BAR CPA Practice Questions: Proprietary Funds

In this video, we walk through 5 BAR practice questions teaching about proprietary funds. These questions are from BAR content area 3 on the AICPA CPA exam blueprints: State and Local Governments

The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.

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Proprietary Funds

In governmental accounting, proprietary funds occupy a unique space. They are designed to function much like private-sector businesses, with a focus on the cost of services, recovery of those costs through fees and charges, and the long-term sustainability of operations. To understand them, it helps to look at what kinds of activities they cover, how they are measured, and the financial statements they produce.

What Are Proprietary Funds?

Proprietary funds are used when a government runs activities that either serve the general public on a fee-for-service basis or serve internal departments on a cost-reimbursement basis. They are accounted for using the economic resources measurement focus and the accrual basis of accounting, just like a private business.

Two fund types fall under this category:

• Enterprise Funds: Used when a government provides goods or services to the public and primarily finances them through user charges. Examples include water utilities, airports, transit systems, or municipal golf courses.
• Internal Service Funds: Used when the government provides services to its own departments. Common examples include central motor pools, IT services, or internal printing operations.

When Must an Enterprise Fund Be Used?

Under GASB standards, enterprise funds are not just optional; they are required when an activity meets at least one of three conditions:

1. Debt criterion: The activity is financed with debt secured solely by fees and charges from the activity.
2. Legal/regulatory criterion: Law or regulation requires that the activity’s costs be recovered with fees and charges.
3. Pricing policy criterion: Pricing policies are established with the intent to recover costs, including capital costs such as depreciation and debt service.

For example, if a city operates a waste management system and state law requires rates that fully recover both operating and capital costs, it must use an enterprise fund.

Measurement Focus and Basis of Accounting

Both enterprise and internal service funds adopt the same accounting approach:

• Economic resources measurement focus: All assets and liabilities, both current and long-term, are reported.
• Accrual basis of accounting: Revenues are recognized when earned and expenses when incurred, regardless of cash flows.

This means enterprise and internal service funds recognize accounts receivable, record depreciation on capital assets, and accrue long-term liabilities, just like private entities.

Example: If a city water utility provides services in December but does not receive payment until January, the revenue is recorded in December, because that is when it is earned.

Treatment of Capital Assets

A major distinction between proprietary funds and governmental funds is how they treat capital outlays:

• Proprietary funds: Capitalize assets and depreciate them over their useful lives.
• Governmental funds: Record capital outlays as expenditures in the period of purchase.

Example: If an enterprise fund buys $5 million of water treatment equipment with a 20-year life, it records the equipment as an asset and recognizes depreciation over time.

Required Financial Statements

Proprietary funds prepare a full set of financial statements that closely resemble those of private sector businesses:

1. Statement of Net Position – Similar to a balance sheet, showing assets, liabilities, and net position.
2. Statement of Revenues, Expenses, and Changes in Fund Net Position – Reports operating revenues and expenses separately from nonoperating items (such as interest revenue or expense) and includes capital contributions and transfers.
3. Statement of Cash Flows – Required to use the direct method, with four categories:
   • Operating activities
   • Noncapital financing activities
   • Capital and related financing activities
   • Investing activities

Example: In the cash flow statement, utility bill collections would appear in operating activities, while proceeds from issuing revenue bonds for a new treatment plant would appear in capital and related financing activities.

Internal Service Funds in Practice

Internal service funds deserve special note because while they are proprietary funds at the fund level, they are usually reported as part of governmental activities in the government-wide statements.

Example: A central garage servicing police, fire, and sanitation departments records vehicle costs in an internal service fund. At the government-wide level, those activities are generally consolidated into governmental activities rather than business-type activities.

Putting It Together: Key Principles

• Proprietary funds account for business-type or internal service operations of a government.
• Enterprise funds are used for activities financed primarily through user fees and must be used when legally required, when debt is backed only by revenues, or when pricing policies are designed to recover costs.
• Internal service funds are used for services to other government departments on a cost-reimbursement basis.
• Proprietary funds follow the accrual basis and economic resources measurement focus, capitalizing and depreciating assets.
• Required financial statements include the statement of net position, statement of revenues/expenses/changes in net position, and a cash flow statement using the direct method.
• Proprietary funds are designed to mirror private sector accounting, which allows clear evaluation of whether fees are sufficient to cover costs.

Example Wrap-Up

Imagine a city government managing several activities:

• A water utility charging residents: Enterprise Fund.
• A central IT department serving all city agencies: Internal Service Fund.
• A new airport project financed by revenue bonds: Enterprise Fund.
• A grant-funded road program: Special Revenue Fund (not proprietary).

By correctly classifying these activities, applying the accrual basis, capitalizing assets, and preparing the required statements, the government provides transparent and comparable financial information that supports accountability and decision-making.