Chapter 6 Accounting for Capital Projects and Debt Service Chapter 6 Granof & Khumawala-6e 1

Learning Objectives Capital Projects Fund Debt Service Fund Special Assessments What is Arbitrage? Debt Refundings Chapter 6 Granof & Khumawala-6e 2

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. o i.e. Fund has a “Project-life focus,” not year-to-year focus. Chapter 6 Granof & Khumawala-6e 3

Overview Governments must maintain capital projects funds for resources that are legally restricted, committed, or assigned to expenditure for capital outlays. o This includes the acquisition or construction of capital facilities o Fund DOES NOT account for Capital Assets themselves. These are maintained in a Schedule of Capital Assets. Basis of Accounting o Fund Statements --Modified accrual basis o Government-wide statements --Full accrual basis. Two types of capital projects o General (public benefit) --Examples: public buildings, roads, highways and bridges, park improvements, sewer systems, plant and equipment; etc. o Special assessment (private benefit) --i.e. Benefits citizens in a specified benefit district. --Examples: street improvements, curbs, sidewalks, street lighting, sewage, etc. Chapter 6 Granof & Khumawala-6e 4

Assume that Simple City proceeds with the creation of a capital equipment replacement fund (which would be considered a capital projects fund). To create the fund, the general fund transfers (this means to give – without the expectation of repayment) $1,000,000 to the new capital equipment replacement fund. General Fund Other financing uses$1,000,000 Cash1,000,000 Capital Equipment Replacement Fund (CPF) Cash$1,000,000 Other financing sources1,000,000 Government-Wide Governmental Activities None Chapter 6 Granof & Khumawala-6e 5 CPF: Capital Assets- Acquisition

Three Phases:  Phase 1: Preconstruction Phase --Project & Financing authorization  Phase 2: Construction Phase  Phase 3: Debt Servicing Phase Chapter 6 Granof & Khumawala-6e 6 CPF: Capital Assets-Construction

Phase 1: Preconstruction Phase Project & Financing authorization Financing Acquire extensive, long-term financing (3 types) Type I - Tax Supported Debt o General obligation (tax-supported) bonds or special taxes restricted to payment of debt Type II - Grants Type III - Other forms of financing o Special Assessments (Special Assessments actually claim only 2 phases because financing & construction are a single phase) Chapter 6 Granof & Khumawala-6e 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: o Issue costs. o Premiums and discounts. Chapter 6 Granof & Khumawala-6e 8

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 Chapter 6 Granof & Khumawala-6e 9 Type I - 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 Chapter 6 Granof & Khumawala-6e 10 Type II Grants-Example

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 Chapter 6 Granof & Khumawala-6e 11 Type II Example (cont’d)

Overview Most Common: Special Assessments --Levied when taxpayers in areas beyond their jurisdiction want to benefit from certain facilities and services. Chapter 6 Granof & Khumawala-6e 12 Type III – Other Forms of Financing

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. Chapter 6 Granof & Khumawala-6e 13

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. Chapter 6 Granof & Khumawala-6e 14 Interim Financing - Example

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 Chapter 6 Granof & Khumawala-6e 15 Interim Financing Example (cont’d)

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. o GASB requires budgeting over integrated funds when control cannot be established by other means (e.g. fixed-price contracts) Chapter 6 Granof & Khumawala-6e 16

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 Encumbrances 50,000 Government-wide (Gov’tal. Activities): No entry needed. Chapter 6 Granof & Khumawala-6e 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 Encumbrances50,000 Cash 48,000 Encumbrances50,000 Gov’t.-wide (Gov’tal. Activities)*: Construction Work in Progress$48,000 Cash48,000 *Note: This entry is not made on the books, this is the conversion at the end of the year Chapter 6 Granof & Khumawala-6e 18 Budgeting Example (cont’d)

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 o Taxes levied by DSF o Taxes levied by GF and transferred to DSF o Special taxes restricted to the payment of debt 3) Other means of financing o Special assessments *2) Grants would not have debt to service Chapter 6 Granof & Khumawala-6e 19 Debt Service Funds(DSF) - Overview

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 Chapter 6 Granof & Khumawala-6e 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 Chapter 6 Granof & Khumawala-6e 21

DSF - Example Assume bonds are issued on January 1, 2013 and pay interest semiannually on January 1 and July 1 in the amount of $100,000. The fiscal year ends on Dec. 31, Q: How much expenditures would be recognized in fiscal 2013? A: Only the July 1, 2013 interest payment, or $100,000, would be recognized as an expenditure of Chapter 6 Granof & Khumawala-6e 22

Type I - Tax Supported Debt Overview: Two Types 1) Serial bonds: Regular serial bonds Deferred Serial bonds 2) Term bonds Chapter 6 Granof & Khumawala-6e 23

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. o Advantage: Self-amortizing; no sinking fund needed Chapter 6 Granof & Khumawala-6e 24 1) Serial Bonds - Overview

A certain city issued $100,000 of 6% serial general obligation (G.O.) bonds on Dec. 1, In addition, interest of $3,000 is due on June 1, 2014, December 1, 2014, 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, Gov’t.-wide (Gov’tal. Activities): Dr. Cr. Cash $100,000 Serial Bonds Payable – 6% 100,000 Chapter 6 Granof & Khumawala-6e 25 Serial Bonds DSF - Example

The budget approved for FY 2014 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 Fund11,000 Interfund Transfers In 11,000 Government-wide (Gov’tal. Activities): No entry needed. Chapter 6 Granof & Khumawala-6e 26 Serial Bonds DSF - Example (cont’d)

On May 28, 2014, the transfer from the General Fund was received. Debt Service Fund:Dr.Cr. Cash $3,000 OFS-nonreciprocal transfer from GF 3,000 (Note: If Interfund (nonreciprocal)Transfers In was accrued at the time the budget was recorded, then Interfund Transfers In would have been credited here rather than Due from General Fund) Govt.-wide (Gov’tal. Activities): No entry needed. Chapter 6 Granof & Khumawala-6e 27 Serial Bonds DSF - Example (cont’d)

The June 1, 2014, 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 Chapter 6 Granof & Khumawala-6e 28 Serial Bonds - Example (cont’d)

The remaining $8,000 transfer was received from the General Fund on November 29, On December 1, the City paid the interest and principal maturing that date. Debt Service Fund: (11/29/14)Dr. Cr. Cash$8,000 OFS-nonreciprocal transfer from the GF8,000 12/01/14 Expenditures—Bond Principal $5,000 Expenditures—Bond Interest 3,000 Cash8,000 Gov’t.-wide (Gov’tal. Activities)*: Interest Expense on Long-Term Debt$3,000 Current Portion of Bonds Payable5,000 Cash8,000 *Note: This entry is not made on the books, this is the conversion at the eoy Chapter 6 Granof & Khumawala-6e 29 Serial Bonds - Example (cont’d)

Closing entries on December 31, 2014 : Debt Service Fund: Dr. Cr. Interfund Transfers In11,000 Estimated Other Financing Sources 11,000 Appropriations$11,000 Expenditures—Bond Principal5,000 Expenditures—Bond Interest 6,000 Gov’t.-wide (Gov’tal. Activities)*: Net Assets – Unrestricted$6,000 Interest Expense on Long-term Debt6,000 *Note: This entry is not made on the books, it is the conversion at the eoy Chapter 6 Granof & Khumawala-6e 30 Serial Bonds - Example (cont’d)

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 value (fv) Changes in fv: reported as a component of investment earnings. More complex accounting than for serial bonds Chapter 6 Granof & Khumawala-6e 31 Term Bonds-Overview

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 assessment revenues 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. Chapter 6 Granof & Khumawala-6e 32

Special Assessments-Overview(cont’d) Governments 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: o It is responsible for the debt in the event of property owner default, or o t 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. Chapter 6 Granof & Khumawala-6e 33

Special Assessments - Overview (cont.) 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. Chapter 6 Granof & Khumawala-6e 34

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—Deferred900,000 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 Chapter 6 Granof & Khumawala-6e 35 Special Assessments - Example

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 Interest80,000 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 Chapter 6 Granof & Khumawala-6e 36 Special Assessments-Example (cont’d)

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. Chapter 6 Granof & Khumawala-6e 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 o Example in text (p ) shows there is no real economic gain or loss from refunding debt o 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) o 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” Chapter 6 Granof & Khumawala-6e 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. Chapter 6 Granof & Khumawala-6e 39

Assuming old bonds are retired shortly after issue of refunding bonds Debt Service Fund: Dr. Cr. Other Financing Uses—Refunded Bonds $100,000 Cash100,000 (Note: Report only the new issue as debt in governmental activities) Chapter 6 Granof & Khumawala-6e 40 Debt Refunding Transactions (cont’d)

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 Chapter 6 Granof & Khumawala-6e 41

In-Substance Defeasance (cont’d) In-substance defeasance should satisfy the following conditions: 1.Debtor must place cash/assets with an escrow agent to be solely used for servicing/retiring the debt 2.Possibility of debtor having to make future payments on the debt must be remote 3.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. Chapter 6 Granof & Khumawala-6e 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 Assessments are 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. Chapter 6 Granof & Khumawala-6e 43