BAR CPA Exam: How to Prepare the Statement of Cash Flows for the Proprietary Funds of a State or Local Government

Introduction

Overview of Proprietary Funds and Their Significance in Governmental Accounting

In this article, we’ll cover how to prepare the statement of cash flows for the proprietary funds of a state or local government. Proprietary funds are essential in governmental accounting as they account for operations that closely resemble private-sector business activities. These funds are used by state and local governments to manage services where costs are primarily recovered through user fees or charges, such as utilities, transportation, and internal services. The ability to track the financial health of these activities ensures that revenues generated are sufficient to cover expenses, providing a clear financial picture for stakeholders.

There are two main types of proprietary funds:

• Enterprise Funds: Used for government activities that are available to the public and primarily financed through the sale of goods or services, such as a municipal water system.
• Internal Service Funds: Used for activities that serve other departments or agencies within the government on a cost-reimbursement basis, such as IT services or fleet management.

Proprietary funds play a critical role in separating self-sustaining government operations from those funded by general taxation, allowing for transparent financial reporting and analysis.

Purpose and Importance of Preparing a Statement of Cash Flows for Proprietary Funds

The Statement of Cash Flows is a key financial statement that tracks the cash inflows and outflows of an organization over a period of time. For proprietary funds, the cash flow statement is particularly important because it provides a detailed view of how these government activities are financed, how cash is managed, and the extent to which they are self-sustaining.

Some key reasons the cash flow statement is crucial for proprietary funds include:

• Assessing Liquidity: It helps governments ensure that proprietary funds have enough cash to meet operational needs and future financial obligations.
• Promoting Accountability: Transparency is vital in government operations, and the statement of cash flows demonstrates how public funds are being used.
• Informed Decision-Making: Detailed cash flow information aids government management in making sound financial decisions about budget allocation, capital projects, and long-term financial planning.

According to the Governmental Accounting Standards Board (GASB) Statement No. 34, state and local governments are required to prepare a Statement of Cash Flows for proprietary funds using the direct method, which offers a clear and detailed view of cash receipts and payments, in contrast to the indirect method often used by private companies.

Key Differences Between Proprietary Funds in Government Accounting and Private-Sector Cash Flow Statements

While the structure of the cash flow statement for proprietary funds shares some similarities with private-sector cash flow reporting, there are significant differences due to the unique nature of governmental operations.

1. Direct Method Requirement: GASB mandates the use of the direct method in preparing cash flow statements for proprietary funds. This method provides greater clarity by directly reporting cash receipts and payments related to operating activities. In contrast, private-sector entities frequently use the indirect method, which adjusts net income for non-cash transactions.
2. Cash Flow Classifications: Proprietary funds report cash flows in four distinct categories:
   • Operating Activities: Cash flows related to providing services and goods, such as customer payments and payments to suppliers.
   • Noncapital Financing Activities: Cash flows related to financing that is not tied to capital assets, such as grants or loans unrelated to capital expenditures.
   • Capital and Related Financing Activities: Cash flows related to the acquisition or sale of capital assets and related debt service.
   • Investing Activities: Cash flows from investment transactions, such as buying or selling securities and earning interest.
     Private-sector cash flow statements typically use only three categories—operating, investing, and financing—without the specialized distinction for capital-related activities required in government accounting.
3. Emphasis on Accountability over Profitability: Unlike private businesses, which are profit-driven, the focus of governmental proprietary funds is cost recovery and accountability to taxpayers. The cash flow statement demonstrates how public resources are managed, ensuring services are provided efficiently while maintaining financial integrity.

These differences reflect the specialized nature of governmental proprietary funds and the need for distinct cash flow reporting that supports transparency and accountability to the public.

Understanding Proprietary Funds in Government Accounting

Definition of Proprietary Funds: Enterprise Funds and Internal Service Funds

Proprietary funds are a category of governmental funds used to account for activities that operate similarly to private businesses. These funds are primarily financed through user fees or charges for services, and their goal is to recover operating costs through those charges. Governments use proprietary funds to track financial performance for activities that provide goods or services to the general public or other departments within the government.

There are two main types of proprietary funds:

• Enterprise Funds: These funds account for services provided to external customers, often in competition with private sector providers. The primary goal is cost recovery through user charges. Examples of enterprise funds include public utilities such as water and sewer services, municipal airports, and public transportation systems.
• Internal Service Funds: These funds account for services provided within the government itself. They are used to manage activities that benefit multiple government departments on a cost-reimbursement basis. Examples include motor pools, centralized IT services, and internal insurance programs. The purpose is to allocate the costs of these services to the departments that use them.

Examples of Activities Covered by Proprietary Funds

Proprietary funds cover a wide range of activities that require efficient financial management and full cost recovery. Some common examples include:

• Water Utilities: Public water and wastewater systems are often funded through enterprise funds, where customer fees are used to cover the operating and maintenance costs of delivering clean water and treating wastewater.
• Transportation Services: Public transit systems, such as buses and light rail, are typically funded through enterprise funds. Passenger fares and government subsidies are used to maintain operations.
• Self-Insurance Programs: Governments may create internal service funds to manage risk by setting up self-insurance programs. These funds pool resources to cover potential liabilities such as workers’ compensation, vehicle accidents, or property damage.

The diversity of activities covered by proprietary funds underscores their importance in tracking the financial performance of government-run business-type services.

Importance of Accrual Accounting for Proprietary Funds

Accrual accounting is the standard method of accounting for proprietary funds. This accounting method recognizes revenues when they are earned and expenses when they are incurred, regardless of when cash is received or paid. The use of accrual accounting in proprietary funds is critical for several reasons:

• Accurate Financial Reporting: Accrual accounting provides a more comprehensive view of a fund’s financial health by capturing all economic events, including receivables, payables, and depreciation of capital assets. This ensures that financial statements reflect the true financial position of the fund.
• Cost Recovery Measurement: Since proprietary funds are designed to recover costs through user charges, accrual accounting allows for an accurate comparison of revenues and expenses over time, making it easier to determine whether the fund is self-sustaining.
• Capital Asset Management: Proprietary funds often involve significant investments in capital assets such as infrastructure or equipment. Accrual accounting enables governments to account for these long-term investments through depreciation, ensuring that asset costs are allocated over their useful lives.

By using accrual accounting, proprietary funds offer a clear picture of financial performance, helping governments make informed decisions about the sustainability of services and the need for future rate adjustments or subsidies.

Purpose of the Statement of Cash Flows

The Role of the Statement of Cash Flows in Providing Financial Information

The Statement of Cash Flows is a critical financial statement that provides detailed insights into the cash inflows and outflows of an organization during a specific period. For proprietary funds in government accounting, the statement of cash flows plays a crucial role in understanding how public resources are being used and how efficiently these activities are being managed. This statement offers a transparent view of a fund’s ability to generate cash from operations, meet obligations, and fund future expenditures.

Some key roles of the Statement of Cash Flows include:

• Assessing Liquidity: The statement provides essential information on the availability of cash to meet day-to-day operations, capital expenditures, and debt service.
• Evaluating Cash Management: It allows users to assess how effectively a governmental entity manages its cash flow, helping stakeholders understand if operations are self-sustaining or require additional financing.
• Understanding Financing Needs: By showing cash flows from operating, financing, and investing activities, this statement helps governments plan for future borrowing or funding needs.
• Promoting Accountability: Public transparency is critical in government operations, and the statement of cash flows ensures that all stakeholders can see how taxpayer funds and other revenues are being used.

In summary, the Statement of Cash Flows helps provide a complete financial picture of proprietary funds, enhancing decision-making and transparency.

Differences in Cash Flow Reporting for Governmental Proprietary Funds vs. the Private Sector

While both governmental proprietary funds and private-sector businesses prepare statements of cash flows, there are notable differences in how these statements are structured and reported, mainly due to the differing objectives and accounting standards governing each sector.

1. Cash Flow Reporting Method:
   • Governmental Proprietary Funds: The Governmental Accounting Standards Board (GASB) requires the direct method of reporting cash flows for proprietary funds. This method provides specific details of cash receipts and payments during the period, offering greater transparency in how cash is generated and used.
   • Private Sector: In contrast, private-sector entities can choose between the direct or indirect method of reporting cash flows, though the indirect method is more commonly used. The indirect method begins with net income and adjusts for non-cash items, such as depreciation, to arrive at cash flows from operating activities.
2. Categories of Cash Flows:
   • Governmental Funds: Cash flows are categorized into four sections:
     • Operating Activities: Cash transactions related to the entity’s principal operations.
     • Noncapital Financing Activities: Transactions related to borrowing or repaying debt unrelated to capital assets, as well as receiving grants and subsidies.
     • Capital and Related Financing Activities: Cash flows related to the acquisition or sale of capital assets and related debt service.
     • Investing Activities: Cash flows from investments, including interest and dividends received, and purchases or sales of investment securities.
   • Private Sector: Private companies report cash flows in three main categories: operating, investing, and financing activities. Unlike government funds, there is no separation between capital and noncapital financing.
3. Emphasis on Cost Recovery vs. Profitability:
   • Governmental Proprietary Funds: The focus is on cost recovery through user fees and ensuring services are provided efficiently. The cash flow statement demonstrates how well the fund is covering its operating costs and managing public resources.
   • Private Sector: Private businesses focus on profitability, and their cash flow statements aim to show how effectively the company generates cash to maximize shareholder value.

These differences highlight the unique nature of government accounting, where transparency and accountability to the public are the primary concerns, as opposed to the profit-driven motives in the private sector.

Overview of GASB (Governmental Accounting Standards Board) Statement No. 34 and Its Guidance on Cash Flow Reporting

The Governmental Accounting Standards Board (GASB) Statement No. 34 provides comprehensive guidance on financial reporting for state and local governments, including specific instructions on the preparation of the Statement of Cash Flows for proprietary funds. Issued in 1999, GASB Statement No. 34 aimed to enhance the clarity and comparability of government financial reports while ensuring transparency for public stakeholders.

Key guidance provided by GASB 34 includes:

• Direct Method Requirement: GASB 34 mandates that all state and local governments prepare their Statement of Cash Flows for proprietary funds using the direct method. This approach requires governments to report the specific sources and uses of cash, giving users more detailed insights into how government operations are financed and managed.
• Four Cash Flow Categories: The statement emphasizes the importance of distinguishing between operating activities, noncapital financing activities, capital and related financing activities, and investing activities. This structure ensures that stakeholders can see exactly how governments are using cash for daily operations, long-term investments, and debt management.
• Reconciliation Requirement: GASB 34 also requires a reconciliation of operating income (or loss) to net cash provided (or used) by operating activities. This helps users understand the adjustments made for non-cash transactions, such as depreciation, changes in accounts receivable or payable, and other working capital changes.

The guidance provided by GASB Statement No. 34 ensures that governmental proprietary funds report cash flows in a manner that prioritizes transparency, consistency, and accountability, making the financial information accessible and useful to a wide range of stakeholders, from government officials to the public.

Components of the Statement of Cash Flows for Proprietary Funds

Operating Activities

Definition and Examples

Operating activities represent the cash inflows and outflows related to the core business operations of a proprietary fund. These activities are the primary source of revenue and expenses for the fund and reflect its daily functions, such as providing goods and services to the public or internal government departments.

Examples of cash flows from operating activities include:

• Receipts from Customers: Cash received from customers or users in exchange for services provided by the proprietary fund. For instance, a water utility fund would report cash inflows from customers paying their water bills.
• Payments for Goods and Services: Cash paid to suppliers for goods and services required to support the fund’s operations. This could include payments for maintenance supplies, electricity, or payroll for employees working within the proprietary fund.
• Payments to Employees: Cash paid for salaries and wages of employees involved in the fund’s operations, such as those working for a municipal transportation system.
• Payments for Other Operating Expenses: Other cash outflows related to operating the fund, such as insurance costs, administrative expenses, or minor repairs.

The operating activities section provides a clear view of the proprietary fund’s ability to generate sufficient cash from its primary operations to cover operating expenses. A positive cash flow from operating activities indicates that the fund is effectively managing its day-to-day operations, while a negative cash flow could suggest financial inefficiencies or a need for external funding.

Understanding How Proprietary Funds Report Cash Inflows and Outflows from Operations

Proprietary funds are required to report their cash flows from operating activities using the direct method, as mandated by the Governmental Accounting Standards Board (GASB). The direct method offers a straightforward presentation of actual cash transactions, showing specific inflows and outflows related to operating activities without adjusting for non-cash items. This method provides greater transparency and clarity, making it easier for stakeholders to assess the fund’s operational efficiency.

Under the direct method, the cash inflows and outflows from operating activities are reported separately, including:

• Cash Inflows: These typically consist of cash receipts from customers or users of the services provided by the fund. For example, a transportation system would report fare collections from passengers as a cash inflow.
• Cash Outflows: Outflows are typically payments for operating expenses, such as wages, supplies, and services required to maintain the operation of the fund. For instance, a water utility fund would report payments for chemicals used in water treatment as a cash outflow.

This direct approach is beneficial for governmental reporting because it clearly outlines how much cash is generated from operations and where it is spent. Stakeholders, including auditors and public officials, can easily track whether the proprietary fund is self-sustaining or if it relies on external financing to cover operating costs. Furthermore, the direct method allows governments to focus on transparency and accountability by providing detailed information on the sources and uses of cash, making it an essential tool for effective financial management.

Noncapital Financing Activities

Examples of Transactions

Noncapital financing activities encompass cash flows related to borrowing and repaying debt, grants, and subsidies that are not connected to capital assets. These activities reflect the external financial support that governmental proprietary funds often rely on to maintain operations without directly impacting the acquisition or management of capital assets. Unlike capital-related financing, noncapital financing activities focus on short-term funding or operational support rather than long-term investments in infrastructure or equipment.

Examples of noncapital financing transactions include:

• Grants and Subsidies: Cash received from federal, state, or local governments in the form of grants or subsidies. For example, a public transit fund may receive a state subsidy to help cover operational costs without needing to increase fare prices for users.
• Operating Transfers: Cash inflows from other government funds, such as transfers from the general fund to help support a proprietary fund’s operations. For instance, a city may transfer money from its general fund to the public utilities fund to cover shortfalls in user charges.
• Debt Service Payments: Repayments of debt that is not associated with capital acquisitions. This could include cash outflows for interest payments or repayments of short-term loans that were taken to cover operating expenses.
• Borrowings for Noncapital Purposes: Proceeds from issuing debt that will be used for operational purposes rather than for the purchase of capital assets. For example, a government might issue bonds to support a transportation fund’s cash flow needs while awaiting fare revenues.

Noncapital financing activities are essential for ensuring that governmental proprietary funds can meet their short-term financial obligations without relying solely on capital-related debt or operational revenues.

Differences in Financing Activities for Government Funds Compared to Private Companies

There are significant differences between how noncapital financing activities are handled in governmental proprietary funds and private companies. These differences arise due to the unique nature of government funding sources and objectives compared to profit-driven businesses.

1. External Support Through Grants and Subsidies:
   • Government Funds: Proprietary funds often receive financial support from other government entities in the form of grants or subsidies. These cash inflows help offset the cost of providing essential public services, such as transportation or utilities, without increasing user fees or reducing service quality. Noncapital financing often involves reliance on intergovernmental support to maintain affordable services.
   • Private Companies: Private-sector businesses rarely rely on external subsidies or grants. Instead, they primarily focus on generating revenue through operations or private investments. Financing activities are usually limited to borrowing through loans or issuing stock to raise capital.
2. Operating Transfers vs. Investor-Based Financing:
   • Government Funds: Operating transfers from other government funds, such as from a general fund to a proprietary fund, are common in the public sector. These transfers help maintain the operational efficiency of funds that may not generate enough revenue to be self-sustaining, especially in cases where services are provided at a subsidized rate to the public.
   • Private Companies: Private-sector companies generally do not engage in internal fund transfers but instead focus on raising funds through equity or debt financing from investors. Operating transfers within different segments of the business are not as common as they are in governmental settings, where distinct funds exist for various activities.
3. Debt Financing for Noncapital Purposes:
   • Government Funds: Noncapital financing activities in governmental proprietary funds may involve borrowing to cover short-term operational needs. Governments may issue bonds or borrow funds to cover deficits in proprietary funds without tying these borrowings to specific capital projects.
   • Private Companies: In the private sector, debt financing is generally used for both operational needs and capital expenditures, but businesses typically focus on generating operating income to cover short-term obligations rather than borrowing specifically for operational purposes. Financing activities for private companies are more heavily focused on raising long-term capital for growth.

While both governmental proprietary funds and private companies engage in financing activities, the sources and purposes of those activities differ significantly. Government funds often rely on grants, subsidies, and transfers, whereas private companies focus on market-based borrowing and investor financing. These differences reflect the public service objectives of government entities compared to the profit maximization goals of private-sector businesses.

Capital and Related Financing Activities

Cash Flows Related to the Acquisition or Sale of Capital Assets

Capital and related financing activities include cash transactions associated with acquiring, constructing, maintaining, or disposing of capital assets such as infrastructure, equipment, or buildings. These activities are critical in governmental proprietary funds because they reflect long-term investments in assets that are essential for providing services to the public. The acquisition and sale of capital assets involve significant cash outflows and, in some cases, cash inflows, which are reported in this section of the statement of cash flows.

Examples of cash flows related to capital asset activities include:

• Cash Outflows for Capital Purchases: These are cash payments made for the acquisition, construction, or improvement of capital assets. For instance, a city may invest in new buses for its public transportation system or upgrade its water treatment facility.
• Proceeds from the Sale of Capital Assets: If a government entity sells an old piece of equipment or disposes of a building, the cash inflow from that sale is reported in this section. This could include the sale of surplus property or obsolete infrastructure.
• Cash Flows from Capital Grants: Sometimes, governmental proprietary funds receive capital grants specifically intended for the purchase or improvement of capital assets. These inflows are critical to help finance large projects without needing to rely solely on operating revenues or borrowing.

The capital and related financing section of the statement of cash flows provides insight into how governments are investing in and managing their capital resources over time. This section is particularly important for stakeholders looking to assess the long-term sustainability of a proprietary fund’s operations, as capital investments often represent substantial, long-term commitments.

Debt Used to Finance Capital Projects

Governmental proprietary funds often rely on debt financing to fund capital projects. This section of the statement of cash flows tracks the borrowing and repayment of debt used for capital-related activities. Debt financing allows governments to invest in large-scale infrastructure improvements or acquisitions that might otherwise be unaffordable through operating revenues alone.

Key examples of debt-related cash flows in capital and related financing activities include:

• Proceeds from Issuing Debt for Capital Projects: Cash inflows from the issuance of bonds or other forms of debt are reported here. These funds are often used to finance long-term capital projects, such as the construction of a new highway or a wastewater treatment plant. Governments frequently issue bonds to raise the necessary capital to fund these significant investments.
• Repayment of Principal and Interest on Capital Debt: Cash outflows for repaying the principal and interest on debt used to finance capital projects are also reported in this section. This could include payments on bonds issued to fund the construction of major public infrastructure. These repayments are typically spread out over many years.
• Capital-Related Debt Service: Governments must also manage the ongoing servicing of debt, which includes both interest payments and principal repayments. The costs associated with servicing debt are an important aspect of capital and related financing activities and reflect the long-term financial obligations governments assume when financing capital projects through borrowing.

Capital and related financing activities give a clear picture of how governmental proprietary funds use debt to finance the acquisition and development of capital assets, as well as how they manage the repayment of that debt over time. These activities are vital for assessing a government’s capital strategy, including its ability to manage and fund major infrastructure projects while maintaining financial stability.

Investing Activities

Cash Flows from Investments

Investing activities in the statement of cash flows for proprietary funds refer to the cash transactions related to the purchase and sale of investment securities, as well as income earned from investments. These activities are critical in managing government resources and ensuring that surplus funds are allocated effectively to generate additional income for the fund.

Examples of cash flows related to investing activities include:

• Interest Received: Governmental proprietary funds often invest in securities such as government bonds or other low-risk financial instruments. The interest earned on these investments is reported as a cash inflow in the investing activities section. For example, a municipal water utility fund may earn interest on its surplus funds invested in bonds.
• Purchases of Investment Securities: Cash outflows occur when a proprietary fund invests in long-term or short-term financial assets. This could involve purchasing bonds, certificates of deposit, or other securities intended to generate future income.
• Proceeds from Sale of Investments: Cash inflows from selling investment securities are also reported here. Governments may sell investments to generate cash for future projects or operational needs, or to realize gains on their investments.
• Dividends Received: Some proprietary funds may also receive dividends from equity investments, although this is less common in government accounting compared to the private sector. Any dividends received would be reported as cash inflows under investing activities.

Investing activities provide insight into how governmental proprietary funds manage their resources, ensuring that any excess cash is invested prudently to generate additional income, which can support the fund’s operations or future capital needs.

Importance of Separating Investing Activities from Operating and Financing Activities

It is essential to separate investing activities from operating and financing activities in the statement of cash flows to provide a clear and accurate picture of the fund’s financial health. This distinction allows stakeholders to differentiate between cash generated from regular operational activities, financing decisions, and resource allocation strategies through investments.

The importance of separating investing activities includes:

• Transparency in Resource Allocation: By clearly reporting cash flows related to investments separately, stakeholders can better understand how surplus cash is being managed. It allows for transparency in how governmental proprietary funds are using public resources to generate additional income through investments.
• Avoiding Misinterpretation of Operational Cash Flows: Including investing activities within operating or financing sections could distort the actual cash generated or used by the fund’s core operations. Separating these activities ensures that stakeholders can accurately assess the fund’s ability to generate cash from its primary functions without confusing investment-related inflows or outflows with operational performance.
• Highlighting Long-Term Financial Strategy: Separating investing activities allows for clearer visibility into the government’s long-term financial strategies. It shows how proprietary funds use investments not only to generate income but also to position themselves for future financial needs, such as funding capital projects or building reserves.

The separation of investing activities ensures that proprietary funds maintain a clear distinction between their day-to-day operational cash flows and their strategic financial decisions related to investments. This clarity supports better financial reporting and enhances the fund’s accountability to stakeholders.

Reconciliation of Operating Income to Net Cash Provided (Used) by Operating Activities

Explanation of Adjustments Needed (Depreciation, Changes in Working Capital, etc.)

The reconciliation of operating income to net cash provided (or used) by operating activities is an essential component of the Statement of Cash Flows for proprietary funds. This reconciliation adjusts the operating income (reported on the accrual basis of accounting) to reflect the actual cash flows from operating activities (reported on the cash basis).

The reconciliation process involves adjusting for non-cash items and changes in working capital that affect cash flow but are not included in the calculation of operating income. Key adjustments include:

• Depreciation and Amortization: Since depreciation is a non-cash expense that reduces the book value of capital assets over time, it is added back to operating income. Amortization of intangible assets follows the same treatment. These adjustments ensure that the actual cash impact of asset usage is not overstated in the statement.
• Changes in Working Capital: Changes in current assets and liabilities affect the cash position of the fund, requiring adjustments to reflect actual cash movements:
  • Accounts Receivable: An increase in accounts receivable represents sales made but not yet collected, reducing cash flow. A decrease in accounts receivable means more cash has been collected.
  • Accounts Payable: An increase in accounts payable means that the fund has incurred expenses that have not yet been paid, increasing cash flow temporarily. A decrease in accounts payable indicates that the fund has made payments, reducing cash flow.
  • Inventory: Increases in inventory represent cash outflows to purchase goods that have not yet been sold, while decreases in inventory reflect sales of previously purchased goods, freeing up cash.
• Accrued Expenses and Prepaid Items: Similar adjustments are made for accrued liabilities (expenses that have been incurred but not yet paid) and prepaid expenses (expenses paid in advance). Accruals increase cash flow by deferring payments, while prepayments reduce cash flow.

These adjustments reconcile the difference between operating income, which is based on accrual accounting, and net cash provided by operating activities, which reflects the actual cash movement associated with those activities.

Differences from Direct Method Reporting in Private Sector Cash Flow Statements

In government accounting, the direct method is required for reporting the cash flows of proprietary funds, whereas private-sector entities often use the indirect method. These methods differ in how they present cash flows from operating activities and in their approach to reconciling operating income to cash flows.

• Direct Method (Governmental Accounting): The direct method provides a detailed breakdown of actual cash receipts and payments from operating activities. This method presents cash inflows (e.g., customer payments) and cash outflows (e.g., supplier payments, wages) separately, giving a clear and transparent view of how cash is generated and used. The reconciliation of operating income to net cash provided by operating activities is included separately at the end of the statement to explain non-cash adjustments like depreciation and changes in working capital.
• Indirect Method (Private Sector): In the private sector, companies often use the indirect method, which begins with net income and adjusts for non-cash items (such as depreciation) and changes in working capital to arrive at net cash provided by operating activities. The indirect method does not provide a direct view of cash receipts and payments; instead, it focuses on how accrual-based net income is adjusted to reflect actual cash flow.

The key difference lies in the presentation:

• The direct method (used in governmental proprietary funds) focuses on transparency, offering detailed cash transaction information for all operating activities.
• The indirect method (common in private sector accounting) emphasizes the relationship between net income and cash flow, providing a more aggregated view of operational cash movement.

In the context of proprietary funds, the direct method, combined with the reconciliation of operating income to net cash provided by operating activities, ensures that stakeholders can easily assess both the operational performance and the actual cash flows generated from core activities, enhancing financial transparency and accountability.

Steps for Preparing the Statement of Cash Flows for Proprietary Funds

Step 1: Gather Financial Data (Trial Balance, General Ledger)

The first step in preparing the Statement of Cash Flows for proprietary funds is to gather all relevant financial data. This typically includes the trial balance and general ledger, which contain detailed information on the fund’s revenues, expenses, assets, liabilities, and equity. These records will provide the necessary data to calculate cash flows and classify them into the appropriate categories.

Key financial data to gather:

• Revenues from user charges and other income sources.
• Operating expenses, including wages, supplier payments, and utility costs.
• Records of debt transactions, both capital and noncapital.
• Purchases and sales of capital assets.
• Investment income and transactions.

Having a comprehensive view of the fund’s financial activities ensures accurate classification and calculation of cash flows.

Step 2: Classify Cash Flows into the Appropriate Categories (Operating, Noncapital Financing, etc.)

Once the financial data is collected, the next step is to classify cash flows into the appropriate categories. Proprietary funds use four specific sections in the Statement of Cash Flows:

• Operating Activities: Cash inflows and outflows directly related to the core operations of the fund. This includes receipts from customers, payments to suppliers, and wages.
• Noncapital Financing Activities: Cash flows not related to capital assets, such as grants, subsidies, and debt service payments that are not connected to capital projects.
• Capital and Related Financing Activities: Cash flows associated with the acquisition, improvement, or sale of capital assets, along with the financing of these projects through debt. This includes cash inflows from issuing debt for capital projects and outflows for the repayment of capital-related debt.
• Investing Activities: Cash flows from investment-related transactions, such as the purchase or sale of securities and interest income.

Proper classification of cash flows into these categories is essential for clear reporting and to ensure compliance with GASB requirements.

Step 3: Calculate Cash Flows for Each Section

Once cash flows have been classified, calculate the cash inflows and outflows for each section of the statement:

• Operating Activities: Add up all cash receipts from customers and deduct payments made to suppliers, employees, and other operating expenses. For proprietary funds, this is done using the direct method, where actual cash transactions are presented.
• Noncapital Financing Activities: Sum all cash inflows from noncapital sources like grants and subsidies, and deduct payments for noncapital debt service and other related outflows.
• Capital and Related Financing Activities: Calculate cash inflows from borrowing or selling capital assets and deduct outflows related to capital asset purchases and capital debt repayments.
• Investing Activities: Total cash inflows from interest, dividends, or sales of investments, and subtract outflows related to the purchase of investment securities.

This step provides a clear calculation of how cash is generated and used within each category.

Step 4: Reconcile Operating Income to Net Cash Provided by Operating Activities

After calculating cash flows for operating activities, it is necessary to reconcile the operating income (as reported on the accrual basis of accounting) to the net cash provided by operating activities (reported on the cash basis).

Adjustments to make in the reconciliation process include:

• Adding back non-cash expenses like depreciation and amortization.
• Adjusting for changes in working capital (accounts receivable, accounts payable, inventory, etc.).
• Reflecting any other non-cash items that affect operating income but not cash flow.

This step ensures that the cash flows from operating activities accurately reflect the fund’s cash transactions, aligning accrual-based figures with actual cash movement.

Step 5: Review and Ensure Compliance with GASB Standards

The final step in preparing the Statement of Cash Flows is to review the entire statement and ensure that it complies with the Governmental Accounting Standards Board (GASB) requirements, particularly GASB Statement No. 34. GASB standards mandate the use of the direct method for reporting cash flows for proprietary funds and require reconciliation of operating income to net cash provided by operating activities.

Key points to check for compliance include:

• Proper classification of cash flows into the four required sections.
• Accurate reconciliation of operating income to cash flow.
• Clear disclosure of significant non-cash transactions (e.g., donated assets or capital assets acquired through financing).
• Adherence to the format and presentation guidelines specified by GASB.

Ensuring compliance with GASB standards is critical to maintaining transparency, accuracy, and accountability in financial reporting for governmental proprietary funds.

Key Considerations and Best Practices

Common Pitfalls to Avoid When Preparing the Statement

When preparing the Statement of Cash Flows for proprietary funds, several common pitfalls can lead to errors and misrepresentation of the fund’s cash position. Avoiding these pitfalls is essential for ensuring accuracy and compliance with GASB standards.

• Misclassifying Cash Flows: One of the most frequent errors is misclassifying cash flows between operating, noncapital financing, capital, and investing activities. For example, incorrectly categorizing debt service related to capital projects as operating activities can distort the true cash flow picture. Ensure that each cash flow is assigned to the appropriate section based on its nature.
• Overlooking Non-Cash Transactions: Failing to account for non-cash transactions, such as donated assets or non-cash financing activities, can result in incomplete financial reporting. These transactions should be disclosed in the notes to the financial statements, even though they do not directly impact cash flows.
• Inaccurate Reconciliation: The reconciliation of operating income to net cash provided by operating activities requires attention to detail. Errors in adjusting for non-cash items like depreciation or changes in working capital can lead to discrepancies between the accrual-based operating income and cash flows.

By avoiding these common pitfalls, preparers can ensure that the Statement of Cash Flows accurately reflects the fund’s financial position.

Importance of Accuracy in Classifying Cash Flows

Accurate classification of cash flows is crucial for providing a clear and meaningful view of the financial operations of proprietary funds. Each cash flow must be properly categorized into one of four sections: operating, noncapital financing, capital and related financing, or investing activities.

• Operating Activities: Cash flows related to the core services provided by the fund. Accuracy in this section ensures that users of the statement can evaluate the fund’s ability to generate sufficient cash from its normal operations.
• Noncapital Financing Activities: Includes cash flows from sources like grants or subsidies, which are not tied to capital assets. Misclassifying these transactions can lead to a misunderstanding of the fund’s reliance on external financial support.
• Capital and Related Financing Activities: Involves cash flows related to the acquisition or disposal of capital assets and associated debt. Correctly classifying these transactions provides insight into the fund’s long-term capital strategy and debt management.
• Investing Activities: Includes cash flows from investments such as interest income or the purchase of investment securities. Accuracy here ensures a clear picture of how surplus funds are managed.

Misclassification of cash flows can result in financial reports that are misleading, affecting decision-making by government officials and stakeholders.

Use of the Direct Method vs. Indirect Method (and Why the Direct Method Is Required for Government Funds)

The direct method is required by GASB for proprietary funds, as opposed to the indirect method often used in private-sector accounting. The direct method presents specific cash inflows and outflows related to operating activities, offering a clearer and more transparent view of actual cash transactions.

Key reasons the direct method is required for government funds:

• Greater Transparency: The direct method provides a straightforward presentation of cash receipts and payments, which is particularly important in the public sector, where accountability to taxpayers is critical. Stakeholders can see exactly where cash is coming from and how it is being spent.
• Enhanced Decision-Making: Government officials and public users benefit from the detailed information provided by the direct method, as it allows for better evaluation of the fund’s cash-generating ability and financial health.
• GASB Compliance: GASB mandates the use of the direct method for governmental proprietary funds to promote consistency and clarity in financial reporting.

While the indirect method (commonly used by private companies) starts with net income and adjusts for non-cash items, it does not provide the same level of detailed cash transaction information, which is critical for government financial statements.

Ensuring Transparency in Reporting, Especially for Public Scrutiny

Transparency is paramount in government financial reporting, as proprietary funds often manage public resources. The Statement of Cash Flows plays a significant role in demonstrating how public funds are managed, invested, and spent, making it essential to ensure clarity and accuracy in the report.

• Detailed Presentation of Cash Flows: By using the direct method and accurately classifying cash flows, the statement provides a transparent picture of financial activities. This transparency helps build trust with stakeholders, including citizens, auditors, and government officials, who rely on these reports to make informed decisions.
• Disclosure of Non-Cash Transactions: Even though non-cash transactions do not impact cash flows directly, they should be disclosed in the notes to the financial statements to provide a complete financial picture. This helps ensure that stakeholders understand all significant financial activities, even those not involving cash.
• Compliance with GASB Standards: Adhering to GASB guidelines is essential to maintaining transparency and ensuring that financial reports meet the expectations of public accountability. Non-compliance can lead to confusion, misinterpretation of financial health, and potential legal ramifications.

Ensuring transparency and adhering to best practices in reporting strengthens public trust and accountability, providing a reliable foundation for evaluating the financial performance of proprietary funds.

Illustrative Example

Detailed Example of a Statement of Cash Flows for a Governmental Proprietary Fund (Water Utility)

Below is a detailed example of a Statement of Cash Flows for a governmental proprietary fund, specifically for a municipal water utility. This example includes sample numbers and an explanation of each section to demonstrate the logic behind the calculation and classification of cash flows.

Statement of Cash Flows — Water Utility Fund (for the Year Ended December 31, 2023)

Cash Flows from Operating Activities
Receipts from customers	$1,200,000
Payments to suppliers for goods and services	($600,000)
Payments to employees	($250,000)
Other operating cash receipts (late fees, service charges)	$50,000
Net cash provided by operating activities	$400,000

Cash Flows from Noncapital Financing Activities
Operating grants and subsidies received	$100,000
Transfers in from general fund	$50,000
Repayment of noncapital debt	($30,000)
Net cash provided by noncapital financing activities	$120,000

Cash Flows from Capital and Related Financing Activities
Proceeds from issuance of capital debt	$500,000
Purchase of capital assets (water treatment facility)	($700,000)
Principal paid on capital debt	($100,000)
Interest paid on capital debt	($20,000)
Proceeds from sale of capital assets	$50,000
Net cash used in capital and related financing activities	($270,000)

Cash Flows from Investing Activities
Interest received	$10,000
Purchase of investment securities	($40,000)
Proceeds from sale of investments	$30,000
Net cash provided by investing activities	$0

| Net increase in cash and cash equivalents | $250,000 |

| Cash and cash equivalents, beginning of year | $500,000 |
| Cash and cash equivalents, end of year | $750,000 |

Explanation of Each Section

Cash Flows from Operating Activities

Operating activities include the cash inflows and outflows directly related to the core water utility services. The water utility fund received $1,200,000 from customers for water services provided throughout the year. Cash outflows consisted of $600,000 in payments to suppliers for materials and utilities, and $250,000 paid in wages to employees who operate the facility. Additionally, the utility fund received $50,000 in other operating cash receipts, such as late fees and service charges.

Net cash provided by operating activities is $400,000, which shows that the water utility is generating enough cash from its operations to cover its day-to-day expenses.

Cash Flows from Noncapital Financing Activities

Noncapital financing activities reflect cash flows related to noncapital-related financial support and debt service. The water utility received $100,000 in operating grants and subsidies from the state government, which helped to supplement revenue and cover operational costs. Additionally, a $50,000 transfer was made from the general fund to the water utility fund to help maintain services. The fund also repaid $30,000 in noncapital debt (short-term loans or lines of credit not related to capital assets).

Net cash provided by noncapital financing activities is $120,000, showing that external financial support was important to help fund operations.

Cash Flows from Capital and Related Financing Activities

Capital and related financing activities involve the acquisition and financing of capital assets. During the year, the water utility issued $500,000 in capital debt to fund a new water treatment facility. However, the construction cost of the facility was $700,000, resulting in a significant cash outflow. The utility also made principal payments of $100,000 and interest payments of $20,000 on existing capital debt. In addition, the utility sold old equipment for $50,000, which provided a small inflow.

Net cash used in capital and related financing activities is ($270,000), indicating that the utility fund used more cash for capital investments than it generated through debt issuance and asset sales.

Cash Flows from Investing Activities

Investing activities represent cash flows related to investments. The water utility earned $10,000 in interest from its investments, but also purchased additional securities for $40,000 and sold investments for $30,000.

Net cash provided by investing activities is $0, showing that the utility fund neither gained nor lost cash from investing activities during the year.

Net Increase in Cash and Cash Equivalents

The overall net increase in cash and cash equivalents for the year was $250,000, reflecting a positive cash flow position. Starting with $500,000 in cash at the beginning of the year, the water utility fund ended with $750,000 in cash and cash equivalents.

This illustrative example demonstrates the flow of cash through a governmental proprietary fund, showing how different activities contribute to or use the available cash. By categorizing cash flows into operating, noncapital financing, capital-related financing, and investing activities, the water utility can provide a clear and transparent financial picture for public stakeholders.

Conclusion

Recap of the Significance of the Statement of Cash Flows in Governmental Accounting

The Statement of Cash Flows plays a critical role in governmental accounting, especially for proprietary funds like water utilities, transportation services, and internal service departments. It provides a transparent and detailed view of how cash flows in and out of the fund, allowing stakeholders to assess the fund’s liquidity, sustainability, and financial performance. By categorizing cash flows into operating, noncapital financing, capital-related financing, and investing activities, the statement offers a comprehensive understanding of how a government manages public resources, invests in infrastructure, and meets its financial obligations.

For governmental proprietary funds, this statement not only helps assess operational efficiency but also ensures accountability to the public and other stakeholders by offering clear insights into how taxpayer funds and user fees are managed.

Key Takeaways for BAR CPA Exam Candidates

As BAR CPA exam candidates, understanding the preparation and interpretation of the Statement of Cash Flows for proprietary funds is crucial. Key takeaways include:

1. Master the Classification of Cash Flows: Recognizing the distinctions between operating, noncapital financing, capital-related financing, and investing activities is essential for accurate reporting.
2. Understand the Direct Method: The GASB mandates the use of the direct method for reporting operating cash flows, which differs from the indirect method commonly used in the private sector. Familiarize yourself with the direct presentation of cash receipts and payments.
3. Accurate Reconciliation: Be sure to understand how to reconcile operating income to net cash provided by operating activities by adjusting for non-cash items and changes in working capital.
4. Ensure Compliance with GASB Standards: Compliance with GASB Statement No. 34 is critical for governmental accounting, and understanding these guidelines will ensure the statement is prepared correctly.

Final Tips for Mastering the Preparation of this Statement

1. Focus on Precision: Accuracy in classifying cash flows and calculating net changes in cash is essential. Ensure that every transaction is classified correctly to reflect the true financial picture.
2. Practice with Examples: Work through sample statements of cash flows for various types of proprietary funds to reinforce your understanding of the structure and calculations involved.
3. Understand Non-Cash Transactions: Even though they don’t affect cash flow directly, non-cash transactions like depreciation and capital asset donations must be properly accounted for in reconciliation and disclosures.
4. Review GASB Guidance: Stay familiar with the requirements set by GASB, especially Statement No. 34, to ensure your preparation aligns with governmental accounting standards.

By mastering the Statement of Cash Flows for proprietary funds, you will be well-prepared to tackle questions on the BAR CPA exam and demonstrate your understanding of this essential financial report in governmental accounting.