© 2003 Prentice Hall Publishing – Governmental and NonProfit Accounting 7e Freeman / Shoulders8 -...

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© 2003 Prentice Hall Publishing – Governmental and NonProfit Accounting 7e Freeman / Shoulders 8 - 1 CHAPTER 8 CHAPTER 8 DEBT SERVICE FUNDS DEBT SERVICE FUNDS

Transcript of © 2003 Prentice Hall Publishing – Governmental and NonProfit Accounting 7e Freeman / Shoulders8 -...

Page 1: © 2003 Prentice Hall Publishing – Governmental and NonProfit Accounting 7e Freeman / Shoulders8 - 1 CHAPTER 8 DEBT SERVICE FUNDS.

© 2003 Prentice Hall Publishing – Governmental and NonProfit Accounting 7e Freeman / Shoulders 8 - 1

CHAPTER 8CHAPTER 8

DEBT SERVICE FUNDSDEBT SERVICE FUNDS

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LEARNING OBJECTIVESLEARNING OBJECTIVES

To understand– Debt Service Funds

PurposesWhen requiredTypes of liabilities commonly serviced

– Recognition ofFinancing methodsExpendituresConditions permitting principal and interest

expenditure accrual before maturity

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LEARNING OBJECTIVESLEARNING OBJECTIVES(Continued)(Continued)

To understand– Accounting and reporting for

Special assessment Debt Service FundsDebt service on term bondsDebt service on deep discount debtRefundings of general long-term liabilities

– How to Record debt service transactionsPrepare Debt Service Fund financial statements

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DEBT SERVICE FUNDSDEBT SERVICE FUNDS

Purpose

– Used to account for accumulation of resources for and payment of GLTD (not debt of specific funds) principal and interest

Required only if -– Legally mandated– Accumulating resources for future years

(Common due to bond indenture requirements)

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DEBT SERVICE FUNDS DEBT SERVICE FUNDS OPTIONAL USEOPTIONAL USE

Use is optional if not required

DSF preferred in order to– Service all debt in a single fund– Improve control and accountability

General or Special Revenue Fund may directly pay debt service– For example, capital leases

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TYPES OF DEBT SERVICEDTYPES OF DEBT SERVICEDGeneral obligation bonds– “Full faith and credit” of government

pledged for repaymentRevenue bonds– Repaid from specific revenue sources such

as gas or sales taxes, special assessmentsOther– Capital lease obligations– Notes and warrants payable

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DEBT NOT SERVICED BY DSFDEBT NOT SERVICED BY DSF

Liabilities of specific governmental funds– Short-term debt– Capital leases

Enterprise funds– Water, sewer, electric, airport

Internal service fundsTrust funds

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TYPES OF DEBT SERVICEDTYPES OF DEBT SERVICEDBonds (most common)– A promise to pay principal and interest

at a specific future date– Common features

$1,000 and $5,000 denominations 15 to 25 year maturities Interest paid annually or semi-annually

– Term bonds Principal payable in a single maturity

– Serial bonds (most widely used) Periodic (usually annual) maturities May not be equal maturities

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TYPES OF DEBT SERVICEDTYPES OF DEBT SERVICED

Notes payable

– Less formal documents with obligation to repay borrowing at specified interest rate

– Single maturity most common– Term of the note typically ranges from

30 – 90 days3 – 5 years

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TYPES OF DEBT SERVICEDTYPES OF DEBT SERVICEDCapital lease obligations– Capital leases– Lease-purchase agreements– Installment purchase contracts

– Certificates of participation (COPs)– A “carving up” of a lease into shares

Shares sold to individual investors

– If transaction is a purchase, it is accounted for like long-term debt; recorded as

General capital assets General Long-Term Liabilities

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TYPES OF DEBT SERVICEDTYPES OF DEBT SERVICED

Deep discount / zero coupon bonds

– Low or zero stated interest– Issued at significant discount from par– No interest payments during bond term– One-time payment of P&I at maturity

Accrued during bond term (effective rate)Common to require– Annual deposits with trustee or– Annual transfers to DSF

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© 2003 Prentice Hall Publishing – Governmental and NonProfit Accounting 7e Freeman / Shoulders 8 - 12

TYPES OF INTEREST RATESTYPES OF INTEREST RATESFixed rate– Set on bond issue date– Initial rate remains constant during term– Benefit - simpler to plan and budget– Negative - higher rate

Variable rate– Initial rate fluctuates every 6 to 12 months– Benefit - lower rate– Negative - harder to budget changing rate

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© 2003 Prentice Hall Publishing – Governmental and NonProfit Accounting 7e Freeman / Shoulders 8 - 13

PLAYERS IN BOND ISSUES PLAYERS IN BOND ISSUES Financial advisor / feasibility consultant

– Assist in bond structuring and issuance Bond counsel

– Prepare legal documents / provide legal opinion Bond underwriters

– Purchase bonds and sell to investors Bond rating agencies (S&P, Moody’s, Fitch)

– Rate bonds regarding repayment Insurance firms (MBIA, FGIC, AMBAC)

– Insure principal and interest payment Registration / fiscal agents

– Register bonds - collect / disburse debt service

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REQUIRED DSF RESERVESREQUIRED DSF RESERVES

Many bond agreements require funded reserves to provide added assurance

Common provisions:– Net assets equal to highest debt service– May be funded over several (2-5) years

When expended for debt service– In case of difficulty during term of bond– Final payment

Held by trustee or the government

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DEBT FINANCING SOURCESDEBT FINANCING SOURCES

Common sources to provide debt service– General obligation bonds

Property taxesResult from voter approval in bond election

– Revenue bonds (specific revenue streams)Sales taxesGas taxesHotel taxes

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DEBT FINANCING SOURCESDEBT FINANCING SOURCES

Fund recording receipt from the source– General Fund - General levy (1st call on $)– Special Revenue Fund - Multi restriction

Recorded initially in SRFTransferred to DSF for debt service

– Debt Service Fund - Specific tax levy

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DSF INVESTMENTSDSF INVESTMENTS

From accumulation of resources prior to payment of debt service– Debt service reserve funds– Periodic transfers from other funds– Invested until required

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DSF INVESTMENTSDSF INVESTMENTS

Bond indenture / state law requirements control type of permitted investments

Compliance with requirements and auditing for compliance

Arbitrage considerations may influence– Excess earnings rebated to U.S. Treasury– State & Local U.S. Governments (SLUGS)

Accounting in compliance with GASB No. 31

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DEBT SERVICEDEBT SERVICEEXPENDITURE RECOGNITIONEXPENDITURE RECOGNITION

Three types of debt-related payments

1. Interest on outstanding long-term debt

2. Principal as it matures

3. Other debt-related fees

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DEBT SERVICEDEBT SERVICEEXPENDITURE RECOGNITIONEXPENDITURE RECOGNITION

Debt service on GLTL usually not accrued at year end, but optional

Recognize when due (most common)– Report principal and interest as

expenditures when they mature or legally payable (even if not paid)

– Do not accrue unmatured principal or interest

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DEBT SERVICEDEBT SERVICEEXPENDITURE RECOGNITIONEXPENDITURE RECOGNITIONFour (4) reasons for “when due” recognition

1. Budget vs. GAAP consistency as many appropriate only when due

2. Interest (main accrual) commonly not budgeted separate from principal

3. Transfer to DSF made only when due and accrual would cause artificial deficit in DSF

4. Without transfer, no financial resources available in DSF, therefore no current liability exists in DSF

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DEBT SERVICEDEBT SERVICEEXPENDITURE RECOGNITIONEXPENDITURE RECOGNITION

Accrual option available as some governments appropriate for debt service due early next year

Accrual of total debt service expenditure (both principal and interest) allowed in DSF, if:– Resources provided in DSF by year end and– Payment due early (first month) next year– Debt principal removed from GLTL accounts

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SERIAL BOND ISSUESERIAL BOND ISSUECASECASE STUDYSTUDY

$1,000,000 5% serial bonds Issued January 1, 20X1 $100,000 annual principal retirement plus interest Debt service financed by property tax levy $150,000 required debt service reserve

– Accumulate in two installment payments– $80,000 in 20X1 & $70,000 in 20X2

$80,000 GF transfer authorized to fund first debt service reserve installment

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SERIAL BOND ISSUESERIAL BOND ISSUECASECASE STUDYSTUDY

Record annual budget (Entry 1)

– Estimated revenues$162,000 property taxes$6,000 investment income

– Appropriations$100,000 bond principal retirement$50,000 annual bond interest$10,000 fiscal agent fees

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SERIAL BOND ISSUESERIAL BOND ISSUECASECASE STUDYSTUDY

Record transfer and investment (Entries 2 & 3)

– Transfer$80,000 transfer from General FundAlso, requires entry in GF

– Investment of transferred funds$80,000 investments purchased$80,000 debt service reserve established

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SERIAL BOND ISSUESERIAL BOND ISSUECASECASE STUDYSTUDY

Record property taxes (Entries 4 & 5)

– Taxes levied$165,000 total taxes receivable - current$3,000 allowance for uncollectible current taxes

– Taxes collected$158,000 taxes receivable - current

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SERIAL BOND ISSUESERIAL BOND ISSUECASECASE STUDYSTUDY

Record investment income (Entries 6 & 10)

– Receipt of interest$4,000 cash received

– Year end adjustments$2,700 interest accrued$300 change in fair value of investments

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SERIAL BOND ISSUESERIAL BOND ISSUECASECASE STUDYSTUDY

Record bonds first maturity (Entries 7 & 8)

– Fund liability for bonds when due $100,000 principal payable

(Also removed as General Long-Term Liability) $50,000 interest payable $10,000 fiscal agent fees payable

– Payment of liabilities $160,000 cash payment

Entries frequently combined if paid to fiscal agent prior to bond maturity

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SERIAL BOND ISSUESERIAL BOND ISSUECASECASE STUDYSTUDY

Record year end property taxes (Entry 9)

– Reclassify delinquent taxes$7,000 taxes receivable current to delinquent$3,000 allowance from current to delinquent

– Defer taxes not collected within 60 days of next fiscal year (considered not available)

$2,000

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DEBT SERVICE FUNDS DEBT SERVICE FUNDS FINANCIAL STATEMENTSFINANCIAL STATEMENTS

Balance Sheet (Figure 8-1)

Statement of Revenues, Expenditures, and Changes in Fund Balance (Figure 8-2)

– GAAP basis operating statementStatement of Revenues, Expenditures,

and Changes in Fund Balance– Budget comparison operating statement– Internal use; not required by GAAP

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SPECIAL ASSESSMENTSPECIAL ASSESSMENTDEBT SERVICE FUNDSDEBT SERVICE FUNDS

What are special assessments?

– Special tax levies imposed on certain properties To repay the financing of the “special assessment”

projects of defined property owners Total assessment made when project is completed However, commonly payable over 5 - 10 years

The financing proceeds (bonds or “pay go”) are accounted for in Capital Projects Funds

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SPECIAL ASSESSMENTSPECIAL ASSESSMENTDEBT SERVICE FUNDSDEBT SERVICE FUNDS

DSF used to account for servicing GLTD (principal and interest) when:

– Debt was issued to finance special assessment capital improvement projects

– Government is obligated to repay debt– Underlying financing source is the special

assessments

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SPECIAL ASSESSMENTSPECIAL ASSESSMENTDEBT SERVICE FUNDSDEBT SERVICE FUNDS

Debt financing role of the government:

– Form special assessment (taxing) district– Issue its own bonds or– Issue special assessment bonds– Guarantee repayment of bonds– Levy assessments to repay bonds & interest– Bill and collect assessments– Service the debt

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SPECIAL ASSESSMENTSPECIAL ASSESSMENTDEBT SERVICE FUNDSDEBT SERVICE FUNDS

Uniqueness is that most of the assessment (tax) is not currently due

Differences from property taxes1. Assessments payable over several years

2. Levied only against benefited properties

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SPECIAL ASSESSMENTSPECIAL ASSESSMENTDEBT SERVICE FUNDSDEBT SERVICE FUNDS

Revenue accounting for debt-related special assessments– Follows same principles as property taxes– Receivable recorded in fund servicing debt– Revenue recognized (1) when measurable

and (2) only when available– Long-term special assessments

Special assessments receivable – deferred Offset by deferred revenues

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SPECIAL ASSESSMENTSPECIAL ASSESSMENTDEBT SERVICE IN OTHER FUNDSDEBT SERVICE IN OTHER FUNDS

Enterprise funds– Examples – Water and sewer lines– Used if the government chooses– Usually chosen when the Enterprise Fund

resources will repay the debt

Agency funds– When government is not obligated in any

manner on the special assessment revenue debt

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SPECIAL ASSESSMENTSPECIAL ASSESSMENTDEBT SERVICE IN OTHER FUNDSDEBT SERVICE IN OTHER FUNDS

Agency Funds – no obligation debt

– Not debt of the government– Therefore, DSF is not used to record

debt service– Debt not reported in financial statements– Agency Fund used to account for

fiduciary responsibility

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SPECIAL ASSESSMENTSPECIAL ASSESSMENTDEBT SERVICE IN OTHER FUNDSDEBT SERVICE IN OTHER FUNDS

Agency Funds – no obligation debtThe government is not obligated if -– It is prohibited from assuming debt in

case of default– It is not legally liable for assuming debt– It makes no statement or indication that

it will honor any defaulted debt

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SPECIAL ASSESSMENTSPECIAL ASSESSMENTDEBT SERVICE IN OTHER FUNDSDEBT SERVICE IN OTHER FUNDS

Agency Funds – no obligation debt– Construction costs (not the capital asset

itself) reported in CPF– Difference in reporting the “other financing

sources” in the CPFCalled “Contributions from property owners”Not “General long-term debt proceeds”

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SPECIAL ASSESSMENTSPECIAL ASSESSMENTDEBT SERVICE FUNDSDEBT SERVICE FUNDS

Illustrative entries assumptions– 5-year, special assessment $1 million, 6% bonds

backed by full faith and credit of government– Government will contribute $260,000– $1 million costs accounted for in CPF– Capital asset capitalized in GCA accounts– Bonds payable in GLTL accounts

Illustrative entries for DSF follow

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SPECIAL ASSESSMENTSPECIAL ASSESSMENTDEBT SERVICE FUNDSDEBT SERVICE FUNDS

Illustrative entries for DSF1. $800,000 4-year levy (deferred)2. $200,000 current assessment recognized3. $260,000 transfer from General Fund4. $260,000 payment of debt service5. $240,000 assessments & interest collected6. $ 20,000 delinquent assessments & interest

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SPECIAL ASSESSMENTSPECIAL ASSESSMENTDEBT SERVICE FUNDSDEBT SERVICE FUNDS

Financial statements– Balance sheet (Figure 8-3) noting the following:

Deferred receivables Offsetting deferred revenues

– Operating statement (Figure 8-4) Assessment revenues (meeting recognition criteria)

and interest Debt service expenditures General Fund transfer

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DEBT SERVICE FUNDS DEBT SERVICE FUNDS OTHER MATTERSOTHER MATTERS

Nonaccrual of interest payable

Combining financial statements

Number of debt service funds

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DEBT SERVICE FUNDS DEBT SERVICE FUNDS OTHER MATTERSOTHER MATTERS

Nonaccrual of interest payable

– Not permitted on long-term debt unless

1. Resources received in DSF by year end

and

2. Debt service payment is due within the

first month of the next year

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DEBT SERVICE FUNDS DEBT SERVICE FUNDS OTHER MATTERSOTHER MATTERS

Combining financial statements– Prepared when there are two or more DSFs– Balance Sheet (Figure 8-5)

Example combines Figure 8-1 and 8-3

– Operating Statement (Figure 8-6) Example combines Figure 8-2 and 8-4

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DEBT SERVICE FUNDS DEBT SERVICE FUNDS OTHER MATTERSOTHER MATTERS

Number of debt service funds– Guiding principle is to hold to a minimum

Single DSF for multiple bond issuesCommon if secured similarly

– Bond agreement or local law may require a separate fund for each bond issue

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DEBT SERVICE FUNDSDEBT SERVICE FUNDSTERM BOND ISSUETERM BOND ISSUE

Difference from serial bonds– Serial bonds:

Interest and principal paid annually

– Term bonds:1. Interest paid annually (same in both)

2. Principal paid in full at end of term

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DEBT SERVICE FUNDSDEBT SERVICE FUNDS TERM BONDTERM BOND SINKING FUNDSSINKING FUNDS

Bond indentures (agreements) require– Establishing debt service fund for– Ensuring timely principal payment– Requiring -

Accumulation of required funded reserves Payment of annual interest Accumulation of a sinking fund sufficient to

retire bond principal at end of term

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DEBT SERVICE FUNDSDEBT SERVICE FUNDS TERM BONDTERM BOND SINKING FUNDSSINKING FUNDS

Requirements illustrated for $1 million term bond for 20 years (Figure 8-7)– Computed at origin of the bond issue– Required annual additions to sinking

fund invested over term life of the bonds $17,460 annual addition plus annual interest Sufficient to retire bonds at end of term

– Activity and balances recorded in DSF

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DEBT SERVICE FUNDSDEBT SERVICE FUNDSDEEP DISCOUNT BONDSDEEP DISCOUNT BONDS

Issue price (proceeds) discounted from par (fraction of the face value) at issuance date– Provides for

Very low or 0% stated interest No payment of principal or interest prior to maturity

Principal paid at “par” upon maturity along with accumulated interest

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DEBT SERVICE FUNDSDEBT SERVICE FUNDSDEEP DISCOUNT BONDSDEEP DISCOUNT BONDS

No GASB guidance results in debt service accounting problems

1. Fund liabilities not incurred for principal of the debt until maturity

2. Fund liabilities incurred for interest not a reasonable measure of the interest cost

Many governments recognize debt service expenditures “when due” upon maturity

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REFUNDINGS OF DEBTREFUNDINGS OF DEBT

Governments may issue new debt to pay (or service) old debt prior to maturity– Termed “advance refundings”– Accounted for as substitutions vs. payments

Reasons for a refunding1. Lower effective interest rates2. Extend maturity dates3. Revise payment schedules4. Remove or modify restrictions

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BOND REFUNDINGSBOND REFUNDINGS

Refunding definition (Illustrated in Figure 8-8)

– Issuance of new debt to finance payment of existing debt interest and principal

– Current refunding - use refunding proceeds to retire debt immediately

– Advance refunding - place proceeds in escrow and use to pay future interest and principal

1. Proceeds placed in an irrevocable trust2. Invested in allowable securities3. Maturing securities plus interest pay P&I on old debt

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DEFEASANCE OF DEBTDEFEASANCE OF DEBTDefeased debt means “terminated” debt– Defeased debt removed from accounts– Not reported in the balance sheet

Current refundings actually retires debt– Old debt paid off at scheduled maturity

Advance refundings of old debt– Payoff may not be possible or advantageous– However, old debt considered terminated, if

Legally defeased or In-substance defeased

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DEFEASANCE OF DEBTDEFEASANCE OF DEBTLegal defeasance– Compliance with original debt agreement by

placing sufficient proceeds in an irrevocable trust for benefit of the bondholders to pay off old debt

– Debt is legally satisfied even though not paid

In substance defeasance– Without defeasance provisions in bond agreements – GASB standards treat as defeased if sufficient sum

is placed in an irrevocable trust for benefit of the bondholders to pay off the old debt

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NONDEFEASANCE OF DEBTNONDEFEASANCE OF DEBT

When old debt is not defeased either legally or in-substance

1. Both the old and the new debt must be– Recorded in GLTL accounts and– Reported in the balance sheet

2. The amounts deposited in escrow must be– Recorded as investments in the DSF– Reported in the balance sheet

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DEBT SERVICE FUNDSDEBT SERVICE FUNDSFOR REFUNDINGSFOR REFUNDINGS

Refundings generally involve two entries1. Receipt of refunding bond proceeds

– Reported in DSF as “Other Financing Sources - Proceeds of Refunding Bonds"

2. Payment of proceeds to escrow trustee– Reported in DSF as “Other Financing Uses –

Payments to Refunding Escrow Agent”

– Payment differs from regular debt retirement Reported in DSF as “Expenditures – Bond Principal

Retirement”

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DEBT SERVICE FUNDSDEBT SERVICE FUNDSFOR REFUNDINGSFOR REFUNDINGS

Source(s) of financial resources to retire or defease debt determines– Reporting of the payment (Figure 8-9)– Recording of transactions illustrated

Current refunding – retirement of old debt Advance refunding – defeasance of old debt Use of both existing resources and new debt

proceeds in refundings

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REPORTING REFUNDINGS REPORTING REFUNDINGS AND DEFEASANCESAND DEFEASANCES

If solely from refunding proceeds, report as:

– “Other financing uses - payment to refunded bond escrow agent” (for in-substance defeasance in advance refunding)

– “Other financing uses - bond retirement” (for actual retirement in current refunding)

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DEBT SERVICE FUNDSDEBT SERVICE FUNDSREFUNDING TRANSACTIONSREFUNDING TRANSACTIONS

Current refunding – retirement of old debt1. Proceeds from issuance of refunding bonds

– Recorded as “Other Financing Source”– Old debt removed from GLTL accounts– New refunding debt recorded in GLTL accounts

2. Payment to retire old bonds– Recorded as “Other Financing Use”– Note the absence of recording revenue, expenditure or

gain / loss for the refunding– Consistent with “flow of current financial resources”

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DEBT SERVICE FUNDSDEBT SERVICE FUNDSREFUNDING TRANSACTIONSREFUNDING TRANSACTIONS

Advance refunding – defeasance of old debt1. Proceeds from issuance of refunding bonds (same)

– Recorded as “Other Financing Source”– Old debt removed from GLTL accounts– New refunding debt recorded in GLTL accounts

2. Payment to escrow agent to defease old bonds– Recorded as “Other Financing Use”– Again, note the absence of recording revenue,

expenditure or gain / loss for the refunding– Consistent with “flow of current financial resources”

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REPORTING REFUNDINGS REPORTING REFUNDINGS AND DEFEASANCESAND DEFEASANCES

If partly from refunding proceeds and partly from existing government resources, report as:

– Other financing uses for portion paid from refunding proceeds (i.e., from borrowed resources)

– Expenditures to extent payment is from existing resources, (i.e., other than from refunding (or borrowed) proceeds

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DEBT SERVICE FUNDSDEBT SERVICE FUNDSREFUNDING TRANSACTIONSREFUNDING TRANSACTIONS

Advance refunding – defeasance of old debt, but refunded with multiple resources

1. Cash transfer and refunding bond proceeds– Both recorded as “Other Financing Source” as follows

Transfer from General Fund Refunding bond proceeds

– The non-borrowed resources

2. Payment to escrow agent to defease old bonds– Recorded as “Expenditures”– the non-borrowed resources– Recorded as “Other Financing Use”- bond proceeds

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DSF FINANCIAL STATEMENTDSF FINANCIAL STATEMENT PRESENTATION OF REFUNDINGS PRESENTATION OF REFUNDINGS

Reflected in operating statementsFigures 8-10 (Phoenix) and 8-11 (Garden Grove)

– Proceeds shown in “Other Financing Sources”– Escrow payments in “Other Financing Uses”– Note equal $ in Phoenix Streets & Highways

Any escrow payments from existing resources would be reported in expenditures (not illustrated)

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ADVANCE REFUNDING ADVANCE REFUNDING REQUIRED DISCLOSURESREQUIRED DISCLOSURES

In year of advance refunding– Description of bonds refunded– How financed (e.g., refunding bonds or existing financial

resources)– Legal or in-substance defeasance– Name of escrow agent– Difference in old and new debt service

As long as in-substance defeased debt is outstanding– Amount outstanding at year end– No requirement to disclose retired or legally defeased debt