GOVERNMENTAL FINANCIAL REPORTING MODEL

By Laurence E. Johnson and David R. Bean

In Brief

Let the Debate Proceed

In its exposure draft of a proposed statement, GASB has retained the thrust of the governmental financial reporting model outlined in its Preliminary Views document of June 1995.

It continues to propose basic financial statements that would have an entity-wide focus while retaining fund-based financial statements. The proposal also will effectively result in the elimination of the current pyramid reporting concept.

The exposure draft would also require a management discussion and analysis that would precede the basic financial statements.

The proposal may be controversial. There were strong objections to the PV document from various interest groups, including many preparers and auditors. However, others including many from the financial statement user community believe that the proposal will improve governmental financial reporting. The GASB is determined to get governmental accounting onto strong footing. Financial reporting for governments not only includes budgetary accountability but also fiscal solvency.

Comments are due to GASB by May 31, 1997. This is perhaps the most significant project in GASB's history.

The Governmental Accounting Standards Board (GASB) has labored at revising the state and local government financial reporting model since its inception in 1984. A significant step toward effecting a revised reporting model was taken in January, as the Board issued its exposure draft (ED) of a proposed statement, Basic Financial Statements--and Management's Discussion and Analysis--for State and Local Governments. The GASB's proposal is intended to improve the understandability and usefulness of governmental financial reports to citizens, legislative and oversight bodies, and investors and creditors. The ED retains the overall thrust of the GASB's June 1995 Preliminary Views document (PV) on the reporting model--that is, a requirement for financial reporting from both an entity-wide and a fund viewpoint. However, the ED contains many notable changes from the PV, made as a result of input from interested parties who participated in the GASB's due
process.

The concept of the comprehensive annual financial report (CAFR), established by the National Council on Governmental Accounting's Statement 1, Governmental Accounting and Financial Reporting Principles, is not altered by the ED. Within the CAFR, though, the ED proposes (see illustration) that the general purpose financial statements (the combined financial statements and related notes) be replaced by--

* management's discussion and analysis (MD&A), designated as required supplementary information

* basic financial statements ("core" financial statements in the PV), including notes to the financial statements

* required supplementary information other than MD&A.

The Short and Long of It

The ED notes that accountability--the paramount objective of governmental financial reports--has both a short-term fiscal dimension and a medium-to-long-term operational dimension. The Board believes that a single set of financial statements is incapable of demonstrating both dimensions of accountability. Thus, the ED proposes that the basic financial statements include two distinct sets of statements.

Fiscal accountability pertains to the inflows and outflows of financial resources during the reporting period and has a budgetary orientation. Noting that the current governmental reporting model serves fiscal accountability well, the ED would require fund-based financial statements that conform closely, but not fully, to existing practices as one component of the basic financial statements.

However, the current governmental financial reporting model is not well suited to some of today's more complex transactions, particularly those that do not require current financial resources, yet have a measurable current-period cost (for example, compensated absences liabilities). Transactions of this nature have an operational accountability dimension. The ED thus would require entity-wide financial statements as the other component of the basic financial statements. The entity-wide statements are intended to provide a comprehensive, longer-term view of a government's financial activities and the related asset, liability, and equity balances.

The Entity-Wide Financial Statements

The ED would require a government to prepare two entity-wide financial statements--a statement of net assets and a statement of activities. (The PV proposal for entity-wide statements of changes in capital assets and changes in long-term obligations is now a proposed disclosure requirement in the ED.) These statements report information in separate columns for (a) the primary government's governmental-type activities, (b) its business like activities, and c) discretely presented component units of the reporting entity in the aggregate. These statements are prepared using the flow of economic resources measurement focus and accrual basis of accounting. In keeping with their entity-wide nature, these statements are reported net of most internal activities. Moreover, because the resources of fiduciary activities (as redefined in the ED) do not represent resources available to finance a government's programs, the entity-wide statements do not reflect the fiduciary activities of the government. Information is presented for discretely presented component units in the aggregate. In a departure from the PV, the ED would not require the entity-wide financial statements to present current-year/prior-year comparisons. However, comparative information would be required in the MD&A.

Statement of Net Assets. The ED would encourage governments to prepare the statement of net assets according to a "net assets" format. (The conventional balance sheet format is also acceptable.) This statement reports capital assets, including infrastructure assets, net of depreciation. In the ED, the Board is proposing to expand infrastructure reporting even beyond the PV provisions. All major infrastructure assets would be required to be reported following an additional three-year transition period beyond the effective date of the final statement. The ED includes an appendix that discusses alternative methods that may be used to identify and determine estimated historical costs for these assets.

Assets and liabilities would each appear in liquidity order; net assets would be classified in three categories:

* Invested in capital assets, net of related debt

* Restricted (imposed externally or by law)

* Unrestricted.

Statement of Activities. The statement of activities (similar to the illustration presented in the March 1996 issue of The CPA Journal), is one of the ED's most radical departures from existing practice. The statement of activities presents, in adjacent columns, a) total expenses by program for the primary government, reduced by b) program charges for services, and c) program grants and contributions, to arrive at subtotals for net program revenues (expenses) for governmental activities and business-like activities. The net program revenues (expenses) subtotals are adjusted for general revenues, extraordinary and "special" items (defined as transactions or events within management's control that are both abnormally large in size and either unusual in nature or infrequent in occurrence), and net transfers between governmental and business-type activities, to arrive at the total changes in net assets. These amounts, plus beginning net asset balances, equal the ending net assets balances, which articulate with those reported in the statement of net assets.

The statement of activities reports aggregate component unit net revenues (expenses), adjusted to ending net assets as is done in the primary government columns. If a government issues a financial report with a complete financial section that includes information in the combining statements for major component units, that information need not be reported in the basic financial statements. However, the basic financial statements would not be "liftable." Major component unit information must appear in basic financial statements issued separately from the complete financial section.

The Fund-Based
Financial Statements

The fund-based financial statements reflect current practice substantially, in terms of both accounting and financial reporting. Within each fund category (governmental, proprietary, fiduciary, and higher education), the ED proposes that financial statements "should be prepared in columnar format with a separate column for each fund type." It is important to note, though, that these statements are no longer considered "combined" financial statements--even though they present fund-type totals in each column. Under existing practice, the combined financial statements are deemed to provide a financial overview of the reporting entity. Under the ED proposal, the financial overview would be provided by both the entity-wide and the fund-based statements.

Also, the ED proposes some notable changes to the current fund structure. The fiduciary fund category would be redefined to exclude those funds that account for resources not available to finance primary government programs--basically, pension trust funds, private-purpose trusts, and agency funds. Moreover, most expendable trust funds would be reclassified as special revenue funds, and nonexpendable trust funds would be reclassified to permanent funds, a new fund type in the proprietary category. These changes are intended to result in more consistent reporting of fiduciary activities.

Another important change proposed in the ED would discontinue the long-standing practice of reporting the nonfund account groups--the general fixed assets account group (GFAAG) and the general long-term debt account group (GLTDAG)--in conjunction with fund-based data. This change is proposed because general capital (fixed) assets, and general long-term debt are not considered governmental fund assets and liabilities under the current financial resources measurement focus.

The "major" fund reporting requirements originally proposed in the PV also have been modified in keeping the major component unit presentations. A complete financial section will include combining statements for all funds. When the basic financial statements are issued separately from a complete financial section, the ED proposes that major funds would be either displayed at the fund level or disclosed (condensed financial statements) in the notes to the basic financial statements.

Governmental Funds. Consistent with existing practice, the ED would require that fund-based financial statements for the governmental fund types be prepared using the current financial resources measurement focus and the modified accrual basis of accounting. The three required statements are--

* balance sheet

* statement of revenues, expenditures, and changes in fund balances ("operating statement")

* budgetary comparison statement for the general fund only. (The ED would eliminate the existing practice of reporting budget-to-actual comparisons in the aggregate for the other governmental fund types.)

In the interest of comparability, the ED proposes that the operating statement follow a specified format (which presents a subtotal for the excess/deficiency of revenues over/under expenditures). The budgetary comparison statement would present both the original budget and the final amended budget. The original budget is the first complete appropriated budget with any modifications that occur before the fiscal year begins. Also, the ED would encourage, but not require, governments to present the budgetary comparison statement in the format, and at the same level of detail, as the government's budget document.

Proprietary Funds. Also consistent with current practice, the ED proposes that fund-based financial statements for the proprietary fund types be prepared using the economic resources measurement focus and the accrual basis of accounting. The three required statements are--

* classified balance sheet

* statement of revenues, expenses, and changes in fund equity ("operating
statement")

* statement of cash flows.

The ED would restructure the proprietary fund operating statement so that transfers in and out are reported below the net income line item, rather than being a component of "net income" as is presently the case. Further, all resource inflows except additions to trust principal in the permanent funds (formerly, nonexpendable trust funds) would be accounted for as revenues--direct additions to "contributed capital" would no longer be reported. Indeed, contributed capital itself, and retained earnings, would be replaced with the same equity classifications appearing in the entity-wide statement of net assets.

Under the ED, the statement of cash flows would be required to be prepared on the direct method and would also include a reconciliation of operating cash flows to operating income. The ED would also redefine the activities for which proprietary accounting and reporting is appropriate: A government may employ proprietary accounting for any activity that involves a fee charged to users for the services provided by that activity. In contrast, a government must use proprietary accounting if any one of the following applies:

* The activity is financed with debt that is secured solely by net revenues from the activity's fees or charges.

* Law or regulation requires that user fees be adequate to recover costs.

* The government's policy (not simply intent) requires that user fees be adequate to recover costs.

Higher Education Funds and Fiduciary Funds. The ED refers to a soon-to-be-issued proposal of the public college and university model that would provide guidance for higher education fund reporting. Statements required for the fiduciary funds are those required by GASB Statement No. 25, Financial Reporting for Defined Benefit Pension Plans and Note Disclosures for Defined Contribution Plans--that is, a statement of net assets and a statement of changes in net assets.

Other Fund-Perspective Proposals. Another notable reporting change proposed by the ED is that the current distinction between "operating transfers" and "residual equity transfers," frequently difficult to make in practice, would be eliminated. Under existing practice, operating transfers are reported as other financing sources (uses) for governmental funds and in a separate section before net income in the proprietary funds. Residual equity transfers are reported as direct changes to equity. The ED proposes that transactions currently classified as operating transfers or residual equity transfers simply be captioned as "transfers." They would be reported as other financing sources (uses) in governmental fund operating statements (below the excess of revenues over expenditures) and following net income in proprietary operating statements.

The ED does not address required notes to the financial statements in detail. The GASB has a separate project on its agenda to review whether existing disclosure requirements should be changed. The ED is clear, however, that a single set of notes would be prepared for the basic financial statements, both the entity-wide and the fund statement.

Management's Discussion and
Analysis (MD&A)

The ED would stipulate that state and local government financial reports include MD&A. Significantly, the required placement of the MD&A would be preceding the basic financial statements so that it serves as an introduction for them. Also significant is the fact that MD&A would have the status of "required supplementary information" (RSI). By designating MD&A as RSI, the GASB intends to ensure that MD&A is objective because auditors have an obligation to perform certain limited procedures on RSI that accompanies audited financial statements.

The ED states that MD&A "should provide a brief, objective, and easily readable analysis of the government's financial activities based on currently known facts, decisions, or conditions." Additionally, "MD&A provides financial management with the opportunity to present both a short- and a long-term analysis."

According to the ED, MD&A would discuss current-year results in relation to those of the prior year, but emphasize the current year. MD&A would focus on the primary government, though there are instances where reference to discretely presented component units may also be appropriate. MD&A would not be required to address prospective information. Moreover, MD&A is not intended to duplicate information a government presents in the letter of transmittal appearing in the introductory section of its CAFR. When potentially duplicate information is required to be presented in MD&A, it should be deleted from the letter of transmittal.

The ED states that MD&A should avoid "boilerplate" text. To this end, the minimum requirements set forth for MD&A are intentionally general. Some of these proposed requirements include--

* an explanation of the objectives of the financial statements;

* condensed, comparative entity-wide financial statements;

* analysis of significant variations between the original and final budgets;

* discussion of whether the government's financial position has improved or deteriorated during the fiscal year;

* a summarized explanation of the differences between the balances and results reported in the entity-wide and fund-based statements.

Why Not a Simpler Approach?

Many of the comments received during the due process on the PV expressed concern over the complexity of the proposed approach. Some advocated entity-wide statements, others supported only fund-based, and still others argued for changes to the measurement focus and basis of accounting proposals. In its basis for conclusions, the board has carefully laid out its arguments for adopting the current proposal and rejecting the multitude of alternatives that it has considered since this project was placed on its technical agenda.

The GASB acknowledges that implementing this new reporting model will impose additional costs on virtually all governments, large and small. The GASB believes these extra costs are justified by the additional information provided to governmental financial report users.

The GASB also stresses that neither the entity-wide statement nor the fund-based statement is more important than, or otherwise superior to, its counterpart. These financial statements are intended, collectively, to provide information that neither statement alone could impart. Likewise, the GASB rejects the notion that the information needs of any user group--citizens, legislative bodies, or investors--are most important. "The fact that [users] do not all need the same information in the same form for the same purposes is no reason to give priority to one group's needs over another's. Rather, it is a challenge for financial reporting that the board believes can and should be met." The board recognizes that simpler approaches to financial reporting exist, but believes none has been identified that meets the objectives of governmental reporting better than the proposed model.

Effective Date

The proposed effective date for the new reporting model is for fiscal years beginning after June 15, 2000. As noted earlier, due to possible implementation difficulties in recording major infrastructure assets--currently optional, but required in the new model--the proposed statement includes a three-year transition period following the initial effective date during which the infrastructure capitalization requirement phases in.

Let Your Views Be Known

The GASB will make one copy of the ED available, free of charge, to anyone who requests a copy until May 30, 1997--also the deadline for submitting written comments on the ED. To request a copy or obtain information on the cost of additional copies, contact:

Order Department

Governmental Accounting Standards

Board

401 Merritt 7

P.O. Box 5116

Norwalk CT 06856-5116

Telephone orders: (203) 847-0700,

ext 10

Public hearings have been scheduled around the country during the summer to receive further input on this important project. All are strongly encouraged to make their views known to the GASB. *