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. You should read the opinion to determine if there are any opinion modifications which bring attention to the adoption of new accounting standards, qualifications (perhaps the entity is not following accepted standards) or other significant matters disclosed within the financial statements.
Management’s discussion and analysis
The MD&A is a multi-page 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.
Government-wide financial statements: Statement of net position and statement of activities
The first two statements shown in the audit report represent the government as a whole, 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.
The exception to this general rule is OPEB reporting. The governmental accounting rules changed in 2015 to begin measuring the unfunded pension obligation, and it is now counted in the measure of net position. This represented a significant improvement to financial reporting. However, the similar rule to begin counting the unfunded retiree healthcare benefits (or other post-employment benefits (OPEB) programs) will not take effect until 2018. Until that time, governments have been reporting a liability (referred to as the Net OPEB Obligation) that represents the difference between the actuarially required annual contribution and the contributions actually made. The full unfunded OPEB is not being shown yet in the Statement of Activities and instead is only being disclosed in the footnotes. For this reason, we recommend pulling out a pencil and doing your own “back of the napkin” calculation – take the amount of net position reported in the statement of net position, subtract the unfunded OPEB liability found in the footnotes, and add back the net OPEB obligation currently reported in the statement of net position.
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 are not 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 and current liabilities. Within fund balance (shown at the bottom of the balance sheet) there are several categories. Fund balance is reported as nonspendable, restricted, committed, assigned, unassigned.
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 percent 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 are experiencing fiscal stress. If your government has such a policy, it will be disclosed in the footnotes to your financial statements.
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.
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 is also important to focus on working capital (current assets less current liabilities) to determine the financial health of these types of funds and their ability to stay current on payments.
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.
- OPEB funding schedules
This section contains a schedule to show the history of the funding levels for OPEB. A key is the trend related to the funding ratio. Is it increasing or decreasing? If the government has not put any funding aside in a trust for retiree healthcare, the funding level will remain at zero. Ideally, the trend should be toward increasing the asset balance and either moderating or reducing the liability levels over time. If these two things happen, the funding percentage will move upward.
Net pension liability and pension contribution schedules
These two schedules focus on the health of the pension plan. Again, the idea is to hopefully show an increase in the funding level over time. In addition, the contribution schedule gives a sense as to whether the annual required contribution is increasing or decreasing over time and whether the entity has made the full contribution.
So where should you look in your annual financial statements to gain a quick understanding of your government’s financial health?
- Read the Management’s Discussion and Analysis 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. Consider adjusting for unfunded OPEB.
- 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.