Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world

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2 Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: Pearson Education Limited 2014 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6 10 Kirby Street, London EC1N 8TS. All trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement of this book by such owners. ISBN 10: ISBN 10: ISBN 13: ISBN 13: British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Printed in the United States of America

3 purchases Method The purchases method is used when the inventory-related appropriations authorize inventory purchases. Its use is limited to the periodic system because it is not compatible with the perpetual inventory system. Under the purchases method, the Expenditures account is charged with inventory purchases during the year. Note in Illustration 3 that the only difference between the entries for the purchases method and the consumption method using a periodic inventory system is the entry recording the change in inventory a $73,000 increase in the illustration. The increase in the inventory account reduces expenditures under the consumption method but results in recording an other financing source under the purchases method. The total change in fund balance is the same under both methods (a decrease of $777,000). However, under the consumption method the net decrease is reported as Expenditures. Under the purchases method, the decrease is the net effect of reporting Expenditures of $850,000 for the cost of the supplies purchased less an Other Financing Source of $73,000 for the increase in the inventory on hand. The Other Financing Sources Inventory Increase results from the fact that (1) GAAP permits the use of the purchases method only for expenditure accounting, and (2) any significant amounts of inventory must be reported in the governmental fund balance sheet. Compared with the consumption method, the purchases method overstates Expenditures in this case, by $73,000 so the Fund Balance account will be understated $73,000 after the Expenditures account is closed. Thus, the $73,000 credit to Other Financing Sources Inventory Increase, which is closed at year end to Fund Balance, may be viewed as correcting for the understatement of Fund Balance caused by the Expenditures overstatement. Note that both the inventory of materials and supplies and the nonspendable fund balance reported in the balance sheet are identical under the two methods. Other services and charges When services are being acquired under contract, an entry is made encumbering appropriations for the amount of the estimated ultimate contractual expenditure liability at the time the contract is awarded. As services and the related invoices are received, the encumbering entries are reversed and the actual expenditures are recorded. Whereas the accounting for most other services and charges is apparent from the discussions in this text, several specific types of other services and charges expenditures warrant at least brief mention. Two types are discussed here: prepayments and capital leases. Related topics including interest on short term governmental fund debt, claims and judgments, compensated absences, and pension and other postemployment benefits (OPEB) contribution underfunding are discussed in the Adjusting Entries section later in this chapter. prepayments Governments may prepay costs that benefit two or more accounting periods. For example, a two year insurance policy may be purchased, or rental on a building may be paid for a year in advance at midyear. As in the case of inventories, governments are permitted to use either the consumption method or the purchases method in accounting for prepayments (prepayals). 9 Moreover, those using the purchases method are not required to report prepayments on the balance sheet. If prepayments are reported as assets, the accounting and financial reporting are identical to that for materials and supplies. Thus, if a two year insurance policy 9 Ibid., sec

4 were purchased for $88,000 at the beginning of 20X1, the entries (omitting subsidiary ledger entries) would be as follows: When Insurance Policy Purchased: Expenditures... $88,000 Vouchers Payable... $88,000 To record payment for two year insurance policy at beginning of 20X1. End of 20X1: (a) Purchases Method No entry. (b) Consumption Method Prepaid Insurance... $44,000 Expenditures... $44,000 To record prepaid insurance Under the consumption method, the General Fund balance sheet must include $44,000 of nonspendable fund balance related to the Prepaid Insurance. If a government using the purchases method reports this Prepaid Insurance as an asset, nonspendable fund balance must be reported on the balance sheet and an other financing source or use must be reported on the operating statement for the change in the prepaid insurance balance during the year. Beginning of 20X2: (a) Purchases Method No entry. (b) Consumption Method Expenditures... $44,000 Prepaid Insurance... $44,000 To reverse the 20X1 adjusting entry and charge the applicable insurance cost to 20X2 expenditures. capital Leases and certificates of participation Many governments lease assets such as vehicles, computers, photocopy machines, other equipment, and buildings rather than buy them. When such leases are ordinary rentals for example, monthly rentals that may be canceled with little notice the rents paid or accrued are usually recorded as rental expenditures. (Advance rental payments might be initially recorded as prepayments, as discussed earlier.) However, if the government is in substance buying the assets or is leasing them for most or all of their useful lives, GAAP require that the accounting for such capital leases reflect their substance instead of their legal form. The GASB s lease accounting and reporting guidance are in GASB Statement No. 62, Accounting and Financial Reporting Guidance Contained in Pre November 30, 1989 FASB and AICPA Pronouncements. GASB Statement No. 62 requires governments to classify leases following essentially the same guidance currently required for businesses. Reporting capital leases parallels FASB guidance as well except in the governmental funds. 10 The GASB Codification requires that: General capital assets (GCA) acquired in capital lease agreements should be capitalized in the GCA accounts at the inception of the lease at the present value of the future lease payments, calculated following guidance equivalent to that for businesses and a general long term liability in the same amount (less any payment at inception) should be recorded in the GLTL accounts. When a general capital asset is acquired by capital lease, its acquisition should be reported in an appropriate governmental fund as both (1) a capital outlay expenditure and (2) an other financing source, as if long term debt had been issued to finance the capital asset acquisition These requirements are discussed in intermediate accounting textbooks. 11 GASB Codification, sec. L

5 Capital lease proceeds need not be accounted for through a Capital Projects Fund, nor does capital lease debt service have to be accounted for through a Debt Service Fund, unless use of such funds is legally or contractually required. Illustration 4 presents an overview of general government capital lease accounting. The key points here are the following: 1. Both a governmental fund expenditure and an other financing source must be recognized at the inception of the capital lease. 2. Neither use of a Capital Projects Fund at the inception of the capital lease nor use of a Debt Service Fund to service the capital lease debt is required unless legally or contractually required, which is rare. 3. Both the governmental fund expenditure and other financing source and the related debt service expenditure on the capital lease may be accounted for in the General Fund or perhaps a Special Revenue Fund. To illustrate, assume that a general government department entered into a capital lease of equipment. The capitalizable cost of the equipment (per FASB Statement No. 13) is $900,000, and the government makes a $40,000 down payment at the inception of the lease. Regardless of the governmental fund in which the capital lease transaction and debt service are recorded, the governmental fund entries are: Inception of Capital Lease: Expenditures... $900,000 Other Financing Sources Capital Lease... $860,000 Cash ,000 To record capital lease expenditure and related other financing source. Expenditures Ledger (Expenditures): Capital Outlay... $900,000 ILLUSTRATION 4 Capital Lease and Certificate of Participation Accounting Overview (Amounts are in $000s) General Fund (or other fund paying for capital lease) General Capital Assets Accounts General Long-Term Liabilities Accounts Inception of the lease Expenditures Capital Outlay 900 OFS Capital Lease 860 Cash 40 Equipment under Capital Lease 900 Net Position 900 Net Position 860 Capital Lease Payable 860 Expenditures recorded at present value of the minimum lease payments. Recorded at present value of the minimum lease payments. Recorded at present value of the minimum lease payments less any initial payment. Annual lease payment Expenditures Debt Service Principal 13 Expenditures Debt Service Interest 5 Cash 18 None Capital Leases Payable 13 Net Position 13 Principal and interest amounts determined using the effective interest rate method. Depreciation expense will be recorded in the GCA accounts. For principal amounts only. 230

6 Note that the effect of the entry at the inception of the capital lease on the fund balance of the governmental fund is equal to the $40,000 decrease in fund financial resources, which indicates the net effect of the $860,000 other financing source and the $900,000 expenditure. Also, $900,000 is the fair market value of the capital asset acquired. The leased equipment and the related capital lease liability affect the GCA GLTL accounts as follows: GCA 2 GLTL 5 Net Position (NP) 1$900,000 1$860,000 1$40,000 Now assume that the first monthly lease payment after inception is for $18,000, including $5,000 of interest. First Debt Service Payment: Expenditures... $ 18,000 Cash... $ 18,000 To record capital lease debt service payment. Expenditures Ledger (Expenditures): Debt Service Interest (Capital Lease)... $ 5,000 Debt Service Principal (Capital Lease)... 13,000 $ 18,000 Note that the capital lease debt service payment must be allocated between interest expenditures and debt principal reduction based on the effective interest rate of the capital lease agreement. The effective interest amount for the first payment is computed by multiplying the effective interest rate for the lease by the carrying amount (book value) of the lease liability, initially $860,000, and dividing by 12. The capital lease liability principal reduction resulting from this first payment affects the GCA GLTL accounts: GCA 2 GLTL 5 NP 2$13,000 1$13,000 Several variations of the traditional capital lease have appeared recently. Certificates of participation (COPs), the most common variation, typically involve governments dealing with brokerage firms or banks rather than with product manufacturers and receiving cash that is used to purchase the computers, vehicles, or other equipment. COPs are otherwise like traditional leases and are accounted for in the same manner. Accounting for general government leases both capital leases and operating leases is illustrated further using transactions and information from the City and County of Denver, Colorado, in the In Practice example on the following page. Accounting for the inception of a major capital lease, the Wellington Webb Municipal Office Building, capital lease payments, and operating leases are included. adjusting entries Most of the expenditure related adjusting entries that may be required in a governmental fund at year end are similar to those covered in intermediate accounting courses. That is, the accountant must ensure that a proper year end cutoff is made for expenditures for payrolls, utilities, and similar costs. The available revenue recognition criterion does not apply to governmental fund expenditure accounting, and an expenditure related liability payable beyond 231

7 1 IN PRACTICE government Lease transactions The City and County of Denver, Colorado, uses leasing both capital and operating extensively. A recent Comprehensive Annual Financial Report indicates that Denver has capitalized leases for a variety of general government properties and other assets, including: Wellington Webb Municipal Office Building Blair Caldwell Research Library Buell Theatre 5440 Roslyn maintenance facility property Jail dorm facility Three fire stations Computer and safety equipment Production press The net book value of Denver s general government leased assets exceeds $300 million. In addition to the capital leases, Denver has significant operating leases. Accounting for a few of Denver s lease transactions is illustrated below. In one recent year, Denver entered into a capital lease of the Wellington Webb Municipal Office Building. The present value of the minimum lease payments for this building lease was $52,103,000. The entry to record this transaction in the General Fund assuming no initial payment was made by the city would be: Expenditures Capital Outlay... $52,103,000 Other Financing Sources Capital Leases... $52,103,000 To record capital lease expenditure and related other financing source. The GCA GLTL accounts entry would be: Buildings Under Capital Lease... $52,103,000 Liability for Capital Lease... $52,103,000 To record leased building and capital lease liability. In another recent year, Denver made capital lease payments of $30,672,000 that reduced the principal of its general government lease liabilities by $15,176,000. The entry to record this transaction in the General Fund would be: Expenditures Lease Principal Retirement.... $15,176,000 Expenditures Interest ,496,000 Cash.... $30,672,000 To record capital lease payments. The GCA GLTL accounts entry would be: Liability for Capital Lease... $15,176,000 Net Position... $15,176,000 To record reduction of capital lease liability. Finally, in the same year Denver paid operating leases of $7,018,000 from its General Fund. The operating leases affect only the General Fund and should be recorded as follows: Expenditures Operating Leases... $ 7,018,000 Cash.... $ 7,018,000 To record operating lease payments. Adapted from a recent Comprehensive Annual Financial Report of the City and County of Denver, Colorado. 232