The GASB has undertaken recent efforts to clarify certain ambiguities inherent to fund balance reporting. The following section outlines one recently adopted GASB statement, two issues currently being considered for GASB action, and how those changes will likely affect public financial management.
14.4.1 How Restricted are Restricted Net Assets?
Some of GASB 34’s most notable implementation issues surround the identification and reporting of restricted net assets. Statement 34’s lan- guage on this issue was designed to establish a consistent method of accounting for assets generated through ‘‘enabling legislation,’’ ‘‘ear- marking,’’ or other legislative action that pairs a specific asset or revenue source with a particular programmatic goal. This is a critical consideration because an entity can overstate its available net assets by understating the restricted portion of those assets, or, by contrast, it can understate its available net assets by applying an aggressively inclusive definition of ‘‘restricted.’’ The result in either case is a distorted portrayal of overall financial condition.
The GASB gave government officials the benefit of the doubt by assuming restricted net assets will only be used for their legally specified purposes.
However, in light of the ever-present temptation to divert restricted resources to other goals and objectives, GASB 34 limits the definition of restricted net assets to those created by ‘‘legally enforceable’’ enabling legislation. In other words, a net asset is considered restricted only if citizens, the judiciary, another level of government, or some other external party can compel the government to restrict use of that asset to the purpose(s) stated in the enabling legislation.
Many entities, particularly state governments, had difficulty interpreting this language because of the ambiguity surrounding ‘‘legal enforceability.’’
On the one hand, it can be argued that the power to enforce the tenets of any legislation, particularly net asset restrictions, rests solely in the hands of citizens. Since citizens in most states have access to the recall, referendum, and other instruments of ‘‘direct democracy,’’ the logic suggests all net asset restrictions are truly legally enforceable. But when the discussion shifts from constitutional possibilities to the reality of American political participation, one can claim with equal fervor that only elected officials can enforce the tenets of any legislation. Many state governments were therefore forced to reconsider all their enabling legislation, and some considered reporting no
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net assets as restricted because of the difficulty in establishing a genuine
‘‘legally enforceable’’ claim. Others pondered whether to declare all earmarking and other enabling legislation unenforceable, and in turn consider non-capital assets to unrestricted. This all or nothing perspective created notable problems for government financial managers, financial statement preparers, and auditors.
The GASB addressed these problems in the recently adopted Statement No. 46 — Net Assets Restricted by Enabling Legislation. This statement (1) ‘‘confirms that the determination of legal enforceability is a matter of professional judgment, which may entail reviewing the legislation and determinations made for similar legislation, as well as obtaining the advice of legal counsel,’’ and (2) requires governments to disclose in the notes to the financial statements the amount of net assets restricted by enabling legislation during a particular fiscal period. It therefore encourages states and municipalities to (1) determine legal enforceability on a case by case basis by considering the legal, organizational, and political implications of diverting restricted net assets away from their intended use, and (2) improve transparency in this area by disclosing the circumstances surrounding net asset restrictions. This statement is an important step toward ensuring the comparability of net asset figures and overall financial condition across multiple units of government.
14.4.2 Fund Balance Reservations and Designations
At a glance, the differences among the three fund balance portions are apparently clear — reservations are legally established restrictions, designations reflect tentative intentions of either elected or appointed officials, and the unreserved portion is available for immediate spending.
But, in practice, these distinctions and their value in understanding finan- cial condition are inherently ambiguous and problematic on three accounts. Each of these three issues may be considered for future GASB statements.
Many local governments outline the parameters of their reserve or contingency funds in intra-organizational working policies, governing board directives to city staff, the budget document preface, notes to the financial statements, or some mechanism other than a municipal ordinance. Although these sorts of ‘‘informal reserves’’ serve the same purpose and are utilized in essentially the same manner as formal reserves, they are not legally binding, per se, and are consequently reported as designated or unreserved fund balance.
The fact that some entities report reserve funds as reserved fund balance, while others report those same reserves in the designated or
unreserved portions, raises a number of issues when attempting to evaluate a government’s capacity to respond to contingencies. On the one hand, a strategic reserve governed by city ordinance is less likely to have its funds diverted to other purposes. The obvious disadvantage to this strategy is that fiscal crises are difficult to predict (Gold, 1995), and even more difficult to address when a formal reserve fund dictates a particular course of action. By limiting the array of fiscal policy responses, formal reserves may actually do more harm than good.6By contrast, the strategy of positing contingency funds in the unreserved designated fund balance allows for greater flexibility in using reserves to address unforeseen contingencies, but leaves open the possibility that funds will be diverted to other purposes.
It then follows that further clarification is needed in determining the minimal requirements for establishing and maintaining a local reserve fund, how these funds should be accounted for, and how and where they should be reported.
A second issue is the apparent lack of oversight or understanding surrounding the appropriate use of designated fund balance. Anecdotal evidence suggests designated fund balance is rarely used for its stated purpose because designations are merely ‘‘intents’’ that are not legally bind- ing and can be carried over from one year to the next with little fanfare or protest. Local governments can therefore enjoy the benefits of a large overall fund balance without the potential political pressures that may result from reporting those balances as unreserved. Further clarification is needed to determine how to evaluate whether designated fund balance is used for its stated purpose.
And third, strong empirical evidence suggests unreserved undesigna- ted fund balance levels can be distorted at various points throughout the budget execution process. One notable source of distortion is inter- fund transfers, or the movement of resources from one fund to another.
In some cases, these transfers take the form of interfund loans that will be repaid at some point in the future. In others, transfers are used for one-time interfund support that will not be repaid. Regardless of the normative implications of these sorts of transfers, empirical research has supported the claim that governments transfer excess revenues from electric utilities and other business-type entities to inflate or maintain current fund balance levels (Tyer, 1989). Similar research has found the single most influential factor affecting the size of a local govern- ment’s unreserved undesignated fund balance is total interfund transfers (Marlowe, 2003). The claim that fund balance represents nothing more than the difference between current fund assets and current fund liabilities may therefore be shortsighted. Further clarification is needed to determine and report this relationship between interfund transfers and fund balance levels.
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