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CHAPTER 11

Public Sector Financial Reporting

This chapter continues the discussion of non-business organizations by addressing the specific issues of governmental financial reporting.

The chapter first discusses the general nature of government—more specifically, the types of government organizations and how the characteristics of government that can affect financial reporting. Next, financial reporting for governments is reviewed. The issues of compliance, objectives, and qualitative characteristics are discussed and a sample set of financial statements is illustrated.

Finally, the major reporting issues are addressed within the context of the characteristics, reporting objectives, and qualitative criteria of government reporting. Issues that are particularly noteworthy for governments are (1) determining the reporting entity, (2) revenue recognition, (3) financial instruments, (4) tangible capital assets and (5) liability measurement. These reporting issues are discussed in the context of the practical problems faced by governments.

Copyright © 2014 Pearson Canada Inc. 529

Chapter 11 – Public Sector Financial Reporting

SUMMARY OF ASSIGNMENT MATERIAL

Case 11-1: Province of Majestic LakesStudents are required to respond to a member of the provincial legislature asking questions on the Government Reporting Model.

Case 11-2: Comparison of ObjectivesStudents are required to describe the major differences in reporting between a large corporation and a large municipality.

Case 11-3: Town of EvergreenStudents are asked to assume the role of a public accountant to assist a town councilor in identifying potential problems with the financial reporting of a municipality.

Case 11-4: Harvest ProvinceStudents are required to prepare financial statements for a mythical province.

Case 11-5: Green ProvinceStudents are required to prepare financial statements for a mythical province that reports using the statement of remeasurement gains and losses.

Case 11-6: District of Maple RidgeStudents are required to indentify several strengths of the financial reporting of a real municipality that has won multiple awards for the quality of its annual reports.

ANSWERS TO REVIEW QUESTIONS

Q11-1: The budget is important because it portrays public policy. It forms a key part of the government’s financial report and is explicitly incorporated into two of the financial statements. Including the budget in the financial report allows for a better evaluation of the government’s fiscal management and thus serves to improve accountability.

Q11-2: Governments are generally characterized by a much broader user group than either businesses or not-for-profit organizations. The main users are the public (either directly or as represented by legislators and councillors), the civil service, other governments, debt investors such as pension funds, and analysts. The primary user group for NFP statements is the primary funders, whether they be members, government ministries, or granting agencies.

Q11-3: The focus on debt is important because, due to their taxing authority, governments have a tremendous capacity to borrow. The debt bears interest and the



principal must be repaid sometime in the future. If the level of debt rises, the burden of rising debt servicing costs will affect a government’s ability to provide services to the public in the future.

Q11-4: The nine unique characteristics that influence governmental reporting are:1. Public Accountability2. Multiple Objectives3. Rights, powers and responsibilities (constitutional or devolved)4. Lack of equity ownership5. Operating and financial frameworks set by legislation6. The importance of the budget7. Governance structures8. Nature of resources9. Non-exchange transactions

Q11-5: The public sector is defined in the Public Sector Accounting Handbook (PSA Handbook) as consisting of the federal, provincial, territorial and local governments, and government organizations.

Q11-6: The three types of organizations and their sources of GAAP are:- Government business enterprises (GBEs) – IFRS (as directed by PSAB)- Government not-for-profit organizations (GNPOs) – PSA Handbook - Other government organizations (OGOs)—PSA Handbook or IFRS (choose

best option based on organization’s objectives)

Q11-7: The Public Sector Accounting Board issues accounting recommendations for governmental reporting. Its mandate is to serve the public interest by issuing recommendations for accounting in the public sector and strengthen accountability in the public sector by developing, recommending and gaining acceptance of accounting standards and financial reporting standards.

Q11-8: Government auditors report in accordance with legislation in their province or, for the federal government, with federal statute. The public sector accounting standards are recommendations, not requirements for the senior levels of government.

Q11-9: Municipal government reporting practices are controlled by provincial legislation. It now appears that almost all municipalities are effectively compelled to comply with PSAB recommendations. All provinces either have a legislative requirement for municipalities to comply with PSAB or require compliance in order for the municipality to receive specific funds from the province. The result will likely be very high compliance with PSAB recommendations.

Q11-10: The objectives of governmental reporting are:



1. to provide an accounting of financial affairs and resources under the government’s control;

2. to demonstrate government’s ability to finance activities, meet liabilities, and provide future services;

3. to account for sources, allocation, and use of government resources; to evaluate how activities affect net debt; and to show how activities were financed and how cash requirements were met; and

4. to display the state of a government’s finances and evaluate if the finances are in accordance with legislative requirements.

Q11-11: The first key message on the SFP is net debt. Remember that debt is a very important issue for governments. Therefore, to help users assess a government’s ability to finance its activities and meet its liabilities, the government’s “net debt” is presented in the SFP. Net debt is the total of government liabilities less the total of its financial assets. Net debt is important because debt has to be serviced and repaid and therefore will impact a government’s ability to deliver programs and services in the future. For users, net debt is an important indicator of a government’s financial position.

The second key message on the SFP is the accumulated deficit or surplus. Tangible capital assets (and other non-financial assets) are viewed in terms of their unexpired or future service potential and not in terms of future cash flows. Thus, the total of tangible capital assets will help users assess a government’s ability to deliver its services and programs in the future.

Net debt is thought of as claims that could reduce future services, while tangible capital assets can be thought of as prepaid future service potential. The two items are combined on the SFP to produce an accumulated deficit or surplus. For users, accumulated deficit or surplus is another important indicator of a government’s financial position because it shows the recognized economic resources that a government has available.

Q11-12: The additional element was accountability value. The addition of accountability value reflects the importance of stewardship in governments. It is manifested in the inclusion of budget figures in the financial statements.

Q11-13: The following five statements are recommended for governments: statement of financial position; statement of operations; statement of remeasurement gains and losses; statement of change in net debt; and statement of cash flow.

Q11-14: Persuasive evidence of control may be indicated by the government having:

a. the power to appoint a majority of the members of a governing body;

b. access and control over the assets of the organization;

c. the majority of the voting shares; or

d. unilateral power to dissolve the organization.



Q11-15: Investments in a GBE (government business enterprise), such as a public utility, should be reported using the modified equity method. Under the modified equity method, the net profit or loss of the business enterprise is included in the government’s statement of operations (net of dividends or distributions) and is added to the investment account related to that enterprise. It is called a modified equity method because the accounting principles for the GBE are not changed to government accounting principles.

Q11-16: A government transfer is the provision of either monetary or tangible capital assets by one entity to another entity (i.e., government, organization or individual). The transferor does not receive any goods or services in return, nor expect to be repaid or expect a financial return. The transfer is a non-exchange transaction. Two kinds of transfer terms can be imposed by the government transferring the resources: eligibility criteria and stipulations. If a term of the transfer must be met before the transfer occurs, it is an eligibility criterion. Typically an eligibility criterion will specify who can receive the transfer or what must be done to receive the transfer. If a term of the transfer can only be met after the transfer occurs, it is a stipulation. Typically, a stipulation describes how the resources must be used or what must be done to keep the transfer.

Q11-17: The transferring government (transferor) will recognize an expense when the transfer is fully authorized and the eligibility criteria have been met. The transfer is fully authorized when is has been approved by the legislature or council. In rare cases, the transferor may recognize the expense before it is fully authorized if two conditions are met. First, the preponderance of the evidence must suggest that the government is committed to the transfer and second, the transfer must receive approval from the legislature or council in the “stub” period (i.e., the period after the government’s year-end but before it issues its financial statements).

Q11-18: The direct transfer of tangible capital assets is recognized when the transfer has been fully authorized by the transferor and the eligibility criteria have been met. The revenue would only be deferred if the transfer created a liability for the recipient. This deferred revenue would then be recognized when the liability had been settled.

Q11-19: Tax concessions are amounts that affect the taxes that an entity currently owes or previously owed. They are provided only to taxpayers and only through the tax system. They reduce the taxes that would otherwise be owed and result in foregone revenue for the government.

Q11-20: PSAB introduced the statement of remeasurement gains and losses in Section PS 1201. It allows public sector entities to defer unrealized gains and losses on items denominated in a foreign currency and fair value items from recognition on the statement of operations. PSAB believes that the concept of remeasurement gains and losses is more meaningful and easier to understand for users than concepts such as other comprehensive income (OCI) and hedge accounting.



CASE NOTES

Case 11-1: Province Of Majestic Lakes

Objectives of the Case

This case is designed to provide a discussion of the key aspects of the “Government Reporting Model”. This case should be written as a report to the member of the provincial legislature.

Report to Member of the Provincial Legislature

The following report summarizes the answers to the questions that you have asked on the “Government Reporting Model.”

What characteristics are unique for governments and what are the reporting implications?

In designing the new government reporting model, the PSAB identified the unique characteristics of a government and how that differs from businesses. These characteristics have reporting implications that mean the financial statements for government should not look like those of a business.

Characteristics of Public Sector Entities, prepared by the Conceptual Framework Task Force on August 2011, identifies the following nine unique characteristics of governments:

- 1. Public Accountability

- 2. Multiple Objectives

- 3. Rights, powers and responsibilities (constitutional or devolved)

- 4. Lack of equity ownership

- 5. Operating and financial frameworks set by legislation

- 6. The importance of the budget

- 7. Governance structures

- 8. Nature of resources

- 9. Non-exchange transactions

What are the five key messages in the model?

The new government reporting model issued in January 2003 focuses on economic rather than financial resources. The new model sends the following five messages about government finances:

- net debt/net financial assets



- accumulated surplus/deficit

- annual surplus/deficit

- change in net debt

- change in cash and cash flows that contributed to the change

What are the required financial statements and what are they like? What key information should I look for in each of the statements?

The required financial statements are:- statement of financial position – reports net debt and then deducts non-financial

assets from net debt to measure the government’s accumulated surplus or deficit.

- statement of operations – shows excess (or deficiency) of revenues over expenses.

- statement of remeasurement gains and losses - reconciles the accumulated remeasurement gains and losses at the beginning of the period with the accumulated remeasurement gains and losses at the end of the period. The accumulated remeasurement gains and losses balance on this statement is increased as unrealized gains or losses are recognized and reduced as the gains and losses are realized. The statement captures unrealized gains and losses that arise from the changes in value of items denominated in a foreign currency and from the changes in value of financial instruments carried at fair value. These changes in fair value are relevant to users to help them assess how well the government has maintained its economic resources.

- statement of change in net debt – reconciles a government’s total expenses for the period to its spending on operations for the period. It also reports the capital spending in the period, the extent to which total government spending was financed by revenues earned in the period and the opening and closing net debt balances.

- statement of cash flow – calculates the cash flow from operating activities. Capital transactions are shown as a separate section.

What is the key impact of the change to “accrual” accounting?

The model sees the deferral of expenditures and measurement of the net cost of services as the ultimate goal.

Why is it important to have a comparison with budgeted numbers?

The new reporting model requires that budget and actual numbers must be reported on the Statement of Operations and the Statement of Change in Net Debt. This highlights the differences between the two, which provides accountability or a measure of the government’s achievement of their objectives.

Why is it important to account for capital assets?



“Many in the government were concerned that the existing modified accrual or “expenditure” model was creating a bias against spending on capital assets – a bias that was contributing to the “infrastructure deficit” in Canada. Governments needing to balance their budgets found that putting off capital spending was an easy way to meet this objective.”

The new reporting model requires the use of full accrual accounting. This requires that capital assets are recorded as an asset and the annual expense of owning and using the capital asset is recognized as an expense.

Case 11-2: Comparison of Objectives


This case is intended to draw out the differences in financial reporting between a large corporation and a large city.

Discussion

(a) Differences in accounting

• Governments, because their major revenues are characterized by non-exchange transactions, recognize revenues on receipt (revenues are not earned). Businesses, because their revenues are characterized by exchange transactions, match expenses to revenues and recognize revenues when earned.

• Government expenses are shown by program or function (i.e., health or education) on the financial statements while business expenses are shown by object or type (i.e., wages or supplies).

• Governments incorporate their budgets into the account structure, while corporations use budgets only as an indicator.

• Corporations capitalize their capital assets and charge depreciation; governments also capitalize their capital assets and charge depreciation. Given that one of the government’s objectives is to provide services (and not to maximize profits) then tangible capital assets are seen as representing future service capability and not as representing a source of future cash flows (as in a business). The carrying value of these assets therefore represents the unexpired service potential of the assets. This difference has a direct impact on any impairment testing. Write-downs will be based on the impairment of future service potential and not on the impairment of future cash flows.

(b) Differences in financial reporting

• The focus of corporate reporting is on the determination of profit for the owners; the focus of municipal reporting is on the flow of resources and on compliance with budgetary restrictions.



• Corporate reporting is directly governed by GAAP, whereas governmental accounting is affected more by legal and contractual requirements. In most situations local governments must now comply with PSAB.

• The types of financial statements prepared by corporations are the statement of financial position, statement of operations, statement of changes in shareholder’s equity and statement of cash flows. Those prepared by governments are the statement of financial position, statement of operations, statement of remeasurement gains and losses, statement of changes in net debt and statement of cash flows.

•

Case 11-3: Town of Evergreen


This case is intended to have students focus on revenue recognition issues in a municipality.

Discussion

- An incentive now exists (the new bonus structure) for the town controller to maximize reported revenues to maximize his bonus.

- Government grants : The determination of when the town recognizes grant revenue should not be when “the province recognizes the transfer” as documented in the notes. The stipulations attached to the grant will affect the timing of the revenue recognition by the town and these grants should be reviewed to ensure that revenue is being recognized properly. For example, government grants are received to subsidize the town recreational program. These grants should be reviewed and if any monies are received in advance, they should be recorded as deferred revenue. In addition, government grants received for constructing new streets should be carefully reviewed. The statements note that “substantial funds are received in advance of construction projects”. These funds should be recorded in a deferred capital contributions account and not recognized in revenue. (It could be that they are now being recognized as revenue in a capital fund and included in consolidated revenues for the town).

- Property taxes : The notes identify that “property taxes are recorded at their gross amount when the taxable event has occurred”. At the same time, further in the notes, a rebate on property taxes is identified as a major expense in a campaign to encourage businesses to set up in town. If this rebate is a tax concession, then the revenue should be shown net of the tax rebates and not at the gross amount. This program should be reviewed carefully to ensure that it is being accounted for appropriately. It appears that the costs related to tax collection are being accounted for properly.



Recommendations:

1. The financial statements should comply with GAAP. Complying with GAAP however will not eliminate the ability to structure the accounting to maximize bonuses. For example, bonuses will be paid on any endowment monies received if the restricted fund method of accounting is used instead of the deferral method. It is unlikely that it was the intention of the compensation committee to pay bonuses in this manner.

2. The bonus structure of the compensation agreement should be revisited as a bonus based on revenues is not optimal. A better approach would be to use a balanced scorecard approach. Further, the compensation committee should meet yearly to review the performance of the controller.

Case 11-4: Harvest Province

Harvest ProvinceConsolidated Statement of Financial Position

As at December 31, 20XX($ millions)

20XX Financial Assets

Cash 1,000 Receivables 750 Investments 1,500

Investment in GBEs 500 3,750

LiabilitiesPayables 2,000 Unmatured debt 5,000

7,000

Net Debt (3,250)

Non-financial assetsTangible capital assets 2,000 Prepaids 250

2,250 Accumulated deficit (1,000)



Harvest ProvinceConsolidated Statement of Operations and Accumulated Deficit

For the fiscal year ended December 31, 20XX($ millions)

20XXActual

RevenueIncome Tax 2,750 Sales Tax 1,750

Total Revenue 4,500

ExpensesHealth 1,800 Education 1,200 Other 1,200

Total Expenses 4,200

Surplus (Deficit) from government units 300

Loss from GBEs 50

Surplus 250

Accumulated Deficit, Beginning (1,250)Accumulated Deficit, End (1,000)

Case 11-5: Green Province

Green ProvinceConsolidated Statement of Financial PositionAs as December 31, 20XX($ millions)

Financial AssetsCash 300 Receivables 225 Investments 600

1125



LiabilitiesPayables 600 Unmatured debt 1500

2100

Net Debt (975)

Non-financial assetsTangible capital assets 600 Prepaids 75

675 Accumulated deficit (300)

Accumulated deficit is composed of: Accumulated operating surplus (deficit) (240) Accumulated remeasurement gains (losses) (60)

(300)

Green ProvinceConsolidated Statement of Operations and Accumulated DeficitFor the fiscal year ended December 31, 20XX($ millions)

RevenueIncome Tax 825 Sales Tax 450 Other Revenue 66 Total Revenue 1341

ExpensesHealth 540 Education 360 Debt Service 75 Other 300 Total Expenses 1275

Surplus (Deficit) 66

Accumulated Deficit, Beginning (306)Accumulated Deficit, End (240)



Green ProvinceConsolidated Statement of Remeasurement Gains and LossesFor the fiscal year ended December 31, 20XX($ millions)

Accumulated Remeasurement Gains and Losses at Beginning of Year (69)

Unrealized Gains Attribitable to Portflio Investments 15

Gain on Portfolio Investments Reclassified to Statement of Operations (6)

Accumulated Remeasurement Gains and Losses at End of Year (60)

Case 11-6: Maple Ridge

This is an exercise to get students to become familiar with a “real” set of municipal financial statements. There are numerous possibilities for discussing the strengths of Maple Ridge’s financial reporting. The following are several highlights but there are many other possibilities:

1. Financial section - note the clarity and level of disclosure in the financial statements and the related notes. For example, see the schedule on debt where both amounts and interest rates are disclosed.

2. Note the section on major property tax payers – the names and amounts paid are identified.

3. The section on general comparative statistics contains non-financial information on major assets and services and the level of debt (expressed in a number of ways) for the last 5 years and a comparative from 10 years ago.

4. The “revenue and expenditures” section provides a summary of the last five years by function and by object. The “capital assets acquired” section provides a summary of the capital assets and sources of funding for the last five years.



5. The Citizens Report should also be reviewed to see an example of an award winning “readers digest” version of the annual report. It can be found under “Municipal Hall”, then “Budget and Business Planning” and then under "Budget and Financial Reports."

6. The “See-It” tool should be tried. It is an online performance reporting tool (with scorecards) that provides an opportunity for feedback. It can be found under “Municipal Hall”, then under “How are we doing?”. Note that there is a tutorial to assist is using this tool, if needed (the tool is very easy to use, but given that the tutorial is less than 5 minutes, we would recommend that students listen to the tutorial to make sure they understand all the features).
