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Chapter 6

Chapter 6 . Accounting for Capital Projects and Debt Service. Learning Objectives. Capital Projects Fund Debt Service Fund Special Assessments What is Arbitrage? Debt Refundings. Capital Projects Funds(CPF)- Definition.

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Chapter 6

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  1. Chapter 6 Accounting for Capital Projects and Debt Service Granof-5e

  2. Learning Objectives • Capital Projects Fund • Debt Service Fund • Special Assessments • What is Arbitrage? • Debt Refundings Granof-5e

  3. Capital Projects Funds(CPF)-Definition • A fund that accounts for and report financial resources that are legally restricted and contractually required for the acquisition of capital assets. • The primary purpose of this fund is to ensure and demonstrate the expenditure of the dedicated financial resource is both legally and contractually compliant. • The total cost of a capital project is accumulated in a single expenditures account, which accumulates until the project is completed, at which time the fund ceases to exist. --i.e. Fund has a “Project-life focus,” not year-to-year focus. Granof-5e

  4. Overview • Governments must maintain capital projects funds for resourcesthat are legally restricted , committed, or assigned to expenditure for capital outlays . • This includes the acquisition or construction of capital facilities • Fund DOES NOT account for Capital Assets themselves. These are maintained in a Schedule of Capital Assets. • Basis of Accounting • Fund Statements --Modified accrual basis • Government-wide statements --Full accrual basis. • Two types of capital projects • General (public benefit) --Examples: public buildings, roads, highways and bridges, park improvements, sewer systems, plant and equipment; etc. • Special assessment (private benefit) --i.e. Benefits citizens in a specified benefit district. --Examples: street improvements, curbs, sidewalks, street lighting, sewage, etc. Granof-5e

  5. Construction Phases • Phase 1: Preconstruction Phase --Project & Financing authorization • Phase 2: Construction Phase • Phase 3: Debt Servicing Phase Granof-5e

  6. Phase 1: Preconstruction Phase Project & Financing authorization Financing Acquire extensive, long-term financing (3 types) • Type I - Tax Supported Debt --General obligation (tax-supported) bonds or special taxes restricted to payment of debt • Type II - Grants • Type III - Other forms of financing --Special Assessments • (Special Assessments actually claim only 2 phases because financing & construction are a single phase) Granof-5e

  7. Type I Tax Supported Debt Overview • Voter approval required • Memo entry for bond/tax authorization • Proceeds accounted for as “other financing sources.” • Difference between face value of bonds and cash received is attributed to: • Issue costs. • Premiums and discounts. Granof-5e

  8. Type I - Example Assume that bonds with a face value of $5,000,000 were issued at 101 to finance the project. Capital Projects Fund:Dr.Cr. Cash $5,050,000 Other Financing Sources-Bond proceeds 5,000,000 Other Financing Sources-Bond premium 50,000 Gov’t.-wide (Gov’tal. Activities)*: Cash $5,050,000 Bonds Payable 5,000,000 Premium on Bonds Payable 50,000 *Note: This entry is not made on the books, this is the conversion at the eoy Granof-5e

  9. Type II – Grants: Example Assume approval is obtained for a federal grant as partial funding for a city’s office building project. Upon approval, the following journal entry would be made: Capital Projects Fund:Dr.Cr. Due from other Governmental Units $100,000 Revenues 100,000 Govt.-wide (Gov’tal. Activities)*: Due from Other Governmental Units $100,000 Program Revenues-Capital Grants and Contributions-General Government 100,000 *Note: This entry is not made on the books, this is the conversion at the end of year Granof-5e

  10. Type II Example (cont’d) The amount due from the federal government for the previously recorded capital grant was received in full Capital Projects Fund:Dr.Cr. Cash $100,000 Due from Other Governmental Units 100,000 Gov’t.-wide (Govtal. Activities)*: Same entry. *Note: This entry is not made on the books, this is the conversion at the eoy Granof-5e

  11. Type III – Other Forms of Financing Overview Most Common: Special Assessments --Levied when taxpayers in areas beyond their jurisdiction want to benefit from certain facilities and services. Granof-5e

  12. Additional Topics – CPFs Interim Financing May be necessary to obtain interim financing until proceeds from intended source are received. • Used often to complete architectural and engineering design during preconstruction phase. Granof-5e

  13. Interim Financing - Example Assume for the office building project, $50,000 was borrowed from the General Fund, to be repaid later from bond proceeds. Capital Projects Fund: Dr.Cr. Cash $50,000 Due to General Fund 50,000 Gov’t.-wide (Gov’tal. Activities): No entry needed. Granof-5e

  14. Interim Financing Example (cont’d) The $50,000 due to the General Fund was repaid. Capital Projects Fund:Dr.Cr. Due to General Fund $50,000 Cash 50,000 Gov’t.-Wide (Gov’tal. Activities)*: No entry needed. (if repaid within period) *Note: This entry is not made on the books, this is the conversion at the eoy Granof-5e

  15. Budgeting • Budgets help ensure control • Since CPF have project (not period) focus, it may be unnecessary to make annual budgets • But, since numerous projects are “integrated” into a single fund, budgetary accounts help control individual project expenditures. • GASB requires budgeting over integrated funds when control cannot be established by other means (e.g. fixed-price contracts) Granof-5e

  16. Budgeting - Example (cont’d) A contract was let in the amount of $50,000 with an architectural firm to complete the architectural design for the new city office building. The following entry would be required in the capital projects fund. Capital Projects Fund:Dr.Cr. Encumbrances $50,000 Reserve for Encumbrances50,000 Govt.-wide (Govtal. Activities): No entry needed. Granof-5e

  17. Budgeting Example (cont’d) The architectural firm for which an encumbrance of $50,000 had been recorded (see preceding slide), tendered its final billing in the amount of $48,000. The city immediately paid the amount due. Capital Projects Fund: Dr.Cr. Construction Expenditures $48,000 Reserve for Encumbrances 50,000 Cash 48,000 Encumbrances 50,000 Gov’t.-wide (Gov’tal. Activities)*: Construction Work in Progress $48,000 Cash 48,000 *Note: This entry is not made on the books, this is the conversion at the eoy Granof-5e

  18. Debt Service Funds(DSF) - Overview • Accounts for and report financial resources that are restricted, committed, or assigned to expenditure for principal and interest on all general long-term debt. • This does not include debt issued for and serviced by Enterprise or Internal Service Funds and some Trust Funds • Debt service funds: accounted for on the modified accrual basis. --Exception: Interest and principal are NOT considered current liabilities of DSF until the period in which they must be paid but the interest revenue on bonds held as investments is accrued. • Resources may come from two types: 1) Tax Supported Debt • Taxes levied by DSF • Taxes levied by GF and transferred to DSF • Special taxes restricted to the payment of debt 3) Other means of financing • Special assessments *2) Grants would not have debt to service Granof-5e

  19. DSFs – Overview (cont’d) GASB requires DSFs be established when: • Legally required, or • Financial resources are being accumulated for principal and interest payments maturing in future years. GASB recommends: • A single DSF for all debt serviced by property taxes • Governments hold number of funds to a minimum Refer to the comprehensive example on pgs. 234-237. Granof-5e

  20. DSFs –Overview (cont’d) Budgets least common for DSFs • If DSF receives fund from other funds, then the other fund maintains controls • Exception: If resources are derived from special taxes or assessments, then an appropriations budget enhances control --Decision of budgetary accounts is usually decided legislatively Granof-5e

  21. DSF - Example Assume bonds are issued on January 1, 2010 and pay interest semiannually on January 1 and July 1 in the amount of $100,000. The fiscal year ends on Dec. 31, 2010. Q: How much expenditures would be recognized in fiscal 2010? A:Only the July 1, 2010 interest payment, or $100,000, would be recognized as an expenditure of 2010. Granof-5e

  22. Type I - Tax Supported Debt Overview Two Types 1) Serial bonds: Two types: • Regular serial bonds • Deferred Serial bonds 2) Term bonds Granof-5e

  23. 1) Serial Bonds Overview • Principal matures in annual installments. • For serial bonds, the amount budgeted for revenues or inter-fund transfers in, is usually just what is needed that fiscal year for matured principal and interest. • Advantage: Self-amortizing; no sinking fund needed Granof-5e

  24. Serial Bonds - Example A certain city issued $100,000 of 6% serial general obligation (G.O.) bonds on Dec. 1, 2010. In addition, interest of $3,000 is due on June 1, 2011, December 1, 2011, and in decreasing amounts every June 1 and Dec. 1 for the next 19 years after that. The first principal maturity of $5,000 is due on December 1, 2011. Govt.-wide (Govtal. Activities):Dr.Cr. Cash $100,000 Serial Bonds Payable – 6% 100,000 Granof-5e

  25. Serial Bonds - Example (cont’d) The budget approved for FY 2011 requires the General Fund to transfer $11,000 to the DSF for debt service which includes principal repayment of $5,000 and two interest payments totaling $6,000. Debt Service Fund:Dr.Cr. Estimated Other Financing Sources $11,000 Appropriations 11,000 Due from General Fund 11,000 Interfund Transfers In 11,000 Govt. wide (Govt. Activities): No entry needed. Granof-5e

  26. Serial Bonds - Example (cont’d) On May 28, 2011, the transfer from the General Fund was received. Debt Service Fund:Dr.Cr. Cash $3,000 OFS-nonreciprocal transfer from GF 3,000 (Note: Assuming Interfund (nonreciprocal)Transfers In was accrued at the time the budget was recorded, thus Interfund Transfers In was credited here rather than Due from General Fund) Govt.-wide (Govtal. Activities): No entry needed. Granof-5e

  27. Serial Bonds DSF -Example (cont’d) The June 1, 2011, interest payment was made on schedule Debt Service Fund:Dr.Cr. Expenditures-Bond Interest $3,000 Cash 3,000 Gov’t.-wide (Gov’tal. Activities)*: Interest Expense on Long-Term Debt $3,000 Cash 3,000 *Note: This entry is not made on the books, this is the conversion at the eoy Granof-5e

  28. Serial Bonds- Example (cont’d) The remaining $8,000 transfer was received from the General Fund on November 29, 2011. On December 1, the City paid the interest and principal maturing that date. Debt Service Fund: (11/29/11)Dr.Cr. Cash $8,000 OFS-nonreciprocal transfer from the GF 8,000 12/1/11 Expenditures—Bond Principal $5,000 Expenditures—Bond Interest 3,000 Cash 8,000 Gov’t.-wide (Gov’tal. Activities)*: Interest Expense on Long-Term Debt $3,000 Current Portion of Bonds Payable 5,000 Cash 8,000 *Note: This entry is not made on the books, this is the conversion at the eoy Granof-5e

  29. Serial Bonds -Example (cont’d) Closing entries on December 31, 2011: Debt Service Fund:Dr.Cr. Interfund Transfers In 11,000 Estimated Other Financing Sources 11,000 Appropriations $11,000 Expenditures—Bond Principal 5,000 Expenditures—Bond Interest 6,000 Gov’t.-wide (Gov’tal. Activities)*: Net Assets – Unrestricted $6,000 Interest Expense on Long-term Debt 6,000 *Note: This entry is not made on the books, it is the conversion at the eoy Granof-5e

  30. Term Bonds - Overview Principal matures in one lump-sum amount at end of the bond term • Not used as frequently for municipal financing as serial bonds. Disadvantages: • Usually requires a sinking fund and therefore investment management • Sinking fund investments: reported at fair market value (fmv) • Changes in fmv: reported as a component of investment earnings. • More complex accounting than for serial bonds Granof-5e

  31. Type III – Other Forms of Financing Special Assessments - Overview --benefits only a select group of individuals Fund Statements • DSF accounted for using modified accrual basis • In the DSF, special assessmentrevenues and receivables are accounted for on a full accrual basis Government-wide statements: • Interest on long-term debt would be accrued and charged as an expense. • Discounts and premiums on bonds payable would be amortized over the maturity term of the bond. • Property taxes would be recognized as revenues. • Principal of special assessments would be recognized as both assets and revenues. Granof-5e

  32. Special Assessments - Overview (cont’d) Government may or may not be obligated to account for special assessment debt (both interest and principle) OBLIGATED: • Government accounts for debt service on special assessment debt in a DSF when the government is obligated in some manner for the debt. • GASB states government is obligated if: --It is responsible for the debt in the event of property owner default, or --It is legally liable for assuming the debt or gives indication that it may honor the debt in the event of default. NOT OBLIGATED • Both the special assessment debt and the debt service are accounted for in an agency fund. • Disclose the amount of debt in the notes to the financial statements. Granof-5e

  33. Special Assessments - Overview (cont’d) • Special Assessments Debt is sometimes paid from a proprietary fund --In this case, all transactions are reported in the proprietary fund. • Improvements financed with assessments should be capitalized. Granof-5e

  34. Special Assessments - Example Example: $1,000,000 of special assessments were levied on property owners in a special benefit district, payable in 10 equal annual installments of $100,000 each. Debt Service Fund:Dr. Cr. Assessments Receivable—Current $100,000 Assessments Receivable—Deferred 900,000 Revenues 100,000 Deferred Revenues 900,000 Assume all current Assessments Receivable were collected during fiscal year along with 8% of interest on the previous unpaid balance. The entry would be: Debt Service Fund:Dr.Cr. Cash $180,000 Assessments Receivable—Current 100,000 Revenues 80,000 Granof-5e

  35. Special Assessments-Example (cont’d) Bond Principal of $100,000 and interest of 8% were paid on schedule: Debt Service Fund:Dr. Cr. Expenditures—Bond Principal 100,000 Expenditures—Bond Interest 80,000 Cash 180,000 Early next year, the following reclassification entries would be made: Debt Service Fund:Dr.Cr. Assessments Receivable—Current 100,000 Assessments Receivable—Deferred 100,000 Deferred Revenues 100,000 Revenues 100,000 Granof-5e

  36. Additional Topics Arbitrage • Investment of idle cash • Issuance of debt at low tax-exempt interest rates and investment of proceeds in taxable securities yielding higher return. • Interest received is exempt from federal taxes. • 2 Provisions to prevent arbitrage abuse: • Arbitrage restrictions. State and local governments must observe arbitrage regulations. • Rebate on arbitrage. Arbitrage rules and regulations are complex and contain several exemptions and exceptions. Investment revenues should be reduced and rebate liabilities established. Granof-5e

  37. Debt Refunding • Means that existing debt is replaced with new issue of debt – hopefully at a lower interest rate • Bonds traded on the open market can be repurchased at the going market rate • Example in text (p. 245-248) shows there is no real economic gain or loss from refunding debt • However, there may be a “book” gain or loss: difference between book value and price paid to retire old bonds • Existing debt may have a “call feature” that lets the government repay face value early (but several years after original issue date) • Bonds without a call feature that are not actively traded are more challenging – this is the situation that leads to use of “in-substance defeasance” Granof-5e

  38. Debt Refunding Transactions • Bond refunding • Refinance • General rule Debt Refunding Transactions: Entries in DSF, assuming that because of reduced market rates of interest, $100,000 of previously issued bonds are refunded by a new $100,000 bond issue with lower interest payments When refunding (new) bonds are issued: Debt Service Fund:Dr. Cr. Cash $100,000 Other Financing Sources- Proceeds of refunding (new) Bonds 100,000 If old bonds are not retired by the end of the fiscal year, both issues would be reported as long-term debt in governmental activities. Granof-5e

  39. Debt Refunding Transactions (cont’d) • Assuming old bonds are retired shortly after issue of refunding bonds Debt Service Fund:Dr. Cr. Other Financing Uses—Refunded Bonds $100,000 Cash 100,000 (Note: Report only the new issue as debt in governmental activities) Granof-5e

  40. In-Substance Defeasance In-substance defeasance (advance refunding) • Provision for the government to lock the savings that would result from a decline in the interest rates. • Advance refunding in which the borrower economically satisfies its existing obligations. • Journal entries are similar to those for regular refundings. • Refer to the example on pgs. 247-248 Granof-5e

  41. In-Substance Defeasance (cont’d) • In-substance defeasance should satisfy the following conditions: • Debtor must place cash/assets with an escrow agent to be solely used for servicing/retiring the debt • Possibility of debtor having to make future payments on the debt must be remote • Assets in escrow fund must be investments considered “risk-free” like US Treasury Bonds • Amortize loss (or gain) over future years using the shorter of the original term or the term of the new debt. Granof-5e

  42. Summary • Capital Projects and Debt Service Fund are accounted for on a modified accrual basis. • The principles for revenue and expenditure are the same as the General fund. Accordingly, the long-term assets and liabilities are accounted for “off the balance sheet.” • Special Assessmentsare accounted for just as any other capital projects. • In Government-wide statements, both CPF and DSF are combined with other governmental funds. Both revenues and expenses are recognized on a full accrual basis. • Arbitrage is issuing of debt at relatively low, tax-exempt interest rates. • Bond refunding is the early retirement of existing (high interest) debt with so that it can be replaced with new (low interest) debt. Granof-5e

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