BAR CPA Exam: Understanding the Basic Concepts and Principles Regarding Proprietary Fund Financial Statements of a State or Local Government

Introduction

Overview of State and Local Government Financial Reporting

Purpose of Government Financial Statements

In this article, we’ll cover understanding the basic concepts and principles regarding proprietary fund financial statements of a state or local government. State and local governments have a unique financial structure compared to private-sector businesses, which necessitates specific accounting and reporting standards. The primary purpose of government financial statements is to provide transparency, accountability, and useful information to various stakeholders, including taxpayers, creditors, and oversight bodies. These financial statements allow users to assess the financial condition, fiscal responsibility, and operating efficiency of governmental entities.

Government financial reporting is essential for decision-making, ensuring public funds are used efficiently, and determining whether entities are fulfilling their legal and fiduciary obligations. Unlike private businesses, which focus on profitability, governmental entities are primarily concerned with ensuring public resources are allocated in a manner that serves the public good.

Introduction to Governmental Funds vs. Proprietary Funds

Government financial statements are generally divided into two broad categories based on the nature of their activities: governmental funds and proprietary funds.

• Governmental Funds: These are used to account for activities primarily supported by taxes and intergovernmental revenues. They focus on short-term resources and expenditures, and typically use the modified accrual accounting method. Common types of governmental funds include the general fund, special revenue funds, capital projects funds, and debt service funds.
• Proprietary Funds: These are used to account for activities that are operated similarly to private businesses, where the government charges fees for services. Proprietary funds follow the accrual accounting method and focus on long-term financial health. This category is further divided into two main types: enterprise funds and internal service funds.

Importance of Proprietary Funds

Definition and Purpose

Proprietary funds are established to report on government activities that provide goods or services to the public or other government departments on a cost-recovery basis. The key purpose of proprietary funds is to ensure that these services are self-sustaining, meaning the revenues generated from providing the services cover the associated costs. These funds mirror private-sector accounting practices by using the full accrual basis of accounting, which helps present a more complete picture of the financial performance and position of the related activities.

Proprietary funds are crucial for governmental activities that operate with a business-like focus, such as utility services (e.g., water, sewage, or electricity) or the operation of airports and toll roads. By segregating these activities into proprietary funds, governments can maintain better oversight and accountability for self-supporting services.

Key Differences Between Governmental and Proprietary Fund Financial Statements

While both governmental and proprietary fund financial statements aim to provide transparency and accountability, they differ in several key aspects:

1. Accounting Basis:
   • Governmental Funds use the modified accrual basis of accounting, where revenues are recognized when they are measurable and available, and expenditures are recognized when the associated liabilities are incurred. This focus is on current financial resources.
   • Proprietary Funds, on the other hand, use the accrual basis of accounting, similar to the private sector. Revenues are recognized when earned, and expenses are recognized when incurred, regardless of when cash is received or paid.
2. Financial Focus:
   • Governmental Funds focus on current financial resources and short-term obligations. This results in an emphasis on near-term liquidity and budgetary compliance.
   • Proprietary Funds focus on economic resources, which means they account for long-term assets and liabilities, providing a more comprehensive view of the entity’s financial health.
3. Financial Statements:
   • Governmental Funds typically present a balance sheet and a statement of revenues, expenditures, and changes in fund balances.
   • Proprietary Funds include more detailed financial statements, such as a statement of net position, statement of revenues, expenses, and changes in fund net position, and a statement of cash flows, similar to what is found in private-sector financial reporting.

These differences are critical for understanding how to interpret and analyze proprietary fund financial statements within the broader context of state and local government financial reporting.

Types of Proprietary Funds

Enterprise Funds

Definition and Common Examples

Enterprise funds are a type of proprietary fund used by state and local governments to account for operations that are financed and operated similarly to private businesses. The key feature of an enterprise fund is that the services provided are funded primarily through user fees, making the operation self-sustaining. This means the costs of providing goods or services, including capital improvements, are recovered through charges to the users rather than through taxes or other governmental revenues.

Common examples of activities accounted for using enterprise funds include:

• Water Utilities: Government-operated water treatment and distribution systems often charge residents and businesses for water usage, with the goal of covering operational and maintenance costs.
• Airports: Many municipal and regional airports are operated as enterprise funds, where fees from airlines, passengers, and commercial activities help fund airport operations.
• Public Transportation: Transit authorities that provide bus, rail, or other public transportation services often operate as enterprise funds, with passenger fares and government grants covering the costs.
• Electric and Gas Utilities: Some local governments operate utility services that provide electricity or gas to residents, with user fees structured to recover operational and capital costs.
• Waste Management Services: Trash collection and recycling services are often run through enterprise funds, with service fees charged to users.

Criteria for Establishing an Enterprise Fund

Governments may establish an enterprise fund when the following conditions apply:

1. Self-Sustaining Operation: The activity is expected to generate sufficient revenues through user charges to cover the costs of providing the service. Enterprise funds are typically set up for services that can operate in a similar fashion to a private business, where customers pay for the services they use.
2. User Fees Are a Primary Revenue Source: Enterprise funds are used for operations where there is a direct charge to users for the goods or services provided. The objective is to recover the cost of providing the service through these fees, rather than relying on general tax revenues.
3. Reporting Requirements: In some cases, external legal or contractual requirements may mandate that a government establish an enterprise fund. For example, bond agreements related to the financing of infrastructure may require that the government accounts for the operation of the facility using an enterprise fund to demonstrate financial accountability and transparency to bondholders.
4. Business-Like Operation: The government activity operates in a way that is similar to a commercial business, meaning it has revenues, expenses, and capital assets that must be tracked. Using an enterprise fund allows for the financial statements of the activity to closely mirror those of a private-sector entity, providing a clearer view of its financial performance.

By using enterprise funds, governments are able to provide essential public services while maintaining financial accountability and transparency. The structure of enterprise funds ensures that users who directly benefit from the services are the ones who bear the costs, making it an efficient financial management tool for state and local governments.

Types of Proprietary Funds

Internal Service Funds

Definition and Common Examples

Internal service funds are a type of proprietary fund used by state and local governments to account for activities that provide goods or services to other departments or agencies within the government, rather than to the public. The goal of these funds is to centralize services that are used by multiple departments, allowing for more efficient allocation of resources and cost recovery through inter-departmental charges.

Internal service funds operate similarly to enterprise funds but serve an internal government function, rather than external customers. They are used to manage costs by charging the benefiting departments a fee based on usage or cost of services provided.

Common examples of activities accounted for using internal service funds include:

• Motor Pools: Many governments manage a centralized fleet of vehicles, such as police cars or maintenance trucks, that are shared among different departments. The costs of maintaining and operating these vehicles are recovered through charges to the departments using the fleet.
• Information Technology (IT) Services: Centralized IT services, including network infrastructure, cybersecurity, and technical support, are often provided to various departments through an internal service fund. Departments pay for the services they consume based on usage metrics, such as data storage or the number of devices supported.
• Centralized Printing Services: Governments may establish a centralized printing and reproduction service that handles all print jobs for different departments. This reduces the need for each department to maintain its own printing equipment and staff.
• Risk Management Services: Some governments manage insurance, risk management, and employee benefits through internal service funds, recovering the costs by charging other departments or agencies for their share of the expenses.

How They Differ from Enterprise Funds

Although both internal service funds and enterprise funds are types of proprietary funds, they differ in several significant ways:

1. Customer Base:
   • Internal Service Funds: These funds provide services exclusively to other departments or agencies within the same governmental entity. Their customers are internal users, such as government departments, rather than the general public.
   • Enterprise Funds: These funds provide services directly to external customers, such as the public or businesses, and operate in a manner similar to private-sector businesses.
2. Revenue Source:
   • Internal Service Funds: Revenues are generated through charges or fees to the government departments that utilize the services. The goal is cost recovery, not profit generation. The charges are typically based on usage, such as miles driven for motor pool vehicles or hours of IT support provided.
   • Enterprise Funds: Revenues come from fees or user charges paid by external customers who receive the goods or services. These fees are designed to cover the costs of operations and, in some cases, contribute to future capital improvements.
3. Focus of Operations:
   • Internal Service Funds: The focus is on internal efficiency and cost management across government departments. By centralizing services in an internal service fund, governments can reduce duplication of efforts, ensure consistent service levels, and optimize resource use.
   • Enterprise Funds: These funds are focused on delivering services to the public and maintaining self-sufficiency through revenue generation. They often compete with private-sector providers of similar services and are expected to be financially independent.
4. Reporting and Accountability:
   • Internal Service Funds: These funds are used to ensure cost control and efficiency within government operations. Since they only serve internal departments, the reporting focuses on cost recovery and resource allocation among departments.
   • Enterprise Funds: The reporting for enterprise funds is more similar to that of private businesses, with a focus on profitability, cost coverage, and long-term financial sustainability. Financial statements for enterprise funds are typically presented to external users, such as citizens or bondholders, and include metrics related to service pricing and operational efficiency.

By utilizing internal service funds, governments can enhance efficiency and transparency in managing internal operations, ensuring that shared services are delivered in a cost-effective manner.

Basic Concepts of Proprietary Fund Accounting

Accrual Accounting Basis

Explanation of Full Accrual Accounting

Proprietary funds utilize the full accrual basis of accounting, aligning their accounting practices closely with those of private-sector businesses. Under full accrual accounting, revenues are recognized when they are earned, and expenses are recognized when they are incurred, regardless of when cash is received or paid. This method provides a comprehensive view of the fund’s financial position and operations by accounting for all assets and liabilities, both current and long-term.

In this context, the full accrual basis captures the economic realities of transactions. It records not only the immediate cash flows but also future obligations and resources, such as receivables, payables, and depreciation of capital assets. This approach ensures that the financial statements reflect the true financial health and performance of the fund over time.

Recognition of Revenues and Expenses in Proprietary Funds

• Revenues: In proprietary funds, revenues are recorded when they are earned, not necessarily when the cash is received. This includes service charges, fees, and other income generated from the fund’s operations. For example, if a municipal water utility provides services in December but doesn’t receive payment until January, the revenue is still recognized in December’s financial statements.
• Expenses: Expenses are recognized when they are incurred, which means when the liability arises, not when the cash is paid out. This includes operating expenses like salaries, utilities, and maintenance costs, as well as non-operating expenses such as interest on debt. Additionally, proprietary funds account for depreciation expense, allocating the cost of capital assets over their useful lives.

By recognizing revenues and expenses in this manner, proprietary funds present a more accurate picture of financial performance, enabling stakeholders to assess operational efficiency and cost management effectively.

Economic Resources Measurement Focus

Differences from the Current Financial Resources Focus in Governmental Funds

Proprietary funds employ the economic resources measurement focus, which differs fundamentally from the current financial resources measurement focus used in governmental funds.

• Economic Resources Measurement Focus:
  • Scope: Includes all assets and liabilities, both current and long-term.
  • Objective: Provides a complete assessment of the fund’s total economic resources and obligations.
  • Accounting Basis: Paired with full accrual accounting to capture the full economic impact of transactions.
• Current Financial Resources Measurement Focus:
  • Scope: Concentrates on short-term assets and liabilities that affect the fund’s current financial resources.
  • Objective: Emphasizes fiscal accountability and budgetary compliance within the current period.
  • Accounting Basis: Used with modified accrual accounting, recognizing revenues when they become available and measurable, and expenditures when liabilities are incurred.

The key difference lies in the time horizon and comprehensiveness of the financial information reported. While governmental funds focus on immediate fiscal periods and liquidity, proprietary funds provide insights into long-term financial sustainability and capital investment.

Examples of Long-Term Assets and Liabilities Reported

Under the economic resources measurement focus, proprietary funds report a wide range of long-term assets and liabilities in their financial statements:

• Long-Term Assets:
  • Capital Assets: Includes property, plant, and equipment such as buildings, infrastructure (e.g., water treatment facilities, transit systems), machinery, and vehicles used in operations.
  • Intangible Assets: Assets lacking physical substance but holding value, like patents, trademarks, or software licenses.
  • Construction in Progress: Costs associated with capital projects that are not yet completed but will become capital assets upon completion.
• Long-Term Liabilities:
  • Bonds Payable: Debt instruments issued to finance significant capital projects, repayable over periods exceeding one year.
  • Notes Payable: Long-term borrowings from financial institutions or other entities.
  • Lease Obligations: Long-term lease agreements, particularly capital leases where the lessee assumes some risks and benefits of ownership.
  • Pension Liabilities: Obligations related to employee retirement benefits that will be paid in the future.
  • Compensated Absences: Liabilities for earned but unused vacation or sick leave that employees can carry over to future periods or receive payment for upon termination.

By reporting these long-term items, proprietary funds provide stakeholders with a transparent view of the fund’s ability to generate future revenues and meet ongoing obligations. This comprehensive reporting is crucial for:

• Assessing Financial Health: Stakeholders can evaluate the fund’s solvency and sustainability over the long term.
• Decision-Making: Management and policymakers can make informed decisions regarding pricing of services, capital investments, and financing strategies.
• Accountability: Demonstrates responsible stewardship of resources by showing how funds are used to acquire assets and manage debts.

The economic resources measurement focus and full accrual accounting together ensure that proprietary fund financial statements offer a complete and accurate portrayal of a government’s business-like activities, facilitating better governance and financial management.

Key Financial Statements of Proprietary Funds

Statement of Net Position

Purpose and Layout

The Statement of Net Position is one of the key financial statements for proprietary funds. Its primary purpose is to provide a snapshot of the financial position of the fund at a given point in time. It is similar to a balance sheet in private-sector financial reporting, detailing the fund’s assets, liabilities, and net position, which represents the difference between the two.

The layout of the Statement of Net Position follows a clear structure:

• Assets: This section lists the fund’s resources, including both current and non-current assets. Current assets typically include cash and cash equivalents, receivables, and inventories. Non-current assets consist of capital assets such as buildings, infrastructure, equipment, and intangible assets.
• Liabilities: This section details the fund’s obligations, both current and non-current. Current liabilities include accounts payable, short-term debt, and accrued expenses, while non-current liabilities may include long-term debt (e.g., bonds payable), pension obligations, and lease liabilities.
• Net Position: This is the equity section of the statement, representing the residual interest in the assets of the proprietary fund after deducting liabilities. The net position is divided into different categories that show how much of the fund’s net resources are restricted, unrestricted, or tied to capital assets.

The Statement of Net Position provides essential information for assessing the overall financial health of a proprietary fund, including its liquidity, solvency, and long-term sustainability.

Categories of Net Position

The net position section is broken down into three key categories: Net Investment in Capital Assets, Restricted Net Position, and Unrestricted Net Position. Each category offers insight into the financial flexibility and constraints of the fund.

1. Net Investment in Capital Assets
   • This category represents the portion of the net position that is tied to the proprietary fund’s capital assets, such as land, buildings, and equipment, minus any related debt. It reflects the amount of capital assets owned by the fund that are free of any external debt or financing obligations.
   • Formula: Capital Assets – Accumulated Depreciation – Outstanding Debt Related to Capital Assets.
   • This figure is important because it shows how much of the fund’s resources are invested in long-term infrastructure and cannot easily be converted into cash for other uses.
2. Restricted Net Position
   • Restricted net position represents resources that are subject to external restrictions. These restrictions are imposed by laws, regulations, or contractual obligations that dictate how these funds must be used. For example, bond covenants may restrict certain revenues to be used exclusively for debt service or capital projects.
   • These funds are not available for general government operations and can only be used for specific purposes as defined by external parties or legal agreements.
3. Unrestricted Net Position
   • Unrestricted net position is the most flexible category, as it represents the residual amount of resources that are not tied to capital assets or restricted for specific purposes. This amount can be used for any legitimate operational needs of the proprietary fund, such as covering day-to-day expenses, managing short-term liabilities, or funding new projects.
   • A positive unrestricted net position indicates a fund’s financial flexibility, while a negative unrestricted net position could suggest financial stress or an over-reliance on debt.

Together, these categories give a complete picture of how the fund’s resources are allocated, the extent of its debt obligations, and the financial constraints or freedoms available for future operations and investments. Understanding these components is crucial for analyzing the financial strength and sustainability of proprietary funds within state and local governments.

Statement of Revenues, Expenses, and Changes in Fund Net Position

Layout and Contents

The Statement of Revenues, Expenses, and Changes in Fund Net Position is designed to provide a detailed view of how a proprietary fund’s financial position has changed over a given reporting period. This statement shows the revenues earned, expenses incurred, and how these activities impact the overall net position of the fund. It essentially tracks the operational performance of the fund, similar to an income statement in the private sector.

The statement is typically divided into several sections to clearly distinguish between operating and non-operating activities:

1. Operating Revenues:
   • These are revenues generated from the fund’s core activities. For example, in an enterprise fund, operating revenues might come from charges for services, such as utility bills paid by customers, public transportation fares, or rental fees. These revenues are the primary income streams that sustain the operations of the fund.
2. Operating Expenses:
   • These expenses relate directly to the fund’s core operations and include the costs necessary to provide services. Examples of operating expenses include salaries, utilities, maintenance, and supplies used in the course of delivering services to customers. Depreciation on capital assets is also categorized as an operating expense, as it represents the consumption of these assets over time.
3. Operating Income (Loss):
   • This section calculates the difference between operating revenues and operating expenses, giving a snapshot of the fund’s profitability from its primary operations. A positive figure indicates that revenues exceed expenses, while a negative figure signals an operating loss.
4. Non-Operating Revenues:
   • Non-operating revenues include income that is not directly related to the fund’s core operations. Common sources of non-operating revenues are investment income, grants, subsidies, and interest earnings. For example, a water utility might receive a federal grant for infrastructure improvements, which would be classified as non-operating revenue.
5. Non-Operating Expenses:
   • Similarly, non-operating expenses are costs that are not directly tied to the primary activities of the fund. These typically include interest on debt, costs associated with financing, or other non-operational activities. For example, interest payments on bonds issued to finance a capital project would fall into this category.
6. Income Before Contributions and Transfers:
   • This section provides the total income (or loss) of the fund after factoring in both operating and non-operating revenues and expenses. It indicates the overall profitability of the fund before considering external contributions, transfers, or other one-time items.
7. Capital Contributions, Transfers, and Special Items:
   • This part of the statement accounts for contributions and transfers that can affect the fund’s net position but are not a result of the fund’s operations. For instance, the transfer of resources from the general fund to a proprietary fund, or one-time capital contributions from federal or state grants, would be recorded here.
   • Special items, such as significant non-recurring transactions or events that are both unusual and infrequent, may also be included in this section.
8. Change in Net Position:
   • The final section shows the net increase or decrease in the fund’s net position over the reporting period. This figure reflects the total financial performance of the fund, including both operational and non-operational activities. It links directly to the Statement of Net Position, illustrating how the fund’s net resources have changed.

Understanding the Flow of Activities

The flow of activities in the Statement of Revenues, Expenses, and Changes in Fund Net Position is designed to provide a comprehensive picture of the proprietary fund’s financial health by clearly separating its core operations from peripheral or one-time transactions.

• Operating Activities: These are the primary focus of the statement, as they reflect the day-to-day business of the fund. By focusing on operating income (or loss), stakeholders can assess how efficiently the fund is generating revenue relative to its operational costs. For example, a public transportation fund’s ability to cover its operating costs through fares and fees is a key measure of its financial health.
• Non-Operating Activities: These activities provide additional insights into the fund’s broader financial management. Non-operating revenues and expenses can significantly impact the overall financial performance of the fund, even though they do not arise from day-to-day operations. For instance, if a water utility receives a significant grant or incurs large interest expenses, this can heavily influence the bottom line even if core operations remain steady.
• Contributions and Transfers: These elements help explain any major shifts in the fund’s net position that result from external sources or one-time occurrences. For example, a capital contribution for new infrastructure could improve the net position without affecting operating performance.

Overall, the Statement of Revenues, Expenses, and Changes in Fund Net Position offers a clear narrative of how a proprietary fund generates and uses its resources. It not only reveals the profitability of core operations but also shows the impact of financial management, debt, and external contributions on the fund’s financial position. This makes it an invaluable tool for assessing the long-term sustainability of government-run business activities.

Statement of Cash Flows

Differences from the Cash Flow Statement in Private-Sector Financial Statements

The Statement of Cash Flows for proprietary funds provides critical information about the cash inflows and outflows related to the fund’s operations, financing, and investing activities over a specific period. While it serves a similar purpose as the cash flow statement in private-sector businesses, there are notable differences in its format and categories due to the unique nature of government activities.

In private-sector financial statements, cash flows are typically classified into three categories: operating, investing, and financing activities. However, for proprietary funds, the Governmental Accounting Standards Board (GASB) requires an additional category to be included—noncapital financing activities—to better reflect the nature of governmental financing and its reliance on sources such as grants or intergovernmental transfers that do not necessarily correspond to capital-related projects. Additionally, the proprietary fund cash flow statement uses the direct method for reporting cash flows from operating activities, unlike the private sector, where companies often opt for the indirect method.

Key differences include:

• Required use of the direct method: GASB mandates that proprietary funds report cash flows from operating activities using the direct method, which shows the specific sources and uses of cash (e.g., cash receipts from customers, cash paid to suppliers). This method provides clearer insight into the actual cash transactions of the fund.
• Inclusion of noncapital financing activities: Governmental proprietary funds often engage in noncapital financing activities that do not involve long-term capital assets but still represent significant cash flows. These activities, such as intergovernmental transfers, are crucial in public-sector accounting.
• Emphasis on cash over accrual-based results: The statement of cash flows focuses entirely on actual cash movement, which contrasts with the accrual-based recognition of revenues and expenses in the other financial statements.

Required Categories (Operating, Noncapital Financing, Capital and Related Financing, Investing Activities)

The proprietary fund Statement of Cash Flows is divided into four categories to show the sources and uses of cash in different types of activities:

1. Operating Activities
   • This category reflects the cash flows associated with the day-to-day operations of the fund, such as providing services and paying suppliers. Examples of cash inflows include receipts from customers for services rendered (e.g., utility payments or transit fares). Outflows may include payments to employees, suppliers, and for operating expenses like utilities.
   • Operating cash flows are important because they reveal whether the fund’s core activities generate sufficient cash to cover its operating expenses.
2. Noncapital Financing Activities
   • This section accounts for cash flows related to non-operating activities that are not associated with capital projects. Examples include intergovernmental transfers, grants, subsidies, and cash receipts from bond proceeds that are not intended for capital expenditures.
   • Noncapital financing activities highlight the reliance of proprietary funds on external financing, such as federal or state grants, to support operations or maintain liquidity without affecting capital assets.
3. Capital and Related Financing Activities
   • This category captures cash flows related to the acquisition, construction, and financing of capital assets, such as buildings or infrastructure. It includes cash inflows from issuing bonds for capital projects and cash outflows for purchasing or constructing long-term assets like new equipment or facilities.
   • In addition, it records debt-related cash flows, such as principal and interest payments on bonds issued to finance capital projects.
   • These cash flows provide insight into the fund’s investments in infrastructure and long-term assets, as well as its strategies for financing those investments.
4. Investing Activities
   • Investing activities reflect the cash flows associated with the purchase and sale of investments, as well as income from investments (e.g., interest and dividends). For proprietary funds, investing activities typically involve managing idle cash reserves or surplus funds.
   • These cash flows help demonstrate how the fund manages its financial resources and generates additional income through short- or long-term investments.

Each of these categories plays an essential role in assessing the liquidity and cash management practices of proprietary funds. By analyzing the cash flow statement, stakeholders can gain a clearer understanding of how the fund generates cash from its operations, finances capital projects, and sustains its financial viability through investments and external funding sources. The inclusion of noncapital financing activities and the required use of the direct method provide a detailed view of how government funds manage their cash flows, ensuring transparency and accountability in public financial management.

Significant Concepts and Principles Specific to Proprietary Funds

Operating vs. Non-Operating Revenues and Expenses

Definition and Examples for Each

Operating Revenues and Expenses refer to the income and costs directly related to the core business activities of a proprietary fund. These activities align with the services the fund is designed to provide to external customers (for enterprise funds) or internal government departments (for internal service funds). Operating revenues and expenses are integral to the fund’s primary mission and the continuous provision of services.

• Operating Revenues: These are generated from the sale of goods or services that the proprietary fund provides as part of its main function.
  For example:
  • In an enterprise fund, operating revenues might come from water utility charges, public transportation fares, or fees for waste disposal.
  • In an internal service fund, operating revenues could include fees charged to other departments for IT support or vehicle fleet services.
• Operating Expenses: These represent the costs incurred to deliver the goods or services central to the fund’s operations.
  Examples include:
  • Salaries and wages of employees running a water treatment facility.
  • Maintenance costs, utilities, and supplies related to the operation of public transportation.
  • Depreciation of equipment or infrastructure used in providing services.

On the other hand, Non-Operating Revenues and Expenses are related to activities that do not directly align with the fund’s primary services but still have an impact on its overall financial health. Non-operating activities often involve external financing, grants, or investments.

• Non-Operating Revenues: These are revenues that arise from activities not central to the fund’s primary mission.
  Common examples include:
  • Investment income or interest earned on cash reserves.
  • Grants and subsidies from other governmental units, especially those not tied to day-to-day operations (e.g., federal grants for infrastructure improvements).
• Proceeds from the sale of capital assets, such as land or equipment that is no longer in use.
• Non-Operating Expenses: These expenses are also unrelated to core operations but are necessary for broader financial management.
  Examples include:
  • Interest expenses on debt issued to finance capital projects (e.g., bond payments for building new infrastructure).
  • Costs related to non-operational activities, such as penalties or settlement payments.

Importance of Distinguishing Between Operating and Non-Operating Activities

Properly distinguishing between operating and non-operating revenues and expenses is crucial for several reasons:

1. Assessment of Operational Efficiency: Separating operating from non-operating activities allows stakeholders to evaluate how well the proprietary fund performs its core functions. For example, a water utility fund may generate substantial non-operating income from investment returns, but the focus for performance assessment should be on the revenues from water sales and how efficiently the utility provides its service relative to operating costs.
2. Financial Transparency and Accountability: Clear reporting of operating and non-operating activities enhances financial transparency, enabling stakeholders—such as taxpayers, bondholders, and regulators—to understand where the fund’s resources are coming from and how they are being used. This distinction is especially important in government accounting, where public trust and accountability are paramount.
3. Budgeting and Resource Allocation: When preparing budgets and allocating resources, it is important for government officials to focus on the operating revenues and expenses. Since these are tied directly to the core functions of the proprietary fund, they provide a reliable basis for future financial planning and decision-making.
4. Evaluation of Financial Sustainability: A fund’s long-term sustainability hinges on its ability to generate sufficient operating revenue to cover its operating expenses. If a fund relies heavily on non-operating revenues (e.g., subsidies or grants), it may face sustainability challenges if those sources of revenue decrease or disappear.
5. Debt and Investment Management: Non-operating revenues and expenses often involve external financing and investment activities. By segregating these from operating activities, the financial statements can clearly show how a fund manages its debt obligations and investment strategies, providing insight into its overall financial health.

Distinguishing between operating and non-operating revenues and expenses provides a clearer, more accurate view of a proprietary fund’s core activities and financial performance. It helps stakeholders assess operational efficiency, manage resources effectively, and make informed decisions regarding the fund’s long-term financial sustainability.

Capital Assets and Long-Term Liabilities

Reporting Capital Assets (e.g., Infrastructure, Land, Equipment)

In proprietary funds, capital assets represent significant investments in long-term resources used to provide services over multiple periods. These assets include infrastructure (such as roads, bridges, and water systems), land, buildings, equipment, and intangible assets like software or patents. Reporting these assets on the financial statements is a crucial element of the Statement of Net Position, as it demonstrates the fund’s commitment to maintaining and improving the infrastructure needed to deliver services.

• Infrastructure: This includes physical systems such as water treatment plants, sewer lines, roads, and power grids that are essential for the provision of services. These assets are often the most valuable on the balance sheet due to their importance and longevity.
• Land: Land is reported at its historical cost and is not subject to depreciation, as it does not deteriorate over time. It is a significant long-term asset that can be used for a variety of government services.
• Buildings and Equipment: These assets support the day-to-day operations of the proprietary fund. For example, office buildings, vehicles, and machinery used in public utilities fall into this category.
• Intangible Assets: Proprietary funds may also report intangible assets such as software, patents, or trademarks that are used in operations. These assets are recognized at their purchase price and are subject to amortization over their useful lives.

The capital assets section in the Statement of Net Position typically provides details such as the historical cost of these assets, any accumulated depreciation, and the net book value, which reflects their current worth after depreciation.

Treatment of Depreciation and Amortization

Depreciation and amortization are accounting methods used to allocate the cost of tangible and intangible long-term assets over their useful lives. Proprietary funds must account for depreciation of capital assets as part of their operating expenses, which distinguishes them from governmental funds, where such assets are often not depreciated.

• Depreciation: Tangible capital assets (e.g., infrastructure, buildings, vehicles, equipment) are depreciated to reflect their gradual wear and tear over time. Depreciation expenses are reported annually to spread the cost of the asset over its expected useful life. For example, a utility truck used by a water department may be depreciated over 10 years, reducing the truck’s value on the balance sheet and recognizing a portion of the cost as an operating expense each year.
• Amortization: This process is applied to intangible assets, such as software or licenses, which have a limited useful life. Like depreciation, amortization spreads the cost of the intangible asset over its estimated lifespan, reducing its book value incrementally.

Both depreciation and amortization are essential for accurately reflecting the consumption of assets over time and ensuring that proprietary funds report the full economic cost of their operations. These expenses reduce the net position of the fund but provide a realistic picture of the wear and tear on assets that support service delivery.

Reporting of Long-Term Liabilities (e.g., Bonds, Leases)

Proprietary funds also report long-term liabilities, which represent financial obligations that extend beyond the current fiscal year. These liabilities are crucial for funding capital projects and ongoing operations, and they are reflected in the Statement of Net Position to give a full view of the fund’s financial obligations.

• Bonds Payable: Many proprietary funds issue bonds to finance large capital projects, such as building a new sewage treatment plant or upgrading a public transit system. Bonds payable represent the debt that the fund must repay, typically over a long period (e.g., 10-30 years). The financial statements report the outstanding principal amount of the bonds, along with any interest due.
• Leases: Governmental proprietary funds often enter into long-term lease agreements for equipment or facilities. Under GASB Statement No. 87, leases are recorded as liabilities, reflecting the obligation to make future lease payments. For example, a public transportation fund might lease buses or train cars, and the total lease payments would be recognized as a long-term liability.
• Pension Obligations: In cases where the proprietary fund participates in a government pension plan, the fund may also report its share of any unfunded pension liabilities. These liabilities reflect future payments due to employees as part of their retirement benefits, adding another dimension to long-term financial obligations.

Long-term liabilities are reported alongside capital assets in the Statement of Net Position and play a key role in determining the financial health of the fund. Properly accounting for these liabilities allows stakeholders to assess the fund’s ability to meet its obligations over time and maintain a sustainable financial position.

By reporting both capital assets and long-term liabilities accurately, proprietary funds provide a complete picture of their financial position, allowing for better decision-making and long-term planning. Understanding the relationship between these assets and liabilities is essential for evaluating the overall fiscal health and operational sustainability of the fund.

Internal Service Funds and Cost Allocation

How Costs Are Allocated Between Funds

Internal service funds are used to manage and allocate the costs of services that benefit multiple departments within a government entity. The goal is to centralize these services—such as IT support, vehicle maintenance, or insurance—and then allocate the costs fairly across the departments that use them. Cost allocation ensures that each department pays its proportional share of the services it consumes, promoting efficiency and transparency in budgeting.

There are several methods used to allocate costs between departments, depending on the type of service being provided:

1. Direct Cost Allocation: In this method, costs are allocated directly to the departments that benefit from the service based on usage. For example, if an internal service fund manages a vehicle fleet, the costs of maintaining and fueling the vehicles would be allocated to each department based on the number of miles driven or hours of use by that department.
2. Indirect Cost Allocation: Some services, such as IT or facilities management, may benefit all departments but cannot be easily tied to a single cost driver. In these cases, costs are allocated using a formula that reflects the size or scope of the department’s operations. For example, IT services may be allocated based on the number of employees in each department or the amount of data storage used.
3. Cost Drivers: A key component of effective cost allocation is identifying appropriate cost drivers—factors that determine how much of a service each department consumes. For instance, IT services may use the number of computers or software licenses as a cost driver, while fleet services may use vehicle mileage or fuel consumption.
4. Budgeting and Forecasting: Internal service funds typically create budgets based on expected usage by each department, helping departments plan for their share of the costs. This ensures that each department is only charged for the services it actually uses, avoiding unnecessary expenses and encouraging more efficient use of shared resources.

By allocating costs fairly, internal service funds ensure that departments pay for the services they use, promoting fiscal responsibility and preventing any one department from shouldering an unfair portion of shared service costs.

Interfund Transactions and Their Impact on the Financial Statements

Interfund transactions occur when there is an exchange of services, resources, or funds between different funds within the same government entity. In the context of internal service funds, these transactions happen frequently, as services are provided to other funds (such as governmental or enterprise funds) and costs are allocated accordingly.

There are two main types of interfund transactions that can impact the financial statements of proprietary funds:

1. Interfund Services Provided and Used: These transactions represent payments from one fund to another for services rendered. For example, if the internal service fund manages IT services for all departments, the general fund might pay the internal service fund for the IT support it receives. These transactions are recorded as revenue for the internal service fund and as an expense for the fund receiving the service. This creates an accurate reflection of the costs and revenues associated with service provision.
   • Revenue Recognition: The internal service fund recognizes revenue when it provides services to other funds, such as IT support or vehicle maintenance.
   • Expense Recognition: The department receiving the service records an expense in its own fund for the cost of the services consumed.
2. Interfund Transfers: Sometimes, funds are transferred between different governmental funds to support internal service operations. For example, the general fund may transfer cash to the internal service fund to help cover startup costs or subsidize specific activities. These transfers are not associated with the exchange of services and are recorded separately in the financial statements.
   • Impact on Financial Statements: Interfund transfers do not affect operating revenues or expenses directly. Instead, they are recorded in the “other financing sources/uses” section of the financial statements. This ensures that transfers are kept distinct from the cost of services provided through normal operations.

Impact on the Financial Statements:

• Internal Service Fund: On the Statement of Revenues, Expenses, and Changes in Fund Net Position, interfund services provided are reported as operating revenue, reflecting the income generated from services rendered to other funds. Transfers, on the other hand, are reported as non-operating items, often under “transfers in” or “transfers out,” depending on whether they represent inflows or outflows.
• Other Funds: For the funds receiving services, the costs of interfund services are recorded as operating expenses. Transfers to internal service funds are shown in the “other financing uses” section, separating them from normal operating costs.

Interfund transactions help allocate resources efficiently across different governmental units while ensuring transparency in how costs are distributed. Accurately accounting for these transactions ensures that the financial statements provide a true representation of each fund’s financial health and operational efficiency.

By carefully managing and reporting these transactions, governments can ensure that costs are equitably distributed and that each fund’s financial statements reflect its true financial position.

Common Adjustments and Differences Between Proprietary Funds and Private-Sector Reporting

Budgetary Comparisons

Whether Budgetary Comparisons Are Required for Proprietary Funds

Unlike governmental funds, proprietary funds are typically not required to provide budgetary comparisons as part of their financial reporting. Governmental funds, which focus on fiscal accountability and budgetary control, emphasize compliance with legally adopted budgets. Proprietary funds, however, are more concerned with operational performance and long-term financial sustainability, similar to private-sector businesses.

That said, some state and local governments may choose to include budgetary comparisons for proprietary funds as part of their internal reporting or supplementary information to demonstrate fiscal discipline. These comparisons, if provided, would show how actual operating results compare with the original budget for the proprietary fund.

Impact on Financial Statements

When budgetary comparisons are included for proprietary funds, they typically appear in the form of supplementary schedules rather than in the core financial statements. This allows stakeholders to assess whether the proprietary fund is adhering to its financial plan. However, because proprietary funds focus on long-term capital planning and accrual accounting, budgetary comparisons do not play the same critical role as they do for governmental funds.

The lack of a required budgetary comparison in proprietary fund reporting emphasizes the fund’s business-like approach, where results are measured by the economic performance of the fund rather than strict adherence to annual budgetary constraints.

Treatment of Special Assessments

How These Are Reported in Proprietary Fund Financial Statements

Special assessments are charges levied on specific properties that benefit from certain public improvements or services. These assessments are common in cases where a local government undertakes projects like road repairs, sewer upgrades, or street lighting that directly benefit specific property owners. In proprietary funds, special assessments may be a significant source of revenue, particularly for enterprise funds that manage utilities or public infrastructure projects.

In proprietary fund financial statements, special assessments are reported as operating revenues if they are part of the core service activities, such as improving public utilities. They are recognized when the service is rendered or the improvements are completed, following the accrual basis of accounting. This treatment reflects the proprietary fund’s business-like approach to revenue recognition, aligning with how private-sector businesses report revenue from service contracts or improvements.

If the assessments are intended to cover specific capital improvements, they may be categorized under non-operating revenues, especially if the assessments are irregular or tied to long-term capital projects. For example, a water utility fund might assess property owners for a new pipeline installation, and these funds would be recognized as non-operating income to support the capital expenditure.

Comparing Proprietary Funds to Private Sector Businesses

Key Differences in Objectives, Capital Structure, and Financial Reporting

1. Objectives:
   • Proprietary Funds: The primary goal of proprietary funds is to provide essential services to the public (enterprise funds) or other government departments (internal service funds) on a cost-recovery basis. They focus on balancing operational efficiency with public accountability and ensuring that services are self-sustaining through user fees.
   • Private-Sector Businesses: In contrast, private-sector businesses are driven by profitability and shareholder value. The key objective is to generate profits and maximize returns for investors, rather than recovering costs or providing public services.
2. Capital Structure:
   • Proprietary Funds: These funds often rely on a combination of user fees, grants, and bond financing to support operations and capital improvements. Proprietary funds have access to public funding sources, including government grants and the issuance of tax-exempt bonds, which are not available to private-sector entities. Additionally, the capital raised by proprietary funds is typically used for long-term infrastructure projects or services that benefit the public.
   • Private-Sector Businesses: Businesses in the private sector fund their operations through a mix of equity financing (by selling shares) and debt financing (through commercial loans or bond issuance). The capital raised is intended to generate returns for shareholders, and the cost of capital is often a critical measure of financial performance.
3. Financial Reporting:
   • Proprietary Funds: Financial statements for proprietary funds follow GASB (Governmental Accounting Standards Board) guidelines, with an emphasis on full accrual accounting and reporting capital assets and long-term liabilities. Proprietary funds focus on providing a comprehensive view of their financial health, similar to business accounting, but include elements like interfund transactions and public accountability measures. Proprietary fund reporting is designed to ensure that user fees are sufficient to cover costs and provide for future capital investments.
   • Private-Sector Businesses: Private-sector financial statements are prepared in accordance with FASB (Financial Accounting Standards Board) standards. These statements are heavily focused on profitability, with metrics such as net income, earnings per share, and return on equity being central to performance evaluation. While both proprietary funds and private businesses use accrual accounting and similar financial statements (e.g., balance sheet, income statement, and cash flow statement), private-sector reporting emphasizes profitability and investor returns, whereas proprietary funds prioritize service delivery and cost recovery.

While proprietary funds share many accounting practices with private-sector businesses—such as full accrual accounting and financial statements that include a statement of net position and statement of cash flows—their underlying objectives and financial structure are distinct. Proprietary funds aim to provide public services efficiently and sustainably, often with access to unique public funding sources and accountability measures that do not apply to private-sector businesses.

Example Financial Statement Analysis

Analyzing a Sample Statement of Net Position

Walkthrough of Key Elements

The Statement of Net Position provides a snapshot of a proprietary fund’s financial health at a specific point in time. Analyzing this statement involves a thorough review of its three primary components: assets, liabilities, and net position.

1. Assets:
   • Current Assets: These include cash, receivables, and inventory that are expected to be converted into cash or consumed within a year. A higher amount of current assets compared to current liabilities typically indicates strong liquidity.
   • Non-Current Assets: This includes capital assets such as land, infrastructure, equipment, and any accumulated depreciation. These assets represent the long-term investments made by the fund to support operations, like a wastewater treatment plant or public transportation fleet.
   • Key Insight: Reviewing the total value of non-current assets and their accumulated depreciation provides insight into how well the fund is maintaining its infrastructure. Significant depreciation may suggest the need for future capital investment.
2. Liabilities:
   • Current Liabilities: These include short-term debts such as accounts payable, accrued expenses, and short-term notes. A proprietary fund should have enough current assets to cover current liabilities, ensuring the fund’s ability to meet short-term obligations.
   • Long-Term Liabilities: These include bonds payable, pension obligations, and long-term leases. Examining long-term liabilities helps assess the fund’s debt management strategy and long-term solvency.
   • Key Insight: High levels of long-term debt relative to assets might indicate a heavy reliance on debt financing, which could impact future cash flows and the fund’s ability to maintain services.
3. Net Position:
   • Net Investment in Capital Assets: This shows the amount of the net position tied up in capital assets (e.g., infrastructure), net of related debt. It indicates the fund’s long-term investment in service capacity.
   • Restricted Net Position: These are funds restricted by external parties (e.g., bondholders) for specific purposes, such as debt service or capital projects.
   • Unrestricted Net Position: This represents the resources available for general operations or future capital projects. A negative unrestricted net position could indicate financial stress.
   • Key Insight: Analyzing the net position categories reveals the financial flexibility of the fund. A strong unrestricted net position suggests healthy reserves for future operations, while a negative position may signal overextension.

Analyzing a Statement of Revenues, Expenses, and Changes in Fund Net Position

Common Trends and Issues to Look For

The Statement of Revenues, Expenses, and Changes in Fund Net Position details the operating performance of the proprietary fund over a specific period. This analysis focuses on understanding the sources of revenue, managing expenses, and identifying potential financial trends.

1. Operating Revenues:
   • Operating revenues typically include fees and charges for services rendered by the proprietary fund, such as utility payments or transit fares. A key metric to assess here is revenue growth: Are revenues increasing in line with demand for services? Consistent growth in operating revenues indicates sustainable operations.
   • Key Insight: If operating revenues are stagnating or declining, it may suggest issues such as pricing inefficiencies, declining service quality, or reduced demand.
2. Operating Expenses:
   • Operating expenses include costs directly tied to providing services, such as salaries, maintenance, and depreciation. Expense control is a critical measure here: Are expenses rising faster than revenues?
   • Key Insight: A large portion of expenses coming from depreciation could signal aging infrastructure that may require capital investment. An increase in operating expenses relative to revenue could lead to long-term financial strain.
3. Non-Operating Revenues and Expenses:
   • Non-operating revenues might include grants, subsidies, or investment income, while non-operating expenses typically involve interest payments on debt. While non-operating income can boost the fund’s financial performance, over-reliance on grants or subsidies can be a red flag for sustainability.
   • Key Insight: If the fund is heavily reliant on non-operating income (e.g., grants) to cover operating expenses, it may struggle to maintain services if those income sources diminish.
4. Change in Net Position:
   • This shows the net increase or decrease in the fund’s net position, which ties back to the Statement of Net Position. A positive change indicates that revenues exceeded expenses, while a negative change suggests financial difficulties.
   • Key Insight: Consistent negative changes in net position could indicate that the fund is operating at a loss, which might require changes in service delivery or fee structures to maintain viability.

Review of a Sample Statement of Cash Flows

Interpreting Cash Flow Categories and Liquidity

The Statement of Cash Flows for proprietary funds provides detailed insight into how cash is generated and used during the reporting period. It is divided into four categories: Operating Activities, Noncapital Financing Activities, Capital and Related Financing Activities, and Investing Activities.

1. Operating Activities:
   • This section reports cash inflows and outflows from providing services. Positive cash flows from operating activities indicate that the fund generates sufficient cash from its core operations to cover operating expenses and maintain liquidity.
   • Key Insight: Consistently positive cash flows from operations are a sign of strong financial health, whereas negative cash flows could indicate the need for operational adjustments, such as increasing fees or reducing costs.
2. Noncapital Financing Activities:
   • These are cash flows related to non-operating activities, such as grants, subsidies, or transfers from other funds. For example, an enterprise fund may receive a state grant to support operations.
   • Key Insight: Heavy reliance on noncapital financing activities may indicate financial vulnerability, especially if these cash inflows are unpredictable or subject to budget cuts.
3. Capital and Related Financing Activities:
   • This section reports cash flows associated with acquiring and financing capital assets, such as issuing bonds or making payments on long-term debt. Cash inflows may come from bond proceeds or grants for capital projects, while cash outflows could be capital expenditures for infrastructure or debt service payments.
   • Key Insight: Large capital expenditures may signal investments in infrastructure, but if these expenditures outpace revenue generation, the fund may face liquidity problems.
4. Investing Activities:
   • Cash inflows and outflows from investing activities, such as interest earned on investments or the purchase of marketable securities, are recorded here. Positive cash flow from investing indicates effective management of idle cash reserves.
   • Key Insight: Strong investment income can bolster the fund’s financial position, but excessive reliance on investment returns to cover operating costs may expose the fund to market risk.

Liquidity

The net cash flow from all categories gives a clear picture of the fund’s liquidity—its ability to meet short-term obligations. A proprietary fund with consistent positive net cash flow across all categories is in a healthy financial position, while negative net cash flow may indicate potential liquidity problems, requiring adjustments in operations, financing, or investment strategies.

By reviewing these cash flow categories, stakeholders can assess how effectively a fund generates cash from its operations, how dependent it is on external financing, and whether it has sufficient liquidity to support future projects or meet debt obligations.

Conclusion

Summary of Key Concepts

Review of the Accrual Basis and Economic Resources Measurement

Proprietary funds operate using the accrual basis of accounting, which is similar to private-sector businesses. This method recognizes revenues when they are earned and expenses when they are incurred, providing a comprehensive view of a fund’s long-term financial health. Unlike governmental funds that use the modified accrual basis, proprietary funds focus on the entire economic impact of financial activities, including capital assets and long-term liabilities.

The economic resources measurement focus employed by proprietary funds ensures that all resources, both current and non-current, are reported in the financial statements. This approach allows stakeholders to see a full picture of the fund’s financial standing, including infrastructure investments, outstanding debt, and financial reserves. By capturing both short- and long-term financial activity, proprietary fund statements provide insights into future sustainability and service capacity.

Importance of Proprietary Fund Financial Statements for Transparency and Accountability

Proprietary fund financial statements play a critical role in ensuring transparency and accountability for state and local governments. These funds operate in a business-like manner, and their financial reports provide essential information on how user fees are utilized to sustain services, manage assets, and cover operational costs. Stakeholders, including taxpayers, bondholders, and oversight bodies, rely on these statements to assess the fund’s performance and financial integrity.

The Statement of Net Position, Statement of Revenues, Expenses, and Changes in Fund Net Position, and Statement of Cash Flows offer a clear and detailed account of the fund’s operations, financial stability, and liquidity. Together, these statements help evaluate whether the fund is self-sustaining, how well it manages public resources, and its capacity to finance future capital needs.

Final Thoughts for CPA Exam Candidates

Tips for Mastering Proprietary Fund Financial Statements for the BAR CPA Exam

As you prepare for the BAR CPA exam, understanding proprietary fund financial statements is essential for success. Here are some key tips to help you master this topic:

1. Focus on Accrual Accounting: Be sure to thoroughly understand how the accrual basis of accounting works, particularly the recognition of revenues and expenses. Review the differences between accrual accounting in proprietary funds and modified accrual accounting in governmental funds.
2. Understand the Economic Resources Measurement Focus: Pay close attention to the role of long-term assets and liabilities in proprietary funds. Familiarize yourself with how capital assets are reported, the treatment of depreciation and amortization, and how long-term debt impacts financial statements.
3. Practice Analyzing Financial Statements: Work through example statements of net position, revenues and expenses, and cash flows. Focus on how operating and non-operating activities are reported and learn to interpret key financial ratios that assess liquidity, solvency, and operational efficiency.
4. Be Prepared for Interfund Transactions: Make sure you understand how interfund services and transfers are recorded and their impact on the financial statements. Knowing how internal service funds allocate costs and interact with other funds is a crucial part of proprietary fund accounting.
5. Use Practice Questions: Incorporate practice questions into your study routine that focus specifically on proprietary fund financial reporting. Look for questions that test your understanding of the distinctions between proprietary fund financials and those of governmental funds and private-sector businesses.

By mastering these key concepts and practicing with sample problems, you’ll be well-prepared to answer questions on proprietary fund financial statements and succeed in the BAR CPA exam.