Interpreting local government financial statements.(Financial report)

The published financial report of a local government provides a wealth of information to anyone with an interest in the government's economic condition. Taking advantage of this information, however, poses a real challenge to many users of these reports. This chapter aims at helping potential users of local government financial statements to meet this challenge.

PUBLIC SECTOR V. PRIVATE SECTOR

The primary goal of a private-sector business is economic--to make a profit. While local governments also have economic goals, their principal objective is social rather than economic--to provide services to citizens. Stated differently, economic goals in the public sector are a means to an end, rather than an end in themselves. Therefore, the approach taken to interpreting financial statements in the public sector must necessarily differ in important respects from the approach taken in the private sector.

Ratio analysis provides a good illustration of this point. It is common in the private sector to combine various financial statement elements into ratios to serve as a point of reference for analysis. Yet few of the most commonly used private-sector ratios can be applied meaningfully to local governments. A number of them, in fact, cannot even be calculated for a typical local government because they presume the ownership of stock and operations focused on the sales of goods and services to customers.

Consequently, even when local government financial statements most closely resemble those of a private-sector business (e.g., the accrual-based government-wide financial statements), it is not possible simply to apply private-sector analytical techniques. A fundamentally different approach is needed, consistent with the unique objectives and circumstances of local governments.

FOCAL POINTS FOR ANALYSIS

It is common in the private sector to speak of a "bottom line" for evaluating financial performance (i.e., net income). Local government financial statements offer no single measure suitable for this purpose. Instead, users of local government financial statements must assess a local government's financial health from three different perspectives.

* Near-term financing. One particularly pressing concern is a local government's near-term financing situation. Is the government able to meet its short-term financial obligations in a timely manner? Are its operating inflows adequate to cover its operating outflows? Is the government financially prepared for contingencies (e.g., budgetary shortfalls and natural catastrophes)?

* Financial position. It would be shortsighted, of course, to focus exclusively on the near term. An equally important concern is a government's overall financial position as represented by the totality of its assets and liabilities, as well as the difference between them (i.e., net assets). Financial position is an essential point of reference for determining whether a government's overall financial situation is improving or deteriorating.

* Economic condition. Needless to say, a local government's finances do not exist in a vacuum. Inevitably, a government's financial position will be affected by its circumstances (e.g., the vitality and diversification of the local economy, the breadth and depth of the government's tax base). Likewise, a government does not exist in a time warp. Past experience often is vital to predicting future developments (e.g., Have intergovernmental revenues been increasing or decreasing over time? Has the government's population been growing or shrinking?).

Consideration of such factors provides the necessary context for interpreting current-year financial data. When financial statement users consider a local government's financial position in the light of such factors, they are said to be concerned with its economic condition. Viewed another way, economic condition focuses on the likelihood that today's financial position will improve or deteriorate in the future. These three perspectives are summarized in Exhibit 1.

ASSESSING A GOVERNMENT'S NEAR-TERM FINANCING SITUATION

Local governments present both fund financial statements and government-wide financial statements. Fund accounting reflects the fact that local governments segregate their financial resources for specific purposes based on special regulations, restrictions, or limitations. Such restrictions naturally have an important effect on near-term financing. Consequently, assessments of a local government's near-term financing situation tend to focus almost exclusively on the fund financial statements rather than on the government-wide financial statements.

Governmental funds--balance sheet. Not all assets and liabilities are directly relevant to near-term financing. Some assets, for instance, cannot be used to pay bills (e.g., assets used in operations, such as land, buildings, improvements, equipment, and infrastructure). Likewise, some liabilities will not come due in the near future (e.g., long-term debt) and therefore will not require the use of financial resources in the short term. Such assets and liabilities are excluded from governmental funds in accordance with their unique current financial resources measurement focus. Consequently, governmental funds are especially well suited for the purpose of evaluating near-term financing needs.

The difference between a governmental fund's assets and liabilities is described as fund balance. As a practical matter, despite their measurement focus, governmental funds still commonly include certain assets that are not actually available for near-term financing purposes (e.g., supplies inventories, long-term receivables, debt service "reserves"). Accordingly, an equivalent portion of fund balance is reported as reserved fund balance to focus readers' attention on the remaining component of fund balance, which is, in fact, available to meet near-term financing needs: unreserved fund balance. It is important that the amount of unreserved fund balance in a government's chief operating fund (i.e., general fund) be large enough to serve as a cushion against unanticipated budgetary shortfalls, disasters, and other contingencies, thereby mitigating risk and helping to stabilize tax rates.

A point of reference is needed for assessing the adequacy of the level of unreserved fund balance maintained in the general fund. For many, this point of reference is operating revenues (i.e., revenues adjusted to remove the effect of any items that would distort trends). For others, it is operating expenditures. As a rule, the choice between the two will depend on which is considered more predictable in a given government's specific circumstances.

Perhaps the most common question posed in connection with local government financial statements is "How much unreserved fund balance is enough?" Although there is no single right answer to this question, it is possible, nonetheless, to offer some practical guidance. The Government Finance Officers Association (GFOA) has formally recommended that the minimum level of unreserved fund balance in the general fund be no less than five to 15 percent of regular general fund operating revenues, or one to two months of regular general fund operating expenditures, depending upon the point of reference selected. (1)

The guidance just described addresses only the minimum amount of unreserved fund balance that should be maintained in the general fund. Prudent financial management often will suggest that higher than minimum levels be maintained, especially in the case of smaller governments, which may not enjoy the economic depth and revenue diversification of their larger counterparts.

Levels of unreserved fund balance will naturally vary with fluctuations in revenues and expenditures. Furthermore, it is only to be expected that a budgetary cushion will temporarily diminish when the contingencies being planned for actually occur. It would be a mistake, therefore, to place undue emphasis on the level of unreserved fund balance at a single point in time. What really is important is the pattern of unreserved fund balance over time (e.g., 10 years). Is fund balance normally in excess of minimum levels? How rapidly has unreserved fund balance been replenished in the wake of events requiring its use?

Governmental funds--statement of revenues, expenditures and changes in fund balances. The statement of activities for governmental funds is titled the statement of revenues, expenditures, and changes in fund balances. The key item on this statement, from a near-term financing perspective, is the excess of revenues over expenditures.

It is to be expected that revenues of the general fund normally will equal or exceed fund expenditures. What is true in general, however, is not necessarily true of any particular year. Thus, a local government that had revenues in excess of budgetary projections in one year might deliberately choose (or even be required) to reduce its revenues the following year to bring fund balance back to a level consistent with the government's fund balance policy (a practice commonly known as "budgeting fund balance"). Thus, a sound analysis of the excess of revenues over expenditures needs to consider patterns in this amount over time (e.g., 10 years).

Proprietary fund statement of net assets. Proprietary funds, unlike governmental funds, report both capital assets and long-term debt, even though neither is directly relevant to near-term financing. Therefore, the difference between proprietary fund assets and liabilities (described as either net assets or equity) is not equivalent to the fund balance reported in governmental funds.

That is not to say, however, that proprietary funds do not provide information useful for assessing their near-term financing situation. Those funds do, in fact, present their assets and liabilities on a classified basis that distinguishes current assets and current liabilities from noncurrent items in both categories. It is possible to take advantage of this distinction to calculate working capital. Working capital bears important similarities to fund balance, although there also are important differences.

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