Chapter

7
Accounting for the Business-Type
Activities of State and Local
Governments

McGraw-Hill © 2007 The McGraw-Hill Companies, Inc. All rights reserved.

 Learning Objectives

After reading this chapter, you should be able to:

 Distinguish between the purposes of internal service
funds and enterprise funds.
`
 Describe the characteristics of proprietary funds,
including those unique to internal service and
enterprise funds.

7-2
 Learning Objectives (Cont’d)

 Explain the financial reporting requirements,

including the differences in reporting of internal
service and enterprise funds in the government-wide
and fund financial statements.
 Describe accounting procedures and prepare journal
entries and financial statements for an internal
service fund.
 Describe accounting procedures and prepare journal
entries and financial statements for an enterprise fund.

7-3
 Proprietary Funds

 Reasons for use

 Enhances management of activities in which goods
or services are provided on a cost-reimbursement
basis to departments of the same government or to
the general public on a user charge basis
 To compare benefits and costs
of the business-type activities of a
government

7-4
 Proprietary Funds
Accounting Equation

Assets - Liabilities = Net Assets

Unrestricted Restricted Invested in

(e.g., for payment of Capital Assets,
debt service) Net of Related
Debt

7-5
 Proprietary Funds—
Accounting Characteristics
 Full accrual basis
 Capital assets and long-term liabilities recorded
within the funds
 Flexible rather than fixed budgets recommended;
generally budgetary accounts are not integrated
into the general ledger
 Depreciation expense and accumulated
depreciation are recorded and reported
 For accounting guidance look to accounting
procedures used by similar type private enterprises

7-6
 Proprietary Funds—
Required Financial Statements
 Similar to those of a
for-profit entity:
 Statement of Net
Assets (or Balance
Sheet)
 Statement of
Revenues, Expenses,
and Changes in Fund
Net Assets
 Statement of Cash
Flows (differs under
GASB)

7-7
 Proprietary Funds—
Statement of Net Assets
 A classified statement is prepared, with current assets
shown in the order of liquidity
 Net assets are divided into three categories
 Invested in capital assets, net of related debt—
calculated as the value of net capital assets less any
outstanding debt related to capital asset acquisition or
construction
 Restricted—restrictions are placed on asset use by
external parties through contracts, legal requirements or
donor stipulation
 Unrestricted—the residual after adjusting for the prior
two net asset categories
7-8
 Proprietary Funds—
Operating Statement
 GASB requires that revenues and expenses be
identified as operating or non-operating

 Operating activities relate to the primary functions of

the proprietary fund

 Separate subtotals are to be provided for operating

information

7-9
 Proprietary Funds—
Statement of Cash Flows
 Similarities between GASB and FASB standards:
 Cash flows statement shows cash inflows/outflows
relating to operating, financing, and investing
activities

 Both sets of standards define cash flows as cash

and cash equivalents (i.e., time deposits,
marketable securities, and other items readily
convertible to cash)

7-10
 Proprietary Funds—
Statement of Cash Flows (cont’d)
 Differences between GASB and FASB standards:
 GASB cash flow statement divides financing activities
into noncapital, and capital and related financing
 Acquisition of capital assets is a capital and related
financing transaction under GASB rather than an
investing activity.
 Interest expense on long-term debt is a capital and
related financing activity under GASB rather than an
operating activity
 Cash flows from operating activities must be shown
using the direct method.
7-11
 Internal Service Funds

 Used
 When authorized by legislative approval
 To account for provision of goods and services to
departments of the same government—generally on
a cost reimbursement basis
 Improve management of common resources by
placing them under centralized management and
control

7-12
Common Types of Internal Service Funds

 Motor pools
 Central purchasing
 Storage
 Issuance of supplies
 Self-insurance pools
 Central data processing
 Printing

7-13
 Internal Service Funds—
Pricing Policies
 Pricing is set by local management or by
legislative policy

 Pricing objectives vary; full cost recovery (direct

and indirect), direct cost recovery, or whatever
management desires

Because legislative bodies do not want purchasing to

occur outside the budget, the bodies are sometimes
reluctant to establish internal service funds
Q: Is the legislative concern justified?

7-14
 Internal Service Funds—
Pricing Policies (cont’d)
Q/A: Is the legislative concern justified?
 Even if an internal service find is created for central
purchasing and sales of supplies, the legislative
body maintains budgetary control over the
expenditures made by most departments and
programs via the General Fund and special revenue
funds’ budgets.

 See and discuss Illustration 7-1

7-15
 Internal Service Funds—
Accounting Procedures

 Generally, use the same accounting procedures

that a similar for-profit entity would use. (Review
illustrative transactions in the text for a supply fund
and compare to business accounting)
 Billings to Departments is a revenue account,
similar to Sales in a for-profit entity
 Revenues and expenses are closed at year-end to
Excess of Net Billings to Departments over Costs
(or Excess of Costs over Net Billings to
Departments) rather than to Income Summary

7-16
 Internal Service Funds—
Financial Statements
 Other than slight differences in terminology, the
fund financial statements are essentially the same
as those of a comparable for-profit entity.
 Statement of Net Assets (see Ill. 7-2)
 Statement of Revenues, Expenses, and Changes in
Fund Net Assets (see Ill. 7-3)
 Statement of Cash Flows (see Ill. 7-4)

7-17
 Internal Service Funds—
External Reporting
 Internal service funds are aggregated and reported in
a separate column in the proprietary fund financial
statements (see Ill. 1-10 through 1-12)—internal
service funds are never considered major funds

 In the government-wide financial statements, internal

service funds are reported as a part of the
governmental activities column—interfund activity
between internal service funds and governmental
funds must be eliminated

7-18
 Internal Service Fund—
Risk Management

If a government uses an internal service fund (ISF)

for a risk management (self-insurance) pool:

 The ISF should recognize claims expense and a

related liability when:
 it is probable that an asset has been impaired or a
liability has been incurred and the amount is
reasonably estimable, or
 if an estimable loss has been incurred and it is
probable that a claim will be asserted
 Disclose other loss contingencies in the notes.

7-19
 Internal Service Fund—
Dissolving a Fund
 Transfer ISF's assets to another fund which will
continue the activity

 Terminate activity and distribute assets in-kind

to another fund or funds

 Convert ISF's assets to cash and distribute

cash to another fund or funds

7-20
 Enterprise Funds

 Reasons for use:

 GASBS 34 requires
 To account for services provided to the general
public on a user charge basis
 When the governing body has determined that
periodic determination of revenues earned,
expenses incurred, and/or net income is
appropriate for capital maintenance, public policy,
management control, accountability, or other
purposes

7-21
 Common Types of Enterprise Funds

 Water and sewer

 Gas and electric utilities

 Transportation systems

 Airports

 Ports

 Toll roads and bridges

 Parking garages and lots

 Golf courses

 Hospitals

 Liquor stores

7-22
 Enterprise Funds

 GASB requires use of an enterprise fund if the

following criteria are met:
 An activity is financed with debt that is secured solely
with revenues from the activity

 Law or regulation requires that the costs of the activity,

including capital costs, be recovered with revenue from
the activity, rather than taxes or other revenues.

7-23
 Enterprise Funds—
Accounting Procedures
 GASB standards provide guidance on business-type
activities.
 However, GASB also requires that proprietary funds
follow pronouncements of the FASB and its
predecessors issued before November 30, 1989,
unless they conflict with a GASB standard
 Additionally, enterprise funds may opt to follow all
FASB and predecessor standards that pertain to
businesses, both those issued before and after
November 30, 1989, unless the standard conflicts
with a GASB standard

7-24
 Enterprise Funds—
Restricted Assets

 Assets whose use is restricted by contractual

agreements or legal requirements
 Typical examples:
Customer deposits of utilities, assets set aside for
repayment of revenue bond principal, reserves for
maintenance of plant, and funding of depreciation
 Ideally, but not required by GAAP, liabilities to be
paid from restricted assets should be reported
separately from liabilities to be paid from
unrestricted assets.
7-25
 Enterprise Funds—
Restricted Assets (cont’d)
Liabilities Payable
from Restricted Assets
Restricted Assets = + Net Assets, Restricted
for payment of debt
service
From Illustration
7-5
$562,600 = $23,700 + $538,900

7-26
 Enterprise Funds—
Utility Plant—Construction in Progress

Q: Should interest incurred on debt during

construction be capitalized?

A: Yes. Notice that this policy differs from

the interest capitalization policy for self-
constructed general capital assets.

7-27
 Enterprise Funds—Utility Plant—
Construction in Progress (cont’d)

Q: Should an imputed amount equivalent to

interest be capitalized if a utility’s own funds
are used for construction?

A: Capitalizing an “equity” component of

Allowance for Funds Used During
Construction (AFUDC) is permitted both by
utility regulators and the FASB

7-28
 Enterprise Funds—
Special Current Liabilities
In addition to the usual Accounts Payable and Accrued
Expenses, use two special current liability accounts:
 Customers Advances for Construction
 Usually up-front deposits required to be made by builders
to provide all or part of the cost of connecting new
structures to utility lines
 May or may not be refunded in part upon completion
 Customer Deposits
 Usually reported under the caption “Liabilities Payable
from Restricted Assets”
 Even if not refundable until service is terminated, AICPA
guidance defines this as a current liability

7-29
 Enterprise Funds—
Long-term Liabilities
 Bonds or other debt that will be repaid from
proprietary fund resources are reported as long-
term debt of the fund.
 Bonds whose interest and principal are to be
repaid from the revenues of a proprietary fund are
called “revenue bonds”
 If bonds primarily or secondarily have general
obligation backing, but are being serviced by a
proprietary fund, they are treated as revenue
bonds. The general obligation contingency is
disclosed in the notes to the financial statements.

7-30
 Enterprise Funds—
Illustrative Transactions
 As indicated previously, there are many types of
enterprise funds, thus accounting procedures will
vary greatly
 Illustrative transactions and related financial
statements for a Water Utility Fund are illustrated
in the textbook (review and discuss)
 Generally, uses the same account titles as those
recommended by the utility regulatory body
 Accounting is essentially business accounting.
Note, however, the capitalization of AFUDC (Entry
9) and entries to restricted assets (Entries 11,12,
13, and 18)
7-31
 Enterprise Funds—
Regulatory Accounting Principles (RAP)
 In a few states, municipally-owned utilities are
subject to rate regulation by a state regulatory
agency, which also regulates investor-owned
utilities that operate in the state.
 Those states may require government-owned
utilities to follow the regulatory accounting
principles specified by organizations such NARUC
and FERC.
 If so, financial statements may appear quite
different from those shown in Ill. 7-6 through 7-8.
7-32
 Enterprise Funds—
RAP (Cont’d)
 Financial statement differences
 Plant assets and long-term liabilities are often
reported above current assets and current liabilities,
respectively

 Plant assets may be reported at depreciated original

cost. Subsequent transfers of ownership require new
owners to report assets at depreciated original cost;
any excess of purchase price above the net book
value of the assets on the old owner's books is
reported as "Utility Plant Acquisition Adjustment" in
the new owner’s accounts. Regulators may require
this account to be amortized at a different rate than
used for depreciation.
7-33
 Enterprise Funds—
RAP (Cont’d)
Q: Why are plant assets and long-term debt
reported above current assets and current
liabilities under RAP?

A: This is because in regulated utilities, the

magnitude of plant assets and long-term debt is
great in relation to current assets and liabilities.
Current assets and liabilities tend to be
comparatively immaterial

7-34
 Municipal Solid Waste Landfills
(MSWLF)

 An EPA rule requires all municipal

landfills to meet stringent location, design, and
operating requirements
 Operators must also provide financial
assurance they can properly close landfills
when full and provide post-closure ground water
monitoring for 30 years after closure
 These stringent rules are designed to protect
the environment from irresponsible handling of
hazardous materials
7-35
 Municipal Solid Waste Landfills—
Recognition Requirements
 Estimate the current cost of hiring a qualified third-
party to close the MSWLF and care for it for 30
years after closure
 Recognize a portion of this cost proportionate to
the ratio of estimated capacity utilized during a
year over the total capacity of the landfill as an
expense of the enterprise fund and as a liability
 Annual adjustments are made as estimates
change from year to year. Several required note
disclosures are described in Chapter 7.
7-36
 Enterprise Funds—
Segment Information

 A segment is an identifiable activity or group of

activities within an enterprise fund
 GASB requires segment reporting within an
enterprise fund if the segment
 has one or more bonds or other debt instruments
outstanding, and
 there is a revenue stream pledged to support the
debt
 Condensed financial information must be presented
in the notes to the financial statements
7-37
 Concluding Comments

 Proprietary funds (internal service and enterprise)

are used to account for the business-type activities
of a government
 Accrual accounting is used for proprietary funds
and the required financial statements are quite
similar to those used by for-profit entities
 Internal service funds are reported as
governmental activities on the government-wide
statements
 Regulatory accounting terminology and principles
are used by some government-owned utilities.

END
7-38