As it turns out, this is an important question in governmental accounting. The same transaction can be reported differently by different funds. Which transactions a fund records and when depend on the fund’s operating objective. It all comes down to the measurement focus and basis of accounting (MFBOA) being used.
Governmental funds are used to account for the general activities of the government financed primarily by taxes and grants. Proprietary funds are used to account for the business-type activities financed primarily by user fees. The activities and operating objectives of these two fund categories are different and therefore their reporting objectives are different. The two types of fund categories use different measurement focuses and bases of accounting.
A key to understanding governmental accounting is recognizing that financial statements can measure different things. For example, a cash flow statement will report all transactions that affect cash only. Measurement focus is concerned with what is being measured and reported in the financial statements. The financial statements for governmental and proprietary funds measure two different things.
Governmental funds use a flow of current financial resources measurement focus. The financial statements measure whether financial resources that can be spent in the near future have increased or decreased for the accounting period.
Inflows of current financial resources are reported as revenues or other financing sources and outflows are reported as expenditures or other financing uses. The net change for the year indicates whether inflows of current financial resources were larger than outflows of such resources.
Another way to describe the measurement basis of accounting is by using the accounting equation. The accounting equation for a governmental fund follows:
Current assets + Deferred outflows of resources = Current liabilities + Deferred inflows of resources + Fund balance
There are three major differences between this accounting equation and that used by a business. The first is that the fund balance represents net financial resources that can be spent in the near future. It does not represent the difference between all the economic assets and liabilities of the organization.
The second major difference between the equations is the exclusion of capital assets. What happens when a capital asset is purchased? Cash and fund balance would both decrease (an expenditure would be recorded). There would be no need to record depreciation because the full cost of the assets would have been recorded as an expenditure when it was purchased.
The third major difference between the equations is the absence of long-term debt. Does this mean that governments do not issue long-term debt for governmental activities? No. When a government issues long-term debt for governmental activities, both cash and fund balance would increase (other financing sources would be recorded). The future repayment of the long-term debt would not need to come from current available financial resources but would be repaid from financial resources generated in the future. When debt is repaid from a governmental fund, cash and fund balance would decrease (an expenditure would be recorded).
Does this mean that capital assets and long-term debt are not reported in the financial statements? It depends. Because the governmental funds’ financial statements are reporting the flow of current financial resources, they would not appear there. However, they would appear in the government-wide financial statements. The government-wide financial statements are reporting all economic resources and liabilities of the government.
Proprietary funds use a flow of economic resources measurement focus. The financial statements measure whether the economic resources have increased or decreased for the accounting period. This is the same measurement focus used by business organizations.
Inflows of economic resources are reported as revenues or gains and outflows are reported as expenses or losses. The net change in economic resources for a year is very similar to the net income measurement used in business.
The accounting equation for a proprietary fund follows:
Assets + Deferred outflows of resources − Liabilities – Deferred inflows of resources = Net position
Proprietary funds would account for both current and noncurrent assets and liabilities. For example, capital assets and long-term debt both would be reported as part of these funds.
The following table lists the key differences between governmental and proprietary funds that result from the measurement focus of accounting.
Key differences resulting from the measurement focus of accounting | ||
Item | Fund balance governmental funds | Net position proprietary funds |
Capital assets acquisition | Decrease | No effect |
Depreciation | No effect | Decrease |
Issuance of long-term debt | Increase | No effect |
Payment of long-term debt principal | Decrease | No effect |
Basis of accounting is concerned with when a transaction or event is recognized in the accounting system. For example, a cash basis of accounting would recognize transactions only when they affect cash. The basis of accounting used by governments is directly linked to the measurement focus.
Governmental funds recognize transactions using one basis of accounting; proprietary funds use another.
Governmental funds use the modified accrual basis of accounting. This basis of accounting requires a transaction that affects current financial resources to be measured as a revenue or expenditure. For example, an inflow of current financial resources will be recorded as revenue only if it is received in time to liquidate a current-period liability.
For an item to be measured as revenue it must meet two conditions: it must be measurable and it must be available to meet current obligations. To meet the availability criterion, revenue must be collected during the year or soon enough after year-end to pay liabilities of the current period.
Expenditures are recorded when incurred only if the transaction will require the use of current financial resources. For example, vacation leave earned by an employee will be recognized as an expenditure only to the extent that it will be paid out of current financial resources. There are certain exceptions to the expenditure recognition rule.
Proprietary funds use an accrual basis of accounting similar to that used by a business. This basis of accounting records transactions when they occur, regardless of the related cash flow. Revenues are recognized when they are both measurable and earned. Expenses are recorded when incurred. In contrast to the modified accrual basis of accounting, the full amount of vacation leave earned by an employee would be recognized as an expense.
The government-wide statements bring the financial activity together in one place and report accrual-based economic resources information. The government-wide statements organize information by whether it relates to governmental activities or business-type activities. The fiduciary funds (such as pension trusts and agency funds) are not included in the government-wide statements, because the resources they account for do not belong to the government. The governmental and business-type activities combine to represent the total primary government. Additionally, discretely presented component units—legally separate entities for which the primary government is financially accountable— are shown on the face of the government-wide statements but are not included in the total for the primary government.
Fiduciary funds generally use the same MFBOA as do proprietary funds and use the accrual basis of accounting.
GASB Statement No. 84, Fiduciary Activities, is effective for fiscal years beginning after December 15, 2018. Agency funds are replaced with custodial funds under this statement. Custodial funds will report a net position and have the same measurement focus as proprietary funds.
Governments use several unique terms to describe their activities. Some of these terms relate to interfund transactions, some to transactions of all funds and activities, and some only to governmental funds transactions. Governments also use unique terms and classifications to describe fund balance and net position.
There are frequent transactions between different funds of a government. Activities among the funds are classified as either reciprocal interfund activity or nonreciprocal interfund activity.
Reciprocal interfund activity includes loans and services provided and used. Interfund loans should be reported separately in the financial statements as interfund receivables and payables. If repayment of a loan is not expected within a reasonable time, the amount recorded as a loan should be reduced and reported as a transfer.
Interfund services provided and used are treated as an internal exchange-like transaction. Revenue is recorded in the seller fund and expenditures or expenses are recorded in the purchaser fund.
Nonreciprocal interfund activity includes transfers and reimbursements. Interfund transfers represent a flow of assets from one fund to another that will not be repaid. In governmental funds, these transfers are reported as “other financing sources” (by the fund receiving the transfer) or “other financing uses” (by the fund making the transfer). Proprietary funds would report transfers after nonoperating revenues and expenses on the statement of revenues, expenses, and changes in fund net position.
Interfund reimbursements represent the repayment for a particular expenditure or expense by a fund responsible for the charge to the fund that initially paid for the item. The net effect of a reimbursement is that the expense or expenditure in one fund would be reduced; the expense or expenditure in another fund would be increased.
Governments separately report transactions or events that meet the definition of special items and extraordinary items. These items are reported at the bottom of the fund financial operating statements for governmental and proprietary funds and at the bottom of the government-wide statement of activities.
A special item is a significant transaction or event within the control of management that is either unusual in nature or infrequent in occurrence.
An extraordinary item is a transaction or event that is both unusual in nature and infrequent in occurrence.
GASB Statement No. 65, Items Previously Reported as Assets and Liabilities, lists several specific items that should now be reported as either deferred outflows of resources or deferred inflows of resources. In addition, GASB Statement No. 53, Accounting and Financial Reporting for Derivative Instruments; GASB Statement No. 60, Accounting and Financial Reporting for Service Concession Arrangements; GASB Statement No. 68, Accounting and Financial Reporting for Pensions — An Amendment of GASB Statement No. 27; GASB Statement No. 69, Government Combinations and Disposals of Government Operations; GASB Statement No. 73, Accounting and Financial Reporting for Pensions and Related Assets That Are Not Within the Scope of GASB Statement 68, and Amendments to Certain Provisions of GASB Statements 67 and 68; GASB Statement No. 75, Accounting and Financial Reporting for Postemployment Benefits Other Than Pensions; GASB Statement No. 81, Irrevocable Split-Interest Agreements; GASB Statement No. 83, Certain Asset Retirement Obligations; and GASB Statement No. 87, Leases, also identified items that should be reported as deferred outflows of resources or deferred inflows of resources.
A deferred outflow of resources is a consumption of net assets by the government that is applicable to a future reporting period. The following is a list of items that the GASB has identified that should be reported as deferred outflows of resources:
A deferred inflow of resources is an acquisition of net assets by the government that is applicable to a future reporting period. The following is a list of items that GASB has identified that should be reported as deferred inflows of resources:
Governmental funds recognize revenue when it is measurable and available. When an asset is recorded in a governmental fund but the revenue is not available, a deferred inflow of resources should be reported.
Governmental funds report certain transactions in a separate section of the statement of revenues, expenditures, and changes in fund balances; this section is called “Other financing sources and uses.” These transactions either provide or use financial resources but are not considered revenues or expenditures.
Other financing sources and uses include the face value of debt issued, issuance premiums or discounts, certain payments to escrow agents for bond refundings, transfers, some insurance proceeds, and sales of capital assets (unless the sale meets the criteria to be reported as a special item).
Only items identified in the preceding paragraph can be reported as other financing sources and uses.
Governmental funds use the term fund balance to represent the difference between current financial assets and current financial liabilities. Under GASB Statement No. 54, Fund Balance Reporting and Governmental Fund Type Definitions, governments have five classifications.
Under GASB Statement No. 54, governmental fund balances should be reported in classifications arranged in a hierarchy. This hierarchy is built primarily on the extent to which a government is bound to honor constraints on the specific purposes for which amounts in those funds can be spent.
Nonspendable fund balance | The nonspendable fund balance classification includes amounts that cannot be spent because they are either (1) not in spendable form or (2) legally or contractually required to be maintained intact. Not in spendable form describes items that are not expected to be converted to cash (such as inventories and prepaid amounts). It also includes the long-term amount of loans and notes receivable as well as property acquired for resale. However, if the use of proceeds from the collection of those receivables or from the sale of those properties is restricted, committed, or assigned, then they should be included under the appropriate fund balance classification (restricted, committed, or assigned) rather than under the nonspendable fund balance classification. |
Restricted fund balance | Fund balances should be reported as restricted when constraints placed on the use of the resources are either
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Committed fund balance | Committed fund balances describe amounts that can be used only for specific purposes pursuant to constraints imposed by formal action of the government’s highest level of decision-making authority. Those committed amounts cannot be used for any other purpose unless the government removes or changes the specified use by taking the same type of action (such as legislation, resolution, or ordinance) it employed previously to commit those amounts. |
Assigned fund balance | Amounts that are constrained by the government’s intent to be used for specific purposes, but are neither restricted nor committed, should be reported as assigned fund balances; an exception is made for stabilization arrangements, as discussed in paragraph 21 of GASB Statement No. 54. |
Unassigned fund balance | An unassigned fund balance is the residual classification for the general fund. This classification represents a fund balance that has not been assigned to other funds and that has not been restricted, committed, or assigned to specific purposes within the general fund. |
GASB Statement No. 54 allows some flexibility in the level of detail presented. For example, the two components of nonspendable fund balances (not in spendable form and legally or contractually required to be maintained intact) may be presented separately or in the aggregate. However, if a nonspendable fund balance is displayed in the aggregate on the face of the balance sheet, amounts for the two nonspendable components should be disclosed in the notes to the financial statements.
GASB Statement No. 54 has several disclosure requirements. For example, governments should disclose the following about their fund balance classification policies and procedures:
For committed fund balance: (1) the government’s highest level of decision-making authority and (2) the formal action that is required to be taken to establish (and modify or rescind) a fund balance commitment | |
For assigned fund balance: (1) the body or official authorized to assign amounts to a specific purpose and (2) the policy established by the governing body pursuant to which that authorization is given. | |
For the classification of fund balances in accordance with paragraph 18 of GASB Statement No. 54: (1) whether the government considers restricted or unrestricted amounts to have been spent when an expenditure is incurred for purposes for which both restricted and unrestricted fund balance is available; and (2) whether committed, assigned, or unassigned amounts are considered to have been spent when an expenditure is incurred for purposes for which amounts in any of those unrestricted fund balance classifications could be used |
The term net position is used to represent the difference between assets (+ deferred outflows of resources) and liabilities (+ deferred inflows of resources) for proprietary funds and in the government-wide statements. Net position is divided into the following three components:
Government funds use different measurement focuses and bases of accounting: governmental funds use the flow of current financial resources measurement focus and the modified accrual basis of accounting; proprietary funds use the flow of economic resources measurement focus and the accrual basis of accounting. Because of these differences, governmental and proprietary funds report certain transactions differently. There are major differences in how the two fund categories report certain transactions related to capital assets and long-term debt.
Governments use unique terminology to describe their activities and balances. Interfund activities, special and extraordinary items, and other financing sources and uses are unique items reported by a government. Components of fund balance and net position also have unique classifications.
Please note that the following practice questions are not required reading material.
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