Chapter 6 Accounting for Capital Projects and Debt Service

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Learning Objectives

• Capital Projects Fund• Debt Service Fund• Special Assessments• What is Arbitrage?• Debt Refundings

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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.

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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 facilitieso Fund DOES NOT account for Capital Assets themselves.

These are maintained in a Schedule of Capital Assets.• Basis of Accountingo Fund Statements --Modified accrual basiso Government-wide statements --Full accrual basis.

• Two types of capital projectso 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.

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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

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CPF: Capital Assets- Acquisition

Three Phases: Phase 1: Preconstruction Phase

--Project & Financing authorization Phase 2: Construction Phase Phase 3: Debt Servicing Phase

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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)

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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.oPremiums and discounts.

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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 $5,050,000Bonds 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

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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 100,000Govt.-wide (Gov’tal. Activities)*:

Due from Other Governmental Units $100,000Program Revenues-Capital Grants andContributions-General Government 100,000

*Note: This entry is not made on the books, this is the conversion at the end of year

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Type II Grants-Example

The amount due from the federal government for thepreviously 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

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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.

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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.

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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.

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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

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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)

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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.

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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 end of the year

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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 DSFo Taxes levied by GF and transferred to DSFo Special taxes restricted to the payment of debt

3) Other means of financingo Special assessments

*2) Grants would not have debt to service

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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. 238-241.

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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

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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, 2013.

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 2013.

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Type I - Tax Supported DebtOverview: Two Types

1) Serial bonds:

• Regular serial bonds• Deferred Serial bonds

2) Term bonds

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• 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

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1) Serial Bonds - Overview

A certain city issued $100,000 of 6% serial general obligation (G.O.) bonds on Dec. 1, 2013. 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, 2014.

Gov’t.-wide (Gov’tal. Activities): Dr. Cr.

Cash $100,000 Serial Bonds Payable – 6% 100,000

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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 Fund 11,000

Interfund Transfers In 11,000

Government-wide (Gov’tal. Activities):

No entry needed.

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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.

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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

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Serial Bonds - Example (cont’d)

The remaining $8,000 transfer was received from the General Fund on November 29, 2014. 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 $5,000Expenditures—Bond Interest 3,000

Cash 8,000 Gov’t.-wide (Gov’tal. Activities)*: Interest Expense on Long-Term Debt $3,000Current 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

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Serial Bonds - Example (cont’d)

Closing entries on December 31, 2014:

Debt Service Fund: Dr. Cr.Interfund Transfers In 11,000

Estimated Other Financing Sources 11,000

Appropriations $11,000Expenditures—Bond Principal 5,000Expenditures—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

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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

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Term Bonds-Overview

Type III – Other Forms of FinancingSpecial 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.

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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, oro 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.

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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.

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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 $100,000Assessments 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

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Special Assessments - Example

Bond Principal of $100,000 and interest of 8% were paid on schedule:

Debt Service Fund: Dr. Cr.Expenditures—Bond Principal $100,000Expenditures—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

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Special Assessments-Example (cont’d)

Additional TopicsArbitrage• 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.

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Debt RefundingMeans 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 rateo Example in text (p. 249-251) shows there is no real

economic gain or loss from refunding debto 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”

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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.

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Assuming old bonds are retired shortly after issue of refunding bonds

Debt Service Fund: Dr. Cr.

Other Financing Uses—Refunded Bonds $100,000Cash 100,000

(Note: Report only the new issue as debt in governmental activities)

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Debt Refunding Transactions (cont’d)

In-Substance DefeasanceIn-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. 251-252

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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 debt2. Possibility of debtor having to make future payments on the

debt must be remote3. 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.

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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.

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