Reading governmental financial statements: A primer

One of the primary duties for a local government official is to understand their government’s financial health and where the financial risks lie. And one of the best places to get information about your government’s finances is the annual audited financial report. An audited statement means an independent party (a CPA firm) evaluated the amounts reported and issued an opinion on whether they are fairly stated and presented in accordance with the appropriate accounting standards. Even for those with a strong background in reading business financial statements, a government’s lengthy, complex audited statements follow a different set of standards and can be daunting. This article is intended as a guide to quickly getting a lay of the land in terms of a government’s financial health.

Independent auditor’s report

The independent auditor’s report is found at the beginning of the financial statement report. This is the external auditor’s opinion on whether the financial statements are presented fairly and free from material misstatements. The report includes several useful paragraphs:

• The auditor’s responsibility will give you an idea whether the auditors followed standard auditing procedures or whether they had to perform more extensive work under Government Auditing Standards (more common in communities with significant federal grants).
• The emphasis of matter paragraph (optional) is meant to draw readers’ attention. It points out significant events and transactions such as adoption of new accounting standards or other significant matters such as valuation of alternative investments.
• The opinion paragraph determines if there are any opinion modifications (opining only on a portion of the statements) or qualifications (perhaps the entity is not following accepted standards or there were transactions that auditors couldn’t audit).

Management’s discussion and analysis

The management’s discussion and analysis (MD&A) is a multipage narrative written by the government’s management presenting summary information on the government’s finances and includes their analysis of the reasons for significant changes from year to year. For newly elected officials, this is always the best place to start, because the MD&A should clearly present the most significant financial issues. A well-written MD&A can sometimes present the entire story, and the remainder of the financial statements merely support the themes written about in the MD&A.

Governmentwide financial statements: Statement of net position and statement of activities

The first two statements shown in the audit report represent the government with separate columns to display all governmental activities separate from the business-type activities. Component units (separate legal entities for which the government is financially accountable) are also reported, if any, in a third column. These two statements present a longer-term focus on the government’s financial health. They are intended to present the annual cost of providing government services, and whether the taxpayers have (or have not) funded the cost of those services. A positive net position (shown at the bottom of the statement of net position) indicates that the taxpayers have generally funded the cost of services received to date.

For newly elected officials, the management’s discussion and analysis is always the best place to start, because it clearly presents the most significant financial issues.

A governmental official may find very useful to perform some calculations in these statements to evaluate the government’s solvency. Leverage ratios such as liabilities-to-assets ratio and liabilities-to-net position ratio provide insight as to government’s ability to satisfy its debt obligations using government’s assets or whether it has to use resources otherwise available for providing public services. Let’s say your government has liabilities–to-assets ratio of 0.75. Then three quarters of the government’s assets are financed with borrowing. A liabilities –to-net position ratio of 3.01 means that for every dollar of resources available to provide public service, you owe $3.01.

Governmental funds: Balance sheet and statement of revenue and expenditures

Next up in the audit are the fund-based statements. The governmental fund statements present a shorter-term focus. The accounting basis is intended to measure how the government spent the resources given to it and how much it currently has available to spend. When budgets are established, they are compiled at the fund level. Fund balance, then, generally measures how much a government has available to appropriate into the future budgets. Separate activities are accounted for in separate funds, in order to show how specific revenue is being spent. In most cases, the general fund is the largest fund and accounts for most activities that aren’t required to be accounted for in other funds such as legally restricted dollars (grants, street funding, etc.) or enterprise activities such as water and sewer. In cities, the general fund accounts for public safety activity as well, but in most townships, the police and fire funds are separate funds as they have separate tax millages to support those activities.

The key here is whether the individual funds have fund balance or if they are in a deficit position. Fund balance is the difference between current assets, current liabilities, and deferred inflows. Within fund balance (shown at the bottom of the balance sheet), there are several categories. Fund balance is reported as nonspendable, restricted, committed, assigned, or unassigned.

When budgets are established, they are compiled at the fund level. Fund balance measures how much a government has available to appropriate into the future budgets.

One key benchmark to evaluate is the unrestricted fund balance of the general fund (committed, assigned plus unassigned fund balances). Compare this to total expenditures of the fund to derive a percentage. For example, a fund balance of $3 million for a fund with annual expenditures of $12 million is a 25% fund balance. This means that the existing fund balance could cover about three months of expenditures. Many governments create a minimum fund balance percentage policy, so that they have a benchmark to determine when they’re experiencing fiscal stress. If your government has such a policy, it’ll be disclosed in the footnotes to your financial statements.

Another useful information regarding health of a fund is understanding how the fund is funded. Governmental fund statement of changes in revenues, expenditures, and fund balances shows the sources of revenue in two categories: revenues and other financing sources/uses. If a fund is covering its expenditures from other financing sources, you may want to ask a question why (especially when looking at special revenue funds).

Proprietary funds: Statement of net position and statement of revenue, expenses, and changes in net position

The proprietary funds represent two distinct types of activities:

• Business-type activities (enterprise funds), where the government is providing a good or service in exchange for fees, and generally, the fees are intended to cover the full costs. Examples would be providing water, sewer, electricity, parking, golf, or similar recreation, etc.
• Internal service funds, which are funds created to account for activity that will be “sold” internally to other funds of the government. Common example of such funds are buildings and ground maintenance, information technology, and employee health benefits.
  
  These funds typically are meant to be self-supporting, and the positive net position indicates that the customers have paid the full cost of the services provided. However, it’s also important to focus on working capital (current assets and less current liabilities) to determine the financial health of these types of funds and their ability to stay current on payments. Additional ratios that are helpful in determining the funds’ ability to pay obligations as they come due in the near term are current ratio (currents assets divided by current liabilities) and quick ratio (cash with current investments divided by current liabilities). Every municipality has different circumstances so it’s difficult to set a fixed number that a government should achieve. Therefore, these ratios are helpful to compare to themselves over extended period of time. It’s generally thought that a number of 2 or higher is a positive indicator.

Notes to the financial statements

The footnotes to the financial statements provide significant detail to gain a more complete understanding of the government’s finances. You will find a brief description of the nature of the government, accounting policies related to specific account balances, details of capital assets (Is the government continuing to invest in infrastructure, critical equipment, etc? One measure is to compare depreciation, which is the using-up of assets to the new asset additions, which are replacing those depleted assets), long-term debt (Are debt balances increasing or decreasing?), and employee benefit obligations (pension and retiree healthcare).

Required supplemental information

• Budgetary comparison schedules
  The budgetary comparison schedules include the general fund and each major special revenue fund reported within the financial statements. These schedules show the original budget and the last amended budget, compared to actual results. Significant amounts, either over or under budget, warrant additional follow-up to understand why.
• Net pension and OPEB liability and pension and OPEB contribution schedules
  These schedules focus on the health of the pension and OPEB plans. Plans fiduciary net positions as percentages of total liabilities ratios on the bottom of the net pension and OEPB liability schedules indicate whether the entity contributed enough resources to fund employees’ retirement and healthcare. The idea is to hopefully show an increase in the funding level over time. In addition, the contribution schedules give a sense as to whether the annual required contributions are increasing or decreasing over time and whether the entity has made the full contributions.

Key takeaways

So where should you look in your annual financial statements to gain a quick understanding of your government’s financial health?

• Read the MD&A for key happenings.
• Measures of short-term financial health:
  • General fund unrestricted fund balance as a percentage of annual expenditures
  • Are there any deficits in any funds?
  • Budgetary comparison schedules — there should be very few revenue variations; nearly all expenditures should be less than budget.
• Long-term financial health
• Total net position for governmental activities (first two statements) should be positive.
• Evaluate whether primary government has too much debt.
• Look for future funding concerns:
  • Have capital outlays kept up with depreciation over last five years?
  • Are pension and OPEB well-funded, and if not, is the funding level increasing?

We hope this article has enabled you to gain a better understanding of how to assess your government’s financial condition. For more information, feel free to contact us. In addition, the Government Finance Officers Association has many publications that may help you gain a better understanding.