult for students to grasp), the net amount of $50 that is restored consists of $1,000 that is added back to unreserved fund balance (the first entry of the second year) and $950 that is deducted (charged as the expenditure).

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    Chapter 4 Chapter 4 Recognizing Revenue in Governmental Funds I begin the discussion of revenue recognition by explaining the relationship between measurement focus and basis of accounting. I note that we can focus on anywhere from a single asset (e.g. cash) to a wide range of assets (e.g. all economic resources). The range of assets that we choose to focus on automatically establishes the basis of accounting. If we focus on cash, we will use a cash basis of accounting; if on all economic resources then we will be on a full accrual basis. If we focus on a limited range of net assets (e.g. current financial resources) then we will be on a basis of accounting in between the cash and full accrual (i.e. a modified accrual basis of accounting). Citing and quoting from Section 1600 of the GASB Codification, I describe and justify the measurement focus and basis of accounting as established by the NCGA and adopted by the GASB and which underlies the fund statements. I then explain what is meant by “measurable and available.” I review briefly the basic provisions of GASB Statement No. 33 using the Power Point presentation which is included with the files for Chapter 4. I do not spend an inordinate amount of time on this presentation as I have found that the students benefit far more from discussions of actual revenue recognition issues. Therefore, I center most of the time allocated to revenue recognition on the transparency, “Issues Relating to Revenues.” I am able to generate considerable discussion as to when each of the revenues in question should be recognized. For each I raise the question of what constitutes the significant event in the “earning” process, and when the resources to be received are available for expenditure. I try to show that there is often a conflict between when the government has “earned” its revenues and when it can first spend them. I compare how each transaction would be recognized in both the fund and the government - wide statements. While going over the transactions, I discuss GASB Statements No. 63 and 65, both of which pertain to deferred inflows and outflows. I conclude the sessions on revenue recognition with a discussion of investment gains and losses – in essence GASB Statement No. 31, Accounting and Financial Reporting for Certain Investments and for External Investment Pools, which mandates that investments be “marked to market.” I use the Excel file “Investment Example” to illustrate how period gains and losses can be readily computed (i.e., by subtracting the “inputs” from the “outputs.” I usually have no difficulty convincing students as to the virtue s of recognizing unrealized gains and losses on equity securities inasmuch as they are generally familiar with the corresponding FASB requirements. Far more challenging is justifying the need to do the same for held - to - maturity bonds. I focus mainly on the opportunity costs that a government incurs when it locks into a long - term investment only to see prevailing interest rates rise and, as a result, the market value of investment fall. I also, however, emphasize the negative consequences of marking long - term bonds to market. The main problem, I note, is that it causes a disconnect between budgeting

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    Comments Page 2 Chapter 4 and financial reporting in that the reported gains and losses have no impact on cash flows. Thus governments may have to report surpluses or deficits when for budgeting purposes none exist.

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    Chapter 5 Chapter 5 Recognizing Expenditures in Governmental Funds I begin the discussion of expenditures by noting that GASB Statement No. 33 (which formed the basis of our sessions on revenues) applies to expenditures as well as revenues. However, it does not apply to nonexchange transactions and that most (albeit not all) expenditures of governments are exchange transactions. I then attempt to justify the modified accrual basis of accounting for expenditures by emphasizing the need, per a key GASB objective, to relate financial reporting to budgeting. But I remind the students of the conflict, discussed the first week of class, between this objective and the need to report on the extent to which interperiod equity was achieved. Hence the need for two sets of financial statements – fund and government - wide. I also remind the students that the principles to be addressed are applicable to all governmental funds, not just the general fund. I then turn to the file, “GASB 33 Expenditures.” In addressing the first transaction – that pertaining to wages and related benefits, I note that many governments (including major states) have moved employee paydays from the last day of the month to the first of the following month. This maneuver allows them to shift budgetary expenditures from one fiscal year to the next. However, it would have had no impact on reported expenditures. In discussing the fifth and sixth transactions – those dealing with installment purchases and capital leases – I point out that as a consequence of accepted practice, the cost of an asset may be recognized as an expenditure twice – once when the asset is acquired (and the note or lease is signed) and again as the note or lease payments are made. Of course, fund balance is reduced only once, since the initial charge is offset by a credit, “other financing sources.” Students generally have difficulty accepting the standards prohibiting the accrual of interest on long - term debt (transaction #7) in fund statements. I justify the standards by explaining that interest is often a major cost of government. If interest had to be accrued, but was not budgeted as an expenditure (and the cost not covered by taxes) until it had to be paid, then governments would often have to report deficits. Of course, the adverse consequences of this standard are most evident when governments issue zero coupon bonds (transaction #15) and report no expenditures until the bonds mature. Students almost always question why sick leave is not accrued (transaction #11) unless it is to be paid as a termination benefit. I explain the underlying rationale – that illnesses (unlike vacations) are within the control of neither employer nor employee. Further, the accounting for sick leave is comparable to that for businesses (see FASB Statement No. 43). I then raise the question of how payments for other types of leaves should be accounted for – e.g. two - week military reserve duty, jury duty, and maternity leave.

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    Comments Page 2 Chapter 5 As I did with revenues, I prefer to discuss the impact of the transactions on the government - wide statements concurrently with that on the fund statements. The main differences, of course, are that both long - term assets and liabilities are recognized in the government - wide statements and hence the related expenses are recognized as they have their main economic impact. Moreover, consistent with the full accrual basis, inventory and prepayments would be accounted for on a consumption rather than a purchases basis. Transactions #16, #17 and #18, pertain to grants. Unlike the other transactions, these are nonexchange transactions and are governed by GASB Statement No. 33.

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