POLS 7830 PUBLIC FINANCIAL MANAGEMENTLECTURES 1 & 2: COST CONCEPTS

• Types of costs• Cost concepts• Break-Even Analysis• Break-Even Analysis with Multiple

Products• Marginal Cost Analysis• Cost Allocation

Cost Concepts

How Much Does Something Cost?

• It depends on how the manager looks at and analyzes cost information– Why is the analysis being done?

• Cost Objective: The focus of the cost analysis– Unit of service– Program– Department

How Much Does Something Cost?

• Relevant Costs: Costs that have an impact on or are impacted by the decision the manager is considering. Determining what costs are relevant depends upon– Cost objective– Time frame for the analysis– Expected range of volume– Relevant range of production analyzed

Cost Definitions• Full Cost= Direct Costs + Indirect Costs• Full (Total) Cost: The sum of all costs associated

with the cost objective• Direct Costs:

– incurred within an organizational unit– cost of resources used to produce a good or service

• Indirect Costs (Overhead)– assigned to a unit from outside– resources not used directly to provide a service

What is Direct? Indirect?Cost Objective Indirect Costs Direct Costs

Patient Unit, department &hospitaladministration

Direct care andsupplies

Surgical Unit Department andHospital

Total patient costs andunit management

SurgicalDepartment

Hospital Total unit costs plusdepartmentadministration

Hospital None Total departmentalcosts plus hospitaladministration

More Cost Definitions

• Relevant Range: The normal range of expected activity, the anticipated range of service volume

• Variable Costs: Costs that vary directly with changes in the volume of service units over a relevant range of activity

More Cost Definitions

• Average Cost: The full cost of a cost object divided by the number of units of service provided (Total Cost/Volume)

• Fixed Costs: The costs that remain (relatively) unchanged in total for some time period as the volume of services changes over a relevant range of activity

Fixed Costs

0200004000060000

0 100 200 300 400

Units of Service

Cost

($)

Fixed Cost

Variable Costs

0

1000

2000

3000

0 100 200 300 400

Units of Service

Cost

s ($

)

VariableCosts

Total Cost

39500

40000

40500

41000

41500

42000

42500

0 100 200 300 400

Units of Service

Cos

t ($)

FixedCosts

VariableCosts

Average Costs

01000020000300004000050000

120

040

060

0

Units of Service

Cos

t ($)

VariableCosts

Even More Cost Definitions• Step costs (Semi-variable): Costs that are

fixed over ranges that are less than the relevant range

• Mixed Costs: Contain both fixed and variable components

• Marginal Costs: The additional costs incurred as the result of providing one more unit of service (Incremental Costs)– Note: Marginal costs are equal to variable costs

unless there are changes in step costs

Volume

Cost

STEP COSTS

Relevant Cost Analysis• Example: Ineedaspleen Hospital has fixed

costs of $300,000 and variable costs of $250 per patient. What would the cost structure look like?

Volume FixedCost

VariableCost

Total Cost AverageCost

100 $300,000 $25,000 $325,000 $3,250500 $300,000 $125,000 $425,000 $8501,500 $300,000 $375,000 $675,000 $4502,500 $300,000 $625,000 $925,000 $3703,000 $300,000 $750,000 $1,050,000 $350

Making a Cost Based Decision• The Hospital treats 2,500 patients per year.

An HMO offers them 500 additional patients and offers to pay $300 for each one. Should the hospital accept the HMO’s patients?– The average cost per patient at 2,500 is $370– The average cost per patient at 3,000 is $350– The variable cost per patient is $250

• What should you do recommend for Ineedaspleen Hospital?

Making a Cost Based Decision• Key Question: How much additional cost will

be incurred by accepting this deal?• Answer: $250, the amount of the variable

costs per unit (the fixed costs remain constant over the additional units)

• So, ACCEPT the deal!– (This was a simple marginal cost analysis)

• What problems are raised by accepting this proposition?

Problems

• Possible fixed cost increases• Possible variable cost increases• Other insurers may want the same rate

Break-Even Analysis

Break-Even Analysis

• Method to identify the break-even price or quantity for a particular service

• VC= Variable Costs• FC=Fixed Costs• TC=Total Costs (Variable + Fixed Costs)• P=Price• BEQ=Q=Break-Even Quantity

Break-Even Analysis

TR= P * QTC= FC+(VC * Q)Break-Even: TR = TC(or) P*Q=FC + (VC*Q)(P*Q)-(VC*Q)=FCQ*(P-VC) = FC, So...Q= and P= TR/Q FC

P-VC

Break-Even Analysis

0

200

400

600

800

1000

0 5 10 15 20 25 30

Units of Service

$

FixedCosts

TotalCosts

TotalRevenue

Profit

Loss

Break-even point

Contribution Margin

• Key to using B-E analysis is to pay attention to the Contribution Margin

• The Contribution Margin indicates the amount available to contribute to paying the fixed costs of the organization– How much of the unit price remains after

paying the variable costs for that unit?• Contribution Margin= P - VC

Contribution Margin

• The Feed-a-Fish foundation raises small vermin to feed to endangered flesh eating fish. They sell 3,000 moles each month at $0.68 a piece and have fixed costs of $1200 per month and variable costs of $0.18 per mole.

• The contribution margin is (0.68-0.18) = $0.50• $0.50 from each sale goes toward the fixed costs.• Note: $1200/$0.50 = 2400 =BEQ (CM can

substitute for P-VC when finding BEQ)

Break-Even Analysis with Multiple Products

What if there is more than one product or service?

• The B-E formula assumes just one item for sale.

• When faced with different prices and different variable costs per service, we must use all of them!

• Key: Find the weighted average contribution margin.– The weighted average contribution margin may

be divided into fixed costs to find BEQ

The Feed-A-Fish Foundation sells moles, voles and shrews as fish food for endangered fish. The variable costs associated with hunting and capturing these animals are $0.18, $0.23 and $0.48, respectively.

• The prices for the vermin are $0.68, $0.75 and $1.09.

Multiple Product Break-Even Analysis

Price VCContribution

Margin (P-VC)Moles $0.68 $0.18 $0.50Voles $0.75 $0.23 $0.52

Shrews $1.09 $0.48 $0.61

Now we need to know the proportion of sales in each category...

Multiple Product Break-Even Analysis

• In order to find the break-even level for a multiple product business we – Find the proportion of sales in each category– Multiply that proportion by the contribution

margin• The result is the weighted average

contribution margin!

Multiple Product Break-Even Analysis

Volume (Units) Share

Contribution Margin (P-VC)

Weighted Average

Contribution Margin

Moles 3000 54% $0.50 $0.27Voles 1350 24% $0.52 $0.13

Shrews 1175 21% $0.61 $0.13Total 5525 100% $0.53

Multiple Product Break-Even Analysis

• Next: Substitute the weighted average contribution margin for (P-VC) to solve for the BEQ!

$ 1200 0.53

= 2264 units

Target Profit• Not-for-profit organizations typically seek

to generate a surplus • This creates the need to set prices such that

they yield a ‘target profit’• We can find the Target Profit Quantity

(TPQ) by adding a target profit to the numerator of the BEQ equation:

FC + TP

TPQ = P - VC

Marginal Cost Analysis

Marginal Cost Analysis

• Key Question: How much additional cost will be incurred by making one choice versus another?

• Provide in-house (Make) when marginal cost of producing the additional units is below the market price.

• Contract-out (Buy) when marginal cost of producing the additional units is above the market price.

Should Millbridge Schools Contract Out?

• Millbridge township has 2,500 students and expects the number of students next year to be 3,000. The average cost per pupil is presently $8,000 and the adjacent town of Millboro has excess capacity it is willing to sell for $7,000 per student.

• Should Millbridge contract out for the additional 500 students?

Should Millbridge Schools Contract Out?

Average Cost Estimates

Student Volume

(A)Fixed Cost

(B)Variable Cost (C=$3,000 x A)

Total Cost (D=B+C)

Average Cost Per Student (E=D/A)

1,500 $15,000,000 $4,500,000 $19,500,000 $13,0002,500 $15,000,000 $7,500,000 $22,500,000 $9,0003,000 $15,000,000 $9,000,000 $24,000,000 $8,000

Marginal Cost Analysis

• Marginal costs (MC) are the additional costs implied by the policy choice– For Millbridge, this is the cost of adding 500

students (not just one)– Absent some fixed costs increases, the MC =

VC per unit of service.

Should Millbridge Schools Contract Out?

Marginal Cost estimates without fixed cost increases

Student Volume

(A)Fixed Cost

(B)

Variable Cost

(C=$3,000 x A)

Total Cost (D=B+C)

Average Cost Per Student (E=D/A)

Marginal Cost per

Additional Student

1,500 $15,000,000 $4,500,000 $19,500,000 $13,000 $3,0002,500 $15,000,000 $7,500,000 $22,500,000 $9,000 $3,0003,000 $15,000,000 $9,000,000 $24,000,000 $8,000 $3,000

Marginal Cost Analysis

• Two notions of Marginal Cost1. The added cost of the next unit produced

Used for comparing costs within a relevant range2. The added cost of the next level of production

Used for comparing various levels of service that exceed the current relevant range

Marginal Cost Analysis

• Sometimes Marginal Costs (MC) include increases in both fixed and variable costs!– E.g. When fixed costs increase across the next

levels of service and you are reporting MC for the step to the next level of production

– If Millbridge needs to build a new school for the 500 students, fixed costs would increase in addition to the total variable costs.• MC would increase!

Marginal Cost Analysis

• Sometimes Marginal Costs (MC) include increases in both fixed and variable costs!– When fixed costs increase across the next levels

of service– If Millbridge anticipated a constant enrollment,

but wanted to contract out and could close one school, fixed costs would decrease.• MC would decrease!

MC w/ increasing FC

• When a decision option requires fixed costs to increase…– Include the increase in the VC calculation– Compute the MC for the whole step in

production – The new per/unit MC within the new relevant

range may be the same as before• The decision-maker cares about the MC of the step

as a whole

Marginal Cost estimates with fixed cost increases

Student Volume

(A)Fixed Cost

(B)

Variable Cost

(C=$3,000 x A)

Total Cost (D=B+C)

Average Cost Per Student (E=D/A)

Marginal Cost

1,500 $15,000,000 $4,500,000$19,500,000 $13,000 Base scenario2,500 $16,500,000 $7,500,000$24,000,000 $9,600 $4,5003,000 $30,000,000 $9,000,000$39,000,000 $13,000 $13,000

Should Millbridge Schools Contract Out?

Note: The marginal cost of moving from 1500 to 2500 students is $4500 (24000-19500).

Marginal

$3,000$3,000$3,000

CostPer unit(Step)

Cost Allocation

Cost Allocation

• Indirect costs must be assigned to appropriate functions of the organization in order to capture the real costs for each function

• The process of allocating these costs can be complicated

Terms• Cost center: Unit or department for which

manager is assigned responsibility for costs• Mission center: Cost center that produces the

final product or service• Cost base: The unit of analysis (basis) for

allocating overhead (e.g. bed days, person hours)

• Cost pool: A grouping of costs to be allocated• Cost objective: Item for which a cost is desired

(unit of service, program, department, etc.)

Terms• Direct costs: Costs resulting from direct

production of a good or service• Indirect costs: Costs that are assigned to an

organizational unit from elsewhere in the organization (not from direct production)

• Full cost: All costs associated with a cost objective (indirect and direct)

Allocation approaches• Direct distribution: allocating indirect costs

solely to mission centers• Multiple distribution: allocation of support

center costs to all other support centers, then to mission centers, remaining support center costs then allocated

• Step-down distribution: form of multiple distribution where support center costs are allocated to every other center that has not yet allocated its costs

Cost Locations

• Mission Center: A cost center that produces the final product or service

• Support Center: A cost center that produces assistance to mission centers, but does not produce a final product or service

Cost Allocation• Your department produces lime Jello cubes for the

Jiggling Food Foundation• Indirect costs from the purchasing department are

allocated based on the number of department purchase orders placed

• The cost pool is the TC of the dept. of purchasing• The cost base is the number of purchase orders• If the departments costs were $68,000 across 46,800

orders, then the cost per order would be: 618/468 = $1.45

Example

Cost Allocation• Assume that there are two other cost

centers, one each for custard and pudding production at the same level of purchase order generation.

• Across 140,400 (3*46,800) orders, the cost per order would be: 618/1404 = $0.44

Example

How to choose a base• What base should you choose for allocating

overhead?• Allocation factors create incentives that

managers can use to control costs or promote organizational goals

• Rule of thumb: If one cost center can affect the costs of another then the base should relate to usage (rather than space, FTE, etc.)– The cost of tracking and allocating the usage

should not outweigh the value of the information

Allocating Costs, Steps

1. Classify each center as either a mission center or a support center

2. Apply the cost test (can mission centers impose costs on support centers)?

3. Select the allocation base and method4. Allocate the support costs to the mission

centers- Do not allocate support center costs to the same support center

Allocating Shelter Costs

• The shelter has two mission centers: Feeding and Counseling

• The shelter has two support centers: Purchasing and Administration

• The base for purchasing is purchase orders• The base for administration (supervision) is

the number of employees

Direct Purchasing AdministrationCost Center Cost $ P.O. % Personnel %

SupportPurchasing 25000 2Administration 280000 95

MissionSoup Kitchen 500000 1 92Counseling 50000 4 6

Total Cost $855,000 100% 100%

Allocating Shelter Costs

Direct Distribution

Direct Distribution

• Support centers are only allocated to mission centers – Most applicable when the organization must

show all costs issuing from mission centers• When allocated on the base of use, the

proportional use of the mission centers is used– Even if the mission centers represent the

smallest portion of the use

Direct Purchasing AdministrationCost Center Cost $ P.O. % Personnel %

SupportPurchasing 25000 2Administration 280000 95

MissionSoup Kitchen 500000 1 92Counseling 50000 4 6

Total Cost $855,000 100% 100%

20%

80%

94%

6%

Allocating Shelter Costs

Direct DistributionDirect

Cost Center Cost $ Purchasing Administration Total

SupportPurchasing $25,000 ($25,000) $0 $0Administration $280,000 $0 ($280,000) $0

MissionSoup Kitchen $500,000 $5,000 $262,857 $767,857Counseling $50,000 $20,000 $17,143 $87,143

Total Cost $855,000 $0 $0 $855,000

20%

80%

94%

6%

Step Down Distribution

Step Down Distribution Method• Support center costs are allocated to both

support centers and mission centers• The process begins with one support center

allocating its costs to all other mission and support centers

• The process continues with the next support center allocating its costs to all remaining mission and support centers

• The process continues until no support center costs remain unallocated

Purchasing

Administration

Jello

Custard

Pudding

Step Down Distribution Method

Administration

Jello

Custard

Pudding

Step Down Distribution Method

Jello

Custard

Pudding

Step Down Distribution Method

Allocating Shelter Costs

1%

4%

94%

6%

95%

DirectCost Center Cost $ Purchasing Subtotal Administration Total

SupportPurchasing $25,000 ($25,000) 0 $0 $0Administration $280,000 $23,750 303750 ($303,750) $0

MissionSoup Kitchen $500,000 $250 500250 $285,153 $767,857Counseling $50,000 $1,000 51000 $18,597 $87,143

• Problem: Which support center should go first when allocating by the step cost method?– Results change significantly

• Solution: Choose the allocation order that produces the most accurate view of costs where they accrue!

Step Down Distribution Method

Other Allocation Approaches

• Algebraic approaches (reciprocal)– Costs distributed to all centers– Matrix algebra is used to solve a set of

simultaneous equations to distribute the support costs that remain after the allocation to the remaining units

Other Allocation Approaches

• Activity Based Costing– Goal: To minimize the distortion and

inaccuracy in other allocation methods• Method: Identifying cost drivers and

determining how much of each cost driving activity is required by each mission center

POLS 7830 PUBLIC FINANCIAL MANAGEMENTLECTURE 3:ACCOUNTING CONCEPTS

• Managerial accounting• Financial Statements• Fundamental equation of accounting• Balance Sheets• Debits and Credits• Measurement Focus and recording basic

transactions• Operating and Cash Flow Statements

(Introduction)

Managerial and Financial Accounting

• Managerial Accounting: Internal Focus– Planning– Implementation– Control

• Financial Accounting– Record events or transactions– Report financial position and results of

operations

The Financial Statements

• Balance Sheet: A snapshot of the resources, obligations and worth of an organization at a specific point in time. (Stock)

• Income Statement: Measures the cumulative resource inflows for an organization over some specified period of time. It is the reporting equivalent of an operating budget. (Flows)

• Cash Flow statement: measures the cumulative cash inflows and outflows for an organization over some specified period of time. It is the reporting equivalent of a cash budget. (Flow)

The Financial Statements

Financial Statement Concepts• Generally Accepted Accounting Principles from

FASB (non-profits and healthcare) or GASB (governments)

• Entity: The organizational component that the accounting seeks to describe

• Objective evidence: Values must be based on an objective valuation of resources

• Cost convention: Cost is used when value is in dispute, or not reasonable to obtain

Financial Statement Concepts• Conservatism: Anticipate entity losses, but not

gains• Going concern: Assumption that organization will

continue in operation– Bankruptcy value is typically much lower

• Materiality: Report detail only to the level necessary for decision-making.

• Accrual concept: Revenues are recorded when the organization entitled to them and expenses when resources are used

Assets

• Anything of value owned by the accounting entity

• (Alternative definition:) Anything that the entity owns that will better enable it to meet its mission

• Generally, assets are any valuable resources owned by the organization

Assets

• Identifying Assets: Easiest when items have clear market value and physicality– Automobiles– Respirators– Artwork

• Identifying Assets: Harder when assets are less corporeal– Taxes owed -Insurance– Bequests stated -Good will

Assets

• Key: An organization’s assets may be worth more than the balance sheet suggests

• The typical reason for this is that certain assets exits that are not readily measurable, or for which no exchange transaction exits to help identify its value.

Liabilities

• Obligations to other entities– Obligations to other funds (government)

• Each time an event happens that causes an entity to owe money to another, a liability has been created– Supplies ordered– Staff hours worked

Liabilities

• Money owed• Collateral: some security (asset) pledged

against the money owed– If the borrower defaults, the collateral becomes

the property of the lender• Accounts payable: List of money owed

– A/P is an balance sheet account, recorded on the liability side of the balance sheet

Equity

• Where did the capital come from to acquire the assets?– Borrowing (liability)– Value of owner shares (equity)

• What would be left if all of the assets of the entity were sold off to pay liabilities?– The difference between assets and liabilities is

equity (or, net assets or fund balance)

Equity=Net Assets=Fund Balance

• Equity: Value of owners shares in a for-profit corporation

• Net assets: The difference between assets and liabilities in a not-for-profit corporation

• Fund balance: The difference between assets and liabilities in a government (fund)

• Note: These are the same concept with different labels!

Fundamental Equation

ASSETS = LIABILITIES+EQUITY

ASSETS= LIABILITIES+ NET ASSETS

ASSETS=LIABILITIES+FUND BALANCE

Fundamental Equation

• The fundamental equation of accounting is always in balance.

• Each transaction that affects a balance sheet account must be exactly offset by another that equals it on the opposite side of the balance sheet

• That’s why it’s called a balance sheet!

Balance Sheet

ASSETSLIABILITIES+

NET ASSETS=

Balance SheetSample U.S. Corporation Balance Sheet

Assets Liabilities + EquityCurrent Assets $11,000Current Liabilities$5,000Fixed Assets $9,000 Long Term Debt $10,000

Equity $5,000Total $20,000 $20,000

Balance SheetSample Local Government Balance Sheet

Assets Liabilities + Fund Balance

Current Assets $11,000Current Liabilities$5,000Fixed Assets $9,000 Long Term Debt $10,000

Fund Balance $5,000Total $20,000 $20,000

Balance Sheet Elements

• Asset subgroups (listed in order of liquidity)– Current Assets (Assets in cash or equivalents, or will be

within one year)• Cash• Marketable securities• Money markets• Current Receivables

– Note: classification may depend on the entity’s intentions

Balance Sheet Elements

• Asset subgroups (listed in order of liquidity)– Long term assets (greater than one year)

• Fixed Assets (property, plant, equipment)• Investments (Stocks, bonds, other financial

ownership interests)

Balance Sheet Elements

• Liability subgroups– Current Liabilities (Obligations presently due,

or due within one year)• Notes payable• Letters of credit payable• Accrued payroll (wages) payable• Accounts payable

Balance Sheet Elements

• Liability subgroups– Long-term Liabilities (Obligations payable

across more than one year)• Long term debt

– Leases -Secured/unsecured loans– Bonds payable

Asset Groups

• Cash and cash equivalents• Marketable securities• Accounts receivable• Inventory• Prepaid Expenses• Fixed Assets

– less depreciation• Sinking funds

Balance Sheet Concepts• Current refers to the next twelve months

– Also: short-term, near-term• Long-term refers to time periods longer than

twelve months• Current assets and current liabilities are

highlighted on the balance sheet to allow readers to determine if the organization is likely to have the resources needed to pay its near-term obligations

Balance Sheet Concepts• Current refers to the next twelve months

– Also: short-term, near-term• Long-term refers to time periods longer than

twelve months• Current assets and current liabilities are

highlighted on the balance sheet to allow readers to determine if the organization is likely to have the resources needed to pay its near-term obligations

Liability Groups

• Accounts/Wages payable• Long-term debt• Secured and unsecured loans• Bonds payable

Marketable Securities

• Marketable securities include equity and debt instruments than can be bought and sold in public and private markets

• The values of marketable securities are reported by governments and not-for-profit organizations at fair market value. For profit organizations use fair market value for reporting most of their marketable securities.

Long-Term Assets• Long Term Assets are generally divided into three

categories– Fixed Assets

• property (land) usually recorded at cost• plant (buildings) recorded at cost and reported at net book

value• equipment recorded at cost and reported at net book value

– Investments– Intangibles

Plant and Equipment• Recorded at cost when acquired• Reported net of accumulated depreciation

on the balance sheet• Example: Feed-A-Fish buys a van for

$30,000 and expects to use it for 5 years and sell it for $5,000. At what value would it appear on the balance sheet after two years?

[(30,000-5,000)/5]*2=$10,000 depreciation$30,000 - $10,000 = $20,000

Fixed Assets on the Balance Sheet

•Note: show cost, accumulated depreciation and net book value

Museum A Museum B

Net Fixed Assets $1,000,000 $1,000,000

PP&E at Cost $40,000,000 $2,000,000Accumulated Depreciation ($39,000,000) ($1,000,000)Net Book Value $1,000,000 $1,000,000

Recognizing Asset Transactions• Financial events are recorded at the time of recognition• Asset transactions are recognized when

– they are owned by the organization– they have a monetary value– that monetary value can be objectively determined

• Which of the following should be recognized as assets?– The amount due on a bill sent to an insurance company– an overhead projector– a fundraising mailing list of organization donors

Short term liabilities

• Short-term liabilities typically include– payables due within thirty days

• wages payable• accounts payable• notes payable

– the current portion of long-term debt (that due within the coming year)

Long term liabilities

• Long term liabilities include:– Long term debt

• Capital leases• Long-term unsecured loans• Mortgages• Bonds payable

– Pension liabilities– Contingent liabilities

Recognizing liability transactions

• Liabilities are recognized when– they are legally owed– have to be paid– the amount to be paid can be objectively measured

• Which of the following should be recognized as a liability– a bill received from a vendor– wages that are due to a worker– a $5 million lawsuit filed against an organization

Amortizing Long term debt• $25,000 of the $32,000 Feed-A-Fish van is

financed for five years at 8% interest. The loan calls for annual payments of $6261. – How much of each year’s payments would be

interest?Beginning

BalanceTotal

PaymentInterest Portion Principal

Ending Balance

Year 1 $25,000 $6,261 $2,000 $4,261 $20,739Year 2 $20,739 $6,261 $1,659 $4,602 $16,136Year 3 $16,136 $6,261 $1,291 $4,971 $11,166Year 4 $11,166 $6,261 $893 $5,368 $5,798Year 5 $5,798 $6,261 $464 $5,798 $0

Net Asset Categories• The net worth of an organization represents the sum of

the organization’s earnings from inception plus any paid-in capital (for-profit firms) less any payments that have been made to owners (e.g. dividends)

• Net Assets– Unrestricted Net assets (cumulative profits appear here)– Temporarily restricted net assets (use restricted by donors)– Permanently restricted net assets (restricted in perpetuity)

Assets LiabilitiesShort Term Assets Short Term Liabilities

Cash 514 Accounts Payable 5250Accounts Receivable 15325 Wages Payable 0Inventory 950 Long Term Liabilities

Total Short Term Assets 16789 Mortgages 28000Total Liabilities 33250

Long Term AssetsBuildings 114000 Net Assets(Less Depreciation) 77600 Unrestricted 9339Buildings (Net) 36400 Temporarily restricted 600

Permanently restricted 10000Total Net Assets 19939

Total Assets 53189 Total Liabilities+ 53189Net Assets

Make-A-Wish FoundationBalance Sheet

31-Jan

Generating a Balance Sheet

• Generating a balance sheet involves:– Beginning with the starting balance sheet– Recording all of the transactions for the period– Adding the impact of the transactions to the

starting balance sheet– Formatting the resulting balance sheet accounts

in the balance sheet reporting format

Recognition

• In accordance with GAAP, one must first record all financial events– Liabilities are recognized (accrual) when they

are legally owed and will have to be paid• Once the amount to be paid can be objectively

measured• E.G. Once an employee has worked a shift, the

amount to be paid should be recorded as a liability.

Recognition

• In accordance with GAAP, one must first record all financial events– Assets are recorded (recognized) when:

• Owned by the entity• Have monetary value• Monetary value can be objectively measured

The truth about debits and credits

Debits and credits have no implicit meaning. They were designed as a convention in recording movements of financial resources. In that system debits are recorded on the left hand side of a ledger and credits on the right.

The truth about debits and credits

Debit CreditEvery entry made in an bookkeeping system has a debit and a credit.

The basic tool for examining these entries is the ‘T’ account.

The truth about debits and credits

Different kinds of financial activity is recorded on different sides of the T account, based on the fundamental accounting equation.

Account Increases Decreases

Asset Debit CreditLiability Credit DebitEquity/NA Credit DebitRevenue Credit DebitExpenditure Debit Credit

The truth about debits and creditsDate Account Debit Credit

1/12/02 Office Equipment 24000Accounts Payable 24000

Date Account Debit Credit

2/1/02 Accounts Payable 24000Cash 24000

Date Account Debit Credit

2/1/02 Prepaid Insurance 12000Cash 12000

Date Account Debit Credit

2/1/02 Insurance expense 1000Prepaid Insurance 1000

3/1/02 Insurance expense 1000Prepaid Insurance 1000

4/1/02 Insurance expense 1000Prepaid Insurance 1000

5/1/02 Insurance expense 1000Prepaid Insurance 1000

6/1/02 Insurance expense 1000Prepaid Insurance 1000

The bookkeeping process1. Each financial event (transaction) is recorded in

the (General) journal in chronological order.2. Adjusting entries are made to record corrections

and non-transaction changes (depreciation, consumption, corrections).

3. Periodically (monthly), entries from the journal are posted to the ledger by account category.

4. Reports are generated based on these records of financial events (Balance sheet, revenue and expense)

Accounting Terms• Expense: Consumption of an asset• Expenditure: Reduction in cash (or increase

in a liability) associated with asset acquisition

• GASB: Government Accounting Standards Board

• FASB: Financial Accounting Standards Board

Accounting Terms• Chart of Accounts: Standardized list of

categories in which to classify and document financial events

• Journal: Document for recording the financial events of an entity as they occur in time

• Ledger: Document for recording financial events as they affect a particular account

Measurement Focus

• Flow of current financial resources– Reports only current assets– Goal is to report whether the fund is better off

financially– Reports revenues and expenditures– Capital outlays recorded as expenditures– Principal payments: reductions in asset (cash)– Depreciation is not recorded

Measurement Focus• Flow of economic resources

– Reports all assets and all liabilities– Goal is to report whether a fund is better or worse off

economically– Reports revenues and expenses– Capital outlays recorded as creation of a fixed asset in

exchange for another asset (cash)– Principal payments: reductions in an asset and a

liability– Depreciation is recorded as the asset is consumed

Basis of Accounting• Accrual

– Used by business firms, proprietary funds, nonexpendable trust funds and pension trust funds

– Used when funds measure the flow of economic resources

– Reports revenues and expenses– Revenues are recognized when services provided– Expenses recorded when benefit produced is received,

regardless of when payment occurs.

Basis of Accounting• Modified Accrual

– Used by governmental funds and expendable trust funds

– Used when funds measure the flow of financial resources

– Funds report revenues and expenditures– Revenues are increases in current financial resources– Revenues recognized when measurable and available– Expenditures (not expenses) are recognized when a

transaction can be measured

Balance Sheet Transactions (Journal Entries)

• The Feed-a-Fish foundation purchases two large tropical fish tanks at $3,500 each.

Assets = Liabilities +Net Assets

Accounts Payable$7,000 (CR)

Equipment$7,000 (DB)

Balance Sheet Transactions (Journal Entries)

• The Feed-a-Fish foundation purchases an $800 supply of rodents as food for the fish.

Assets = Liabilities +Net Assets

Inventory$800 (DB)Cash

$800 (CR)

Balance Sheet Transactions (Journal Entries)

• The Feed-a-Fish foundation purchases two large tropical fish tanks at $3,500 each. They pay $3,000 in cash.

Assets = Liabilities +Net Assets

Accounts Payable$4,000 (CR)

Equipment$7,000 (DB)Cash$3,000 (CR)

Journal Ledger

• Journal entries document each financial transaction

• Over a month many thousands of transactions accumulate

• How can this information be presented in a form that managers find useful?– Post all journal transactions into account ledgers– Generate a balance sheet

Assets LiabilitiesShort Term Assets Short Term Liabilities

Cash 6350 Accounts Payable 450Accounts Receivable 15325 Wages Payable 0Inventory 150 Long Term Liabilities

Total Short Term Assets 21825 Mortgages 28000Total Liabilities 28450

Long Term AssetsBuildings 114000(Less Depreciation) 78600 Net AssetsBuildings (Net) 35400 Net Assets 28775

Total Assets 57225 Total Liabilities+ 57225Net Assets

Balance Sheet31-Dec

Feed-A-Fish Foundation

Feed-A-Fish FoundationGeneral Journal

Date Description Account Debit Credit

1-Jan Pay Rent Rental Expense 1200Cash 1200

1-Jan Pay Electric Utilities Expense 136Cash 136

6-Jan Buy Fishtanks Equipment 7000Accounts Payable 4000Cash 3000

10-Jan Buy Rodents Inventory 800Accounts Payable 800

12-Jan Staff Wages Wages Expense 1500Wages Payable 1500

15-Jan Payroll Wages Payable 1500Cash 1500

Feed-A-Fish FoundationGeneral LedgerCash

Debit Credit

31-Dec Balance 6350

1-Jan Pay Rent 1200

1-Jan Pay Electric 136

6-Jan Buy Fishtanks 3000

15-Jan Payroll 1500

31-Jan Balance 514

Feed-A-Fish FoundationGeneral LedgerAccounts Payable

Debit Credit

31-Dec Balance 450

6-Jan Buy Fishtanks 4000

10-Jan Buy Rodents 800

31-Jan Balance 5250

Feed-A-Fish FoundationGeneral LedgerWages Payable

Debit Credit

31-Dec Balance 0

12-Jan Wages Earned 1500

15-Jan Payroll 1500

31-Jan Balance 0

Assets LiabilitiesShort Term Assets Short Term Liabilities

Cash 514 Accounts Payable 5250Accounts Receivable 15325 Wages Payable 0Inventory 950 Long Term Liabilities

Total Short Term Assets 16789 Mortgages 28000Total Liabilities 33250

Long Term AssetsBuildings 114000(Less Depreciation) 77600 Net AssetsBuildings (Net) 36400 Net Assets 19939

Total Assets 53189 Total Liabilities+ 53189Net Assets

Balance Sheet31-Jan

Feed-A-Fish Foundation

Journal Ledger

Date Account Debit Credit

2/1/02 Prepaid Insurance 100Cash 100

2/10/02 Accounts Payable 2000Cash 2000

2/12/02 Inventory 3000Accounts Payable 3000

2/16/02 Cash 12000Accounts Receivable 12000

General JournalDate Activity/ Event Debit Credit

2/1/02 Opening Balance 52000

2/1/02 Pay insurance 1002/10/02 Pay for supplies 20002/16/02 Collect revenue 12000

2/28/02 Ending Balance 61900

Ledger Account: Cash

Journal Ledger

Date Account Debit Credit

2/1/02 Prepaid Insurance 100Cash 100

2/10/02 Accounts Payable 2000Cash 2000

2/12/02 Inventory 3000Accounts Payable 3000

2/16/02 Cash 12000Accounts Receivable 12000

General JournalDate Item/event Debit Credit

2/1/02 Opening Balance 7000

2/10/02 Pay fire insurance 20002/12/02 Buy Inventory 3000

2/28/02 Ending Balance 8000

Ledger Account: Accounts Payable

Journal Ledger

Date Account Debit Credit

2/1/02 Prepaid Insurance 100Cash 100

2/10/02 Accounts Payable 2000Cash 2000

2/12/02 Inventory 3000Accounts Payable 3000

2/16/02 Cash 12000Accounts Receivable 12000

General JournalDate Item/event Debit Credit

2/1/02 Opening Balance 50002/12/02 Buy Inventory 30002/28/02 Ending Balance 8000

Date Item/event Debit Credit

2/1/02 Opening Balance 02/1/02 Buy Fire Insurance 100

2/28/02 Ending Balance 100

Ledger Account: Prepaid Insurance

Ledger Account: Inventory

A Non Transaction

• HOS signs a binding contract to buy and X-ray machine that will cost $50,000

• The event will not give rise to a journal entry because it does not meet the rules for recognition!– The value of the transaction is known– The timing of the transaction is known– But HOS does not yet own the equipment (there has

been no exchange!)

A Non Transaction?• The Town of Madison signs a binding contract to

buy a copier that will cost $50,000• This event will give rise to a journal entry because

it meets the rules of recognition for a government entity– The value of the transaction is known– The timing of the transaction is known– The funds have been obligated (encumbered)

A Non Transaction• The Town Manager of Madison decides to

renovate the planning department offices. She has budgeted $15,000 for the renovation.

• This event will not give rise to a journal entry because it fails to meet the rules of recognition for a government entity– The value of the transactions are not yet known– The timing of the transaction is not known– The funds have not been obligated (encumbered)

A Non Transaction?• The Town Manager of Madison decides to

renovate the planning department offices. She signs a purchase order for $5,000 of painting services next month.

• This event will give rise to a journal entry because it meets the rules of recognition for a government entity– The value of the transactions is known– The timing of the transaction is known– The funds have been obligated (encumbered)

Cash Flow Production Cycle

Cash

AccountsReceivables

Inventory

Fixed Assets

Equity & Liabilities

Collection ofReceivables Cash

Sales

Credit Sales

Production

Investment

Interest, Taxes & Dividends

Source: Higgins (1998)

Depreciation

D Cash + D in All Other Assets = D in Liabilities + D in Net AssetsOR

D Cash = D in Liabilities + D in Net Assets - D in All Other AssetsOR

D Cash = D in Liabilities + (Rev-Expenses) + D in Other Net Assets - D in All Other Assets

SOWe are seeking to show the route to (end of period) cash as affected

by changes in net income, assets, liabilities and net assets.

Understanding the Cash Flow Statement

Understanding the Cash Flow Statement

• Indirect Method– Uses Net Income and Non-Cash transactions, and

Operating Cash transactions to adjust cash balance– Less Transparent in reporting cash activity– May be easily calculated from other financial

statements

Statement of Cash FlowsIndirect Method• Start with Net Income from Op Statement• Adjust cash flows for each non-cash balance sheet

transaction– Add decreases in assets– Subtract increases in assets– Add increases in liabilities– Subtract decreases in liabilities

• Add Non-cash expenses• Adjust for flows from investing/financing

Understanding the Cash Flow Statement

• Direct Method– Uses Cash Transactions alone to adjust cash– More transparent (better reflects cash activities)– Requires information from ledgers

POLS 7830 PUBLIC FINANCIAL MANAGEMENTLECTURE 4: OPERATING AND CASH FLOW

STATEMENTS

• More balance sheet concepts• Operating Statements

– Recognizing expenses– Recording revenues

• Analyzing the operating statement• Depreciation• Where the income statement and balance

sheet meet• Statement of Cash Flows

Balance Sheet Concepts• Current refers to the next twelve months

– Also: short-term, near-term• Long-term refers to time periods longer than

twelve months• Current assets and current liabilities are

highlighted on the balance sheet to allow readers to determine if the organization is likely to have the resources needed to pay its near-term obligations

Balance Sheet Concepts• Current refers to the next twelve months

– Also: short-term, near-term• Long-term refers to time periods longer than

twelve months• Current assets and current liabilities are

highlighted on the balance sheet to allow readers to determine if the organization is likely to have the resources needed to pay its near-term obligations

Liability Groups

• Accounts/Wages payable• Long-term debt• Secured and unsecured loans• Bonds payable

Marketable Securities

• Marketable securities include equity and debt instruments than can be bought and sold in public and private markets

• The values of marketable securities are reported by governments and not-for-profit organizations at fair market value. For profit organizations use fair market value for reporting most of their marketable securities.

Long-Term Assets• Long Term Assets are generally divided into three

categories– Fixed Assets

• property (land) usually recorded at cost• plant (buildings) recorded at cost and reported at net book

value• equipment recorded at cost and reported at net book value

– Investments– Intangibles

Plant and Equipment• Recorded at cost when acquired• Reported net of accumulated depreciation

on the balance sheet• Example: Feed-A-Fish buys a van for

$30,000 and expects to use it for 5 years and sell it for $5,000. At what value would it appear on the balance sheet after two years?

[(30,000-5,000)/5]*2=$10,000 depreciation$30,000 - $10,000 = $20,000

Fixed Assets on the Balance Sheet

•Note: show cost, accumulated depreciation and net book value

Museum A Museum B

Net Fixed Assets $1,000,000 $1,000,000

PP&E at Cost $40,000,000 $2,000,000Accumulated Depreciation ($39,000,000) ($1,000,000)Net Book Value $1,000,000 $1,000,000

Recognizing Asset Transactions• Financial events are recorded at the time of recognition• Asset transactions are recognized when

– they are owned by the organization– they have a monetary value– that monetary value can be objectively determined

• Which of the following should be recognized as assets?– The amount due on a bill sent to an insurance company– an overhead projector– a fundraising mailing list of organization donors

Short term liabilities

• Short-term liabilities typically include– payables due within thirty days

• wages payable• accounts payable• notes payable

– the current portion of long-term debt (that due within the coming year)

Long term liabilities

• Long term liabilities include:– Long term debt

• Capital leases• Long-term unsecured loans• Mortgages• Bonds payable

– Pension liabilities– Contingent liabilities

Recognizing liability transactions

• Liabilities are recognized when– they are legally owed– have to be paid– the amount to be paid can be objectively measured

• Which of the following should be recognized as a liability– a bill received from a vendor– wages that are due to a worker– a $5 million lawsuit filed against an organization

Amortizing Long term debt• $25,000 of the $32,000 Feed-A-Fish van is

financed for five years at 8% interest. The loan calls for annual payments of $6261. – How much of each year’s payments would be

interest?Beginning

BalanceTotal

PaymentInterest Portion Principal

Ending Balance

Year 1 $25,000 $6,261 $2,000 $4,261 $20,739Year 2 $20,739 $6,261 $1,659 $4,602 $16,136Year 3 $16,136 $6,261 $1,291 $4,971 $11,166Year 4 $11,166 $6,261 $893 $5,368 $5,798Year 5 $5,798 $6,261 $464 $5,798 $0

Net Asset Categories• The net worth of an organization represents the sum of

the organization’s earnings from inception plus any paid-in capital (for-profit firms) less any payments that have been made to owners (e.g. dividends)

• Net Assets– Unrestricted Net assets (cumulative profits appear here)– Temporarily restricted net assets (use restricted by donors)– Permanently restricted net assets (restricted in perpetuity)

Assets LiabilitiesShort Term Assets Short Term Liabilities

Cash 514 Accounts Payable 5250Accounts Receivable 15325 Wages Payable 0Inventory 950 Long Term Liabilities

Total Short Term Assets 16789 Mortgages 28000Total Liabilities 33250

Long Term AssetsBuildings 114000 Net Assets(Less Depreciation) 77600 Unrestricted 9339Buildings (Net) 36400 Temporarily restricted 600

Permanently restricted 10000Total Net Assets 19939

Total Assets 53189 Total Liabilities+ 53189Net Assets

Make-A-Wish FoundationBalance Sheet

31-Jan

Generating a Balance Sheet

• Generating a balance sheet involves:– Beginning with the starting balance sheet– Recording all of the transactions for the period– Adding the impact of the transactions to the

starting balance sheet– Formatting the resulting balance sheet accounts

in the balance sheet reporting format

The operating and cash flow statements

• Operating Statement– compares an entity’s cumulative revenue and support to its

expenses for any period of time -like a fiscal year.– Shows whether the organization was able to cover its costs

• Names for an operating statement: Income statements, Activity Statement, Statement of revenues and expenses, P&L

• The Cash Flow statement looks at where an entity obtained its cash and where it spent cash during some period of time

Operating Statement• Revenues and Support

– represent inflows that the organization has received or is entitled to receive

– result in an inflow of assets to the organization and an increase in net assets

• Revenues are generally the result of an exchange for goods and services that the organization has provided

• Support is the result of gifts, grants and other contributions to the organization

Operating Statement• Expenses

– represent the recognition of the use of an asset to generate revenue and support or otherwise carry on the operations of the entity

– result in an outflow of assets and a decrease in net assets

• Net Income (difference between revenues and expenses)– Profits are an excess of revenues over expenses. Also

called a surplus or excess revenues over expenses– Losses are an excess of expenses over revenues. Also

called a deficit.

Recognizing Revenue and Support

• Revenue is recognized if:– the goods or services have been provided to the

customer– the amount owed can be objectively measured– there is a reasonable likelihood of collection

• Support is recognized if– all of the conditions of the gift have been met– the value of the pledge can be objectively

measured– there is a reasonable likelihood of collection

Operations and the Balance Sheet• At the end of the accounting period, the

total Revenues-Expenditures is used to adjust net assets– Only changes, or their effects, show on BS

Net Assets (11/30) 950

Net Assets - Revenue 1500Net Assets - Expenses 1400Changes in Net Assets 100

Net Assets (12/31) 1050

Recognizing Expenses• Expense Recognition depends on the type of

expense– Product costs are those directly connected to providing

goods and services. They are recognized:• based on the matching principle which holds that expenses

should be recorded in the same period as the revenue they were used to generate

– Period costs (like rent) are those related to the passage of time. They are recognized:• in the time period when they are incurred

Expired and Unexpired Costs• Suppose Meals for the Homeless bought 100 canned hams

at a cost of $1,000 in March– At acquisition, Meals would recognize the hams as an asset

(inventory). They are also an unexpired cost.– If they paid for the hams in cash, cash would decrease by $1,000

• In May, meals used 50 of the hams to produce meals.– At use, the hams become an expense (expired cost) of $500 and

the value of the asset (inventory) is reduced by $500.

Classifying Revenues and Expenses

• Revenues and support may be classified and reported based on:– nature (gift, grant etc.)– source( government, foundation, patients)– organizational unit (University, College, School)

• Expenses may be classified and reported based on:– nature or object of expense (salaries, supplies, rent)– function (provide housing, meals, medical care)– organizational unit (opera, ballet, theatre)

• Why is it useful to be able to report on these different bases?

2000 1999Revenues and Support

MealsClient Revenue $10,000 $8,000County Revenue 20000 16000

Shelter CounselingClient Revenue 1000 1000County Revenue 10000 10000

FundraisingFoundation Grants 70000 50000Annual Ball 12000 11000Telephone Solicitation 25000 28000

Mail SolicitationDirect Mail Campaign 48000 45000

Total Revenues and Support $196,000 $169,000

ExpensesFood $17,000 $16,000Kitchen Staff 35000 33000Counseling Staff 35000 34000Rent on Kitchen Locations 15000 14000Administration and General 75000 65000Bad Debts 4000 4000Depreciation 10000 10000

Total Expenses $191,000 $176,000

$5,000 ($7,000)Excess of Revenues and Support over Expenses

Meals for the HomelessActivity Statement

Analyzing the Operating Statement

• Why are two years of statements shown?• Administrative and General expenses rose by

$10,000. What is included? Should Meals’ board be concerned about the increase?

• Meals’ clients only paid the organization $11,000 for meals and counseling this year. Operating and Administrative expenses were $191,000. Can the organization survive?

• What other items deserve further analysis?

• Bad debt expense represents the portion of the revenues earned for that period of time that is unlikely to be collected– Reflects bad debts from a period of payables

accumulation• Allowance for uncollectable accounts is the

portion of receivables not expected to be collected– Reflects the sum of unlikely receivables at a moment in

time

Uncollectable Accounts(Bad Debts)

Uncollectable Accounts(Bad Debts)

Balance Sheet (fragment)

AssetsCurrent Assets

Pledges Receivable $13,000 Allowance for Uncollectable Pledges -$4,000Pledges Receivable, Net $9,000

Contra Account

1998Debit Credit

03/08/98 Pledges Receivable $50,000Pledge Revenue $50,000

03/08/98 Bad Debt Expense $4,000Allowance for Uncollectable Pledges $4,000

05/25/98 Cash $32,000Pledges Receivable $32,000

Balance Sheet for 12/31/98 (fragment)

AssetsCurrent Assets

Pledges Receivable $31,000 Allowance for Uncollectable Pledges -$8,000Pledges Receivable, Net $23,000

1999

2/5/1999 Pledges Receivable $50,000Pledge Revenue $50,000

2/5/1999 Bad Debt Expense $4,000Allowance for Uncollectable Pledges $4,000

5/15/1999 Cash $5,000Pledges Receivable $5,000

Balance Sheet (fragment)

AssetsCurrent Assets

Pledges Receivable $76,000 Allowance for Uncollectable Pledges -$12,000Pledges Receivable, Net $64,000

Charlie Smith Dies

6/1/1999 Allowance for Uncollectable Pledges $500Pledges Receivable $500

Balance Sheet after adjusting entry (fragment)

AssetsCurrent Assets

Pledges Receivable $75,500 Allowance for Uncollectable Pledges -$11,500Pledges Receivable, Net $64,000

Uncollectable Accounts• Assume that Meals begins the year with $125,000 in

pledges receivable, and $15,000 in the allowance for uncollectable pledges contra account.

• During the year $50,000 of new pledges are made, but cash is not received. Experience shows 10% of pledges are never collected.

• During the following year it is decided that specific pledges totaling $3,000 will never be collected

Balance Sheet (fragments)

AssetsPledges Receivable 125000Allowance for Uncollectable debts (15000)

Debit Credit Pledges Receivable, Net 110000

Cash 50000 AssetsPledges Receivable 50000 Pledges Receivable 175000Pledge Revenue 100000 Allowance for Uncollectable debts (15000)

Pledges Receivable, Net 160000Note: Record pledges

Bad Debt Expense 5000 AssetsAllowance for Uncollectable Debts 5000 Pledges Receivable 175000

Allowance for Uncollectable debts (20000)Note: Estimated Uncollectable debt Pledges Receivable, Net 155000

Allowance for Uncollectable Debts 3000 AssetsPledges Receivable 3000 Pledges Receivable 172000

Allowance for Uncollectable debts (17000)Note: Write off Uncollectable debt Pledges Receivable, Net 155000

Depreciation Expense

• Depreciation expense represents the current periods’ share of the cost of using a capital asset over its life– This illustrates the matching principle (HOW?)– Depreciation expense may be calculated either

on a straight-line or an accelerated bases. Why would you want to use accelerated depreciation?

Straight Line Depreciation Example

• Cost of a van $32,000Less Salvage (Residual) value 2,000Depreciable amount $30,000(Divide across useful life) five yearsDepreciation expense/year $6,000

Sum of Years Digits Depreciation

• Calculates the sum of the digits in the years of the life of the asset.

• Subtracts salvage value first• The sum simply consists of adding from 1 to the

last year of the asset’s life (inclusive)– An asset with a six year life would have a depreciation

denominator of 21• 1+2+3+4+5+6 = 21

– First year’s depreciation = residual value * 1/21

Sum of Years Digits Depreciation Example

• Cost of a van $32,000Less Salvage (Residual) value 2,000Depreciable amount $30,000Sum of Years Digits (1+2+3+4+5) = 15First year depr. at 5/15 $10,000Second year depr. at 4/15 $8,000Third year depr. at 3/15 $6,000Fourth year depr. at 2/15 $4,000Fifth year depr. at 1/15 $2,000

Double Declining Balance Depreciation

• Starts with a depreciable base EQUAL to the total asset cost– Ignore salvage value when determining annual amount

of depreciation• The cost is multiplied by double the straight line

ratio• Does not shorten the asset life!

– Each year the previous year’s depreciation is subtracted from the existing depreciable base to get a new depreciable base

– Last year’s depreciation expense=salvage value minus the depreciable base at that point

Double Declining Balance Depreciation Example

• Cost of a van $32,000Ignores Salvage value 0Depreciable base $32,000First year depr. At 2/5 -$12,800Depreciable base $19,200Second year depr. At 2/5 -$7,680Depreciable base $11,520Third year depr. At 2/5 -$4,608Depreciable base $6,912Fourth year depr. At 2/5 -$2,765Depreciable base $4,147Fifth year depr. (balance) -$2,147*

Cost $2,400 $2,400 $2,400Base $2,100 $2,400 $2,100Term 6 Years 6 Years 6 YearsSalvage Value 300 300 300

DepreciationDepreciation

RatioResidual

Value DepreciationDepreciation

RatioResidual

Value DepreciationDepreciation

RatioResidual

ValueYear 1 $350 1/6 $2,050 $800 2/6 $1,600 $600 6/21 $1,800Year 2 $350 1/6 $1,700 $533 2/6 $1,067 $500 5/21 $1,300Year 3 $350 1/6 $1,350 $356 2/6 $711 $400 4/21 $900Year 4 $350 1/6 $1,000 $237 2/6 $474 $300 3/21 $600Year 5 $350 1/6 $650 $158 2/6 $316 $200 2/21 $400Year 6 $350 1/6 $300 $16 2/6 $300 $100 1/21 $300

Total Depreciation $2,100 $2,100 $2,100

DEPRECIATION METHODOLOGIES

Straight Line Double Declining Balance Sum of Years Digits

Inventory Expense

• Inventory expenses represent the cost of using supplies to operate an organization. Inventory expense and the ending inventory value are calculated using the following relationshipBeginning inventory + purchases – Consumption = Ending Inventory

Inventory Systems• Periodic

– Inventory is ‘taken’ (counted) annually or semiannually and accounting adjustments are made accordingly

– Difficult to make informed ordering decisions– Not suitable for inventory based enterprises (where

inventory is a significant input in service production, e.g. hospitals, clinics, print shops)

– Inexpensive method– Poor as a control system

Inventory Systems• Perpetual

– Each use of inventory is recorded as it occurs– Items removed for reasons other than sale are

recorded as they occur– Perpetual systems can be very costly

(technology, labor)– Good for control systems

Perpetual Inventory Systems• Economic Order Quantity

– Tracks system wide variables• Shelf space• Storage costs• Account activity• Historical levels of inventory• Carrying costs• Ordering costs

– Executes orders automatically when system variables combine to indicate optimal time

Perpetual Inventory Systems• Just-in-Time Inventory

– Focused on minimizing carrying costs– Contracts with vendors specify precise hour of

delivery– Eliminates need for most warehousing– Mostly applied in manufacturing/ repetitive

industries– Input prices may bear a premium from JIT

requirement

FIFO and LIFO

Inventory Method

Beginning Balance Purchases

Consumption (Inventory Expense)

Ending Balance

LIFO $20,000 $45,000 3000*$15 =$45,000 $20,000

FIFO $20,000 $45,000 2,000*$10+1,000*$15=$35000 $30,000

NY City’s subway system started the year with 2,000 railroad ties that cost $10 each and bought 3,000 more during the year for $15 each. If they had 2,000 left at the end of the year, what was their inventory expense and how much was the remaining inventory worth?

Deferred Revenue• Deferred revenue arises when an organization is

paid in advance for goods or services– Why is this a liability?

• A museum sells a five year membership for $250.– How much of the $250 should be recorded as deferred

revenue?– How much of the $250 would the museum recognize as

revenue during the first year of the membership?

Deferred Revenue• Deferred revenue arises when an organization is

paid in advance for goods or services– Why is this a liability?

• A museum sells a five year membership for $250.– How much of the $250 should be recorded as deferred

revenue? $200– How much of the $250 would the museum recognize as

revenue during the first year of the membership? $50

Statement of Cash FlowsIndirect Method• Start with Net Income from Op Statement• Adjust cash flows for each non-cash balance sheet

transaction– Add decreases in assets– Subtract increases in assets– Add increases in liabilities– Subtract decreases in liabilities

• Add Non-cash expenses• Adjust for flows from investing/financing

A mixed Balance Sheet and Operating Statement Transaction• HOS paid $48000 in wages. $30,000 for

money owed to employees for work performed last year and $18,000 for this year’s work.

Debit CreditLabor Expense 18000Wages Payable 30000Cash 48000

A mixed Balance Sheet and Operating Statement Transaction• HOS paid $48000 in wages. $30,000 for

money owed to employees for work performed last year and $18,000 for this year’s work.

Assets= Liabilities + Revenues- Expenses

-Cash = -wages pybl +no change -labor expense

-$48000= -30000 -18000

(2) Operating Statement Transaction(s)• HOS provided services and billed patients

$81,000. It consumed $4,000 worth of inventory to deliver the services.

Debit CreditAccounts Receivable 81000Revenue 81000

Debit CreditSupplies Expense 4000Inventory 4000

A Non-Cash Transaction

• HOS owed its staff $27,000 for wages for the last two weeks of the year which were not due until the first week of the new year.

Debit CreditWages Payable 27000Wages Expense 27000

Where Income Statement and Balance Sheet Meet

Event Statement Impact NoteRevenueRecognized

You providea service andearn revenue.

AR or Cash

Revenue

BS

IS

AR is a 'holdingarea' for unpaid billsyou have sent out.

No impacton revenue

Someonepays a billyou sent

AR

Cash

BS

BSNo impacton expenses

You purchaseSomething

AR Inventory

BSBS

AP is where youkeep track of whatyou owe to others.

ExpenseRecognized

When youusesomething

Asset (or)Liability Expense

BSBSIS

Reflecting Net Income on the Balance Sheet

• Net income is reported as a change in net assets on the balance sheet

Total Revenue/Support $81,000Total Expenses ($80,050)Net Income $950

Unrestricted Temp. Rest. Perm. Rest.Beginning Balances $113,000 $15,000 $10,000Changes in Net Assets $950Ending Balance $113,950 $15,000 $10,000

Cash Flow Production Cycle

Cash

AccountsReceivables

Inventory

Fixed Assets

Equity & Liabilities

Collection ofReceivables Cash

Sales

Credit Sales

Production

Investment

Interest, Taxes & Dividends

Source: Higgins (1998)

Depreciation

D Cash + D in All Other Assets = D in Liabilities + D in Net AssetsOR

D Cash = D in Liabilities + D in Net Assets - D in All Other AssetsOR

D Cash = D in Liabilities + (Rev-Expenses) + D in Other Net Assets - D in All Other Assets

SOWe are seeking to show the route to (end of period) cash as affected

by changes in net income, assets, liabilities and net assets.

Understanding the Cash Flow Statement

The Cash Flow Statement

• The Statement of Cash Flows focuses on the sources and uses of cash for the organization. It divides those cash flows into:– Cash flows from operations– Cash flows from investing– Cash flows from financing

The Cash Flow Statement

• The first approximation of cash flow is net income. Why isn’t this adequate?

• The first adjustment is for “Expenses not requiring cash” (e.g. depreciation, amortization, depletion)

• The remainder of the adjustments to operating cash flow are for changes in balance sheet accounts related to operations

Understanding the Cash Flow Statement

• Indirect Method– Uses Net Income and Non-Cash transactions, and

Operating Cash transactions to adjust cash balance– Less Transparent in reporting cash activity– May be easily calculated from other financial

statements

Statement of Cash FlowsIndirect Method• Start with Net Income from Op Statement• Adjust cash flows for each non-cash balance sheet

transaction– Add decreases in assets– Subtract increases in assets– Add increases in liabilities– Subtract decreases in liabilities

• Add Non-cash expenses• Adjust for flows from investing/financing

Statement of Cash FlowsCash Flows from Operating Activities 2000 1999

Net Income $5,000 ($7,000)

Add Expenses Not Requiring Cash:Depreciation $10,000 $10,000

Other Adjustments:Add Decrease in Inventory $2,000 $2,000Add Increase in Notes Payable $1,000 $3,000Subtract Increase in Receivables ($17,000) ($12,000)Subtract Decrease in Wages Payable ($1,000) $0Subtract Decrease in Accounts Payable ($1,000) ($2,000)Subtract Increase in Prepaid Expenses ($1,000) $0

Net Cash used for Operating Activities ($2,000) ($6,000)

Statement of Cash FlowsCash Flows from Investing Activities

Sale of Stock and Investments $4,000 $5,000Purchase of Delivery Van ($32,000)

Net Cash from Investing Activities $4,000 ($27,000)

Cash Flows from Financing ActivitiesIncrease in Mortgages $25,000Repayments of Mortgages ($5,000) ($4,000)

Net Cash from Financing Activities ($5,000) $21,000

Net Increase/(Decrease) in Cash ($3,000) ($12,000)Cash, beginning of year $5,000 $17,000Cash, End of year $2,000 $5,000

Analyzing the Cash Flow Statement

• Meals bought a van for $32,000. What was the probably source of funding?

• Meals’ net cash flow increased across the past year. What are the major causes of this increase?

• The change in accounts receivable used $17,000 in cash. Could this be the sign of a problem?

• Can Meals continue to operate in this fashion?

Cash Flow and the Balance Sheet

• Rules of thumb:– Asset increases consume cash– Asset decreases provide cash– Liability increases provide cash– Liability decreases consume cash

Understanding the Cash Flow Statement

• Direct Method– Uses Cash Transactions alone to adjust cash– More transparent (better reflects cash activities)– Requires information from ledgers

POLS 7830 PUBLIC FINANCIAL MANAGEMENTLECTURE 5: CASH MANAGEMENT

MANAGING SHORT TERM RESOURCES/OBLIGATIONS• Working Capital• Short term Obligations (Current Liabilities)

– Accounts Payable• Short term Resources• Cash Management • Accounts Receivable• Inventory

– Economic Order Quantity

Working Capital Management

• Working capital management focuses on making sure that the organization has the resources it needs to operate during the current year. It is a continuous process!

Working Capital Management• Net Working Capital is defined as the difference

between the resources that an organization can use to provide goods and services over the next year (Short-Term Assets) less what will have to be paid to other organizations and individuals over the coming year (Short-term liabilities)

Net Working Capital=Current Assets -Current Liabilities

Short Term Obligations

• Accounts Payable• Payroll Payable• Notes Payable• Taxes Payable• Remittances/Transfers pending

Current Liabilities

• Short-term payables– Amounts owed by the organization that have not

yet been paid. Specific “payables” accounts can be set up for any general category of creditors

Current Liabilities

• Short-term payables– Accounts Payable- for goods and services– Payroll/wages payable- for salaries and benefits

due to employees– Interest payable- for amounts due on loans– Taxes payable- for tax obligations that have not

yet been paid

Calculating Short Term Interest

• Interest=loan amount (principal) * Annual interest rate*fraction of year

• Example: HOS borrows $1m at an annual interest rate of 5.5$% for 45 days. How much interest will they have to pay?$1,000,000*.055*.123288 (45/365=.123288)=$6,780.82

Payroll Deferral

• The choice of when to make payroll distributions can seriously affect cash position and interest earnings

• Example: The Town of Toxic Dales is considering changing from a weekly to monthly payroll. Payroll is $24m per year and the interest cost is 8% per year. How much would they save through change?

Payroll Deferral

Each Month

Length of Deferral Portion of Year in Weeks

Amount Deferred

Interest @ 8% per year

Week 1 3/52 $500,000 $2,308Week 2 2/52 $500,000 $1,538Week 3 1/52 $500,000 $769Week 4 - $0 $0

Monthly Total $4,615

Annual Savings= $4,615 * 12 = $55,384.62

Accounts Payable

• Strategies for A/P cost savings– Take advantage of pre-payment discounts that

pass a cost/benefit test– Manage payroll to maximize expense to

payment period, and float– Establish electronic transfers to submit payroll

taxes and withholdings– Capture economies of scale with sole source

vendors (selected by bid)

Accepting a pre-payment discountThe city of Billious Hills receives a bill from

Billious Power and Light for $94,000 on the first of March for services in February. The payment is due on March 31st, and a late fee of $1410 will be assessed if it does not arrive by April 7th. BP&L indicates that Billious hills need only pay $93,365 if their payment is received by March 7th. Today is March 7th. Should Billious Hills accept the discount? If not, what should they do?

Accepting a pre-payment discount• Option A:

– Invest $94,000 for one month at k%– Pay $94,000 and keep the investment earnings

• Investment earnings = m• Option B:

– Pay $93,364 and invest $636 for perpetuity– Decision depends on the value of k: What is a

reasonable return to expect on a one month investment?• To accept the offer k must be large enough that m is greater

than $636 (plus one month of interest)

Option A Earnings FV Interest Option A Option BFV of $94,000 at 2.00% for 1/12 of one year = $94,156.67 $156.67 $156.67 $637.06FV of $94,000 at 3.00% for 1/12 of one year = $94,235.00 $235.00 $235.00 $637.59FV of $94,000 at 4.00% for 1/12 of one year = $94,313.33 $313.33 $313.33 $638.12FV of $94,000 at 5.00% for 1/12 of one year = $94,391.67 $391.67 $391.67 $638.65FV of $94,000 at 6.00% for 1/12 of one year = $94,470.00 $470.00 $470.00 $639.18FV of $94,000 at 7.00% for 1/12 of one year = $94,548.33 $548.33 $548.33 $639.71FV of $94,000 at 8.00% for 1/12 of one year = $94,626.67 $626.67 $626.67 $640.24FV of $94,000 at 9.00% for 1/12 of one year = $94,705.00 $705.00 $705.00 $640.77FV of $94,000 at 10.00% for 1/12 of one year = $94,783.33 $783.33 $783.33 $641.30

Accepting a pre-payment discount

Finding the discount rateThe decision about whether to take the discount or not depends upon what

the implicit interest rate is in the discount, and how that compares with prevailing rates.To find the discount rate simply take the amount of the discount and divide it into the undiscounted total:

Period DiscountBase

X # of Annual Periods

100X

Accepting a pre-payment discount

In our example:

63694000

= .006766 X 12 = .08119 X 100 = 8.12 %

So, we only choose option A if the return on our investment will be at an annualrate of at least 8.12%.

Short Term Resources

• Cash• Accounts receivable• Notes and agreements receivable• Inventory• Remittances/transfers pending

Short Term Resources

• Cash Resources– Cash for transactions, investment and as a safety

margin• Cash for daily operating transactions• Short-term investments to provide income from idle cash• Cash on hand for unanticipated events

– Managed by cash budgeting, cash management and credit management (who to sell to on credit, whether to give a discount)

Too much cash?• Under what circumstances does an organization

have too much cash?– When cash on hand is much greater than routine cash

flow needs– When the opportunity cost of cash on hand exceeds

short term cash benefits• E.g. long term investment rates typically exceed short term

rates– When the organization is undercapitalized

• Response: Move cash to investments, or spend in mission areas of the organization

Short Term Resources

• Accounts receivable: bills that have been sent out by the organization but have not yet been collected– Managed through credit policies, collection

efforts and billing controls– Aging schedules are a valuable management

tool

Short term cash management strategies

• Interest bearing operating accounts• Strategic use of ‘float’ and overnight

deposits• Certificates of deposit• Concentration banking• Objective hierarchy: Legality, maintain

liquidity, minimize risk, maximize earnings (yield)

Short Term Resources

• Inventory– Supplies on hand for use in operations/

production– Managed with periodic and perpetual control

systems

Short term investments

• Marketable securities– Equities

• Shares– Values fluctuate with market performance and anticipated

per-share earnings

– Non-Equities• Bonds, notes, other debt instruments

– Values more inversely with market interest rates

Short term investments• Certificates of Deposit

– Bank-held - FDIC Insured– Non-negotiable - Fixed rate

• Money Market accounts– Bank or fund held -Variable rate– MM bank accounts are FDIC insured

• T-bills (three months to one year)– Discounted to PV at prevailing interest rate

• Commercial paper• Repurchase agreements

Repurchase Agreements (REPOS)

• Short term collateralized securities• Typical agreements last between 1-30 days• Organization with idle cash provides it to

the borrower at an agreed-upon interest rate– Borrower creates (and sells the lender) a money

market instrument and agrees to buy it back on the specified date

Unsuitable investments• Any leveraged securities• Derivatives, in general

– Returns are not know in advance and risk can be higher than average as a result

– not necessarily poor choices for larger and longer term funds due to the ability to present a risk hedge

• Stocks• Low quality bonds• Personal notes

Accounts Receivable

• Strategies for A/R cost savings– Offer only those pre-payment discounts that

pass a cost/benefit test– Recapture the cost of extending credit through

bank cards– Establish direct bank transfers with regular

customers– Implement a collections protocol while tracking

aged accounts

Payer 1-30 Days 31-60 Days 61-90 Days 90+ Days Total

Medicare $4,400,000 $3,200,000 $2,000,000 $1,000,000 $10,600,000Medicaid $3,800,000 $2,400,000 $1,500,000 $125,000 $7,825,000SuddenDeath HMO $2,500,000 $1,300,000 $800,000 $450,000 $5,050,000SlowDeath HMO $3,100,000 $800,000 $400,000 $0 $4,300,000Blue Cross/Blue Shield $842,000 $419,000 $210,000 $49,000 $1,520,000Self-Pay $2,000,000 $1,000,000 $750,000 $150,000 $3,900,000 Totals $16,642,000 $9,119,000 $5,660,000 $1,774,000 $33,195,000

Amounts by PercentMedicare 41.51% 30.19% 18.87% 9.43% 100%Medicaid 48.56% 30.67% 19.17% 1.60% 100%SuddenDeath HMO 49.50% 25.74% 15.84% 8.91% 100%SlowDeath HMO 72.09% 18.60% 9.30% 0.00% 100%Blue Cross/Blue Shield 55.39% 27.57% 13.82% 3.22% 100%Self-Pay 51.28% 25.64% 19.23% 3.85% 100% Totals 50.13% 27.47% 17.05% 5.34% 100%

Carvaspleen HospitalAccounts Receivable

Aging Schedule

Accounts Receivable

• Billing• Aging• Lock Boxes• Electronic payments

Inventory

• Supplies and items used to produces goods and services

• Objective: Keep inventory at the lowest level at which operations may continue unimpeded

• Periodic systems (count and order annually)• Perpetual systems ( count and order as

supplies are consumed)

Economic Order Quantity

• Inventory costs include – Cost of the items– Cost of the space to store the items– Cost of the insurance for the items on hand– Costs of ordering and shipping items

• Problem: How much should be ordered, how often and with how much on hand?

• Answer: Economic Order Quantity

Economic Order Quantity

Total Inventory Cost= Purchase Cost + Carrying Cost

P=Price per unitCC=Total Carrying costsOC=Total ordering costsN=Total number of annual units ordered

TC= (P*N) + CC + OC

Economic Order Quantity

• Whenever we order we will have some quantity of inventory on hand between 0 and the maximum quantity included in any inventory order

• Consequently, on average, at any given time, we will have half of the order quantity on hand (all of it at first, none of it at last)

• So, the average number of units on hand at any given time = Q/2

Economic Order Quantity

CC= Carrying Cost= C* =

C=Annual carrying Cost for one unit per yearCC=Total Carrying costs for all units per year

• Note: CC is different when maintaining a minimum stock (MS):

– The MS may be ignored when finding the EOQ

2Q

2CQ

MSCQ

2

Economic Order Quantity

OC= Ordering Cost= O* =

O=Cost of completing one orderOC=Cost of placing one order (O) multiplied times the

number of orders placed per year

QN

QON

Economic Order Quantity

• Example: Meals pays $2 per sack for rice and each order costs $8.075 of labor cost and $1 of delivery cost. The opportunity cost of capital is 8% which adds $0.16 per sack (8%*$2 =$0.16). Other carrying costs are $3 per sack per year.

• What is the total cost of inventory, given 10 orders per year?

Economic Order Quantity

P*N=$2*2,000=$4000CC=($3*200)/2 = $300OC=($9.075*2000)/200=$90.75TC= (P*N) + CC + OC, soTC= $4000 + $300 + $90.75 = $4,390.75

Great, but what about EOQ???

Economic Order Quantity

So, in our example...

=110

CONQ 2*

3$2000*075.9$*2*Q

What are the costs at this volume?

Economic Order Quantity

So, in our example...

What are the carrying costs at this volume?

2CQCC

165$2110*3

Economic Order Quantity

So, in our example...

What are the ordering costs at this volume?

QONOC

1102000*075.9$

= $165

Economic Order QuantityThe total costs are

= $4,330

TC= (P*N) + CC + OC

TC= $4000 + 165 +165

So, in our example...

Which is less than the $4,390.75 when ordering 200

Economic Order Quantity

• Key: determining the carrying and ordering costs– These may be hard to measure precisely– Labor costs are generally available– How should the cost of storage be treated?

• Average or marginal cost?

POLS 7830 PUBLIC FINANCIAL MANAGEMENT

LECTURE 6: FORECASTING REVENUES AND EXPENDITURES

• Definitions• Purposes• Forecast Types• Financial Forecasts• Forecasting Problems• Forecasting Methods• Evaluating Forecast Accuracy• Models of trends

POLS 7830 PUBLIC FINANCIAL MANAGEMENTLECTURE 6: FORECASTING REVENUES AND

EXPENDITURES

Forecasting• “Any statement about the future”• The methods used to predict outcomes• Public sector applications

– benefit/cost analysis– revenue forecasting

• forecasting tax and fee proceeds• forecasting donations and service revenues

– cash flow forecasting– expenditure forecastings

• forecasting demand/expenditure need• forecasting factor/input prices

Purposes of Forecasting

• Process• Prediction• Control

Purposes of Forecasting“ …a multi-year forecasting model

necessarily forces managers to lengthen their time perspective by giving some thought to what might be in store for a jurisdiction a few years ahead…the forecast can show managers and staff how their own agencies fit into the overall scheme of government, thus broadening their perspective.” -Larry Schroeder

Process Forecasting

• Predicting important elements of repetitive processes inside a public organization – Cash flow analysis– Revenue planning– Expenditure tracking– Transaction analysis

Process Forecast• Purpose

– To anticipate the size or magnitude of recurring events– To try to anticipate potential problems so that

corrective action can be taken• Time Horizon

– Short to medium term (typically 2 years or less)– Fixed forecast duration (e.g. monthly, quarterly,

annually)• Frequency

– Repeated on a regular basis

Prediction Forecast• Purpose

– Analyze likely impact of a policy or program to help in its development and selection

• Time Horizon– Medium to long term (2- 5 Years)

• Frequency– Typically a one time analysis

• Example– Projected benefit stream for CBA

Corn Price

0

200

400

600

800

1000

1200

1400

1850 1900 1950 2000

($) P

rice

Control Forecast• Purpose

– Set objectives and goals• Time horizon

– Any length• Frequency

– Depends on planning function • Content

– Follows goals statements and attaches them to quantifiable measures of accomplishment

– Assigns projected values to potential outcomes

The Use of Forecasts

Type Use Characteristics Example

Process/ Projection

Extrapolation of ongoing process

Recurring at fixed intervals Cash flow forecastingFixed forecast horizons

Revenue and expenditure forecasting

Short to medium term

Service demand forecasting

Prediction Prediction of Policy oriented Policy analysisevents and/or Non-recurring Tax reforminfluence of events Variable forecast Economic development

Medium to long Planningterm Macroeconomic forecasts

Control Evaluation Normative Service planningReflect goals and Setting service targetsobjectives Performance auditsPolitical Influence

Financial Forecasts

• Expenditure Forecasts• Revenue Forecasts• Cash flow projections

Revenue Forecasting• Forecast object: Tax, fee or sales revenue due to a

government or enterprise• Forecast objective: Develop accurate, reliable,

(and methodologically transparent) judgement of what revenues will be at a later point in time– Revenue forecasts used in budgeting to identify

allocation base for future fiscal year(s)– Revenue forecasts used by non-profit managers to

make decisions about demand and service levels

Expenditure Forecasting• Forecast object: Classified government

expenditures for a future period• Forecast objective: Improve planning and

budgeting ability by determining in advance the likely costs of programs and services– Heavily used in planning entitlement spending– Used less in discretionary spending categories

• Political factors• Incrementalism

Cash Flow Projection

• Start with reconciled cash balance at present time

• List by date each anticipated increase (debit) to cash

• List by date each anticipated decrease (credit) to cash

• Strategize to cover deficits

3/1/1999 MDMH Revenue $39,218 $39,4333/15/1999 Payroll $38,912 $5213/29/1999 MDMH Revenue $39,218 $39,7394/12/1999 Payroll $38,912 $8274/26/1999 MDMH Revenue $39,218 $40,0455/10/1999 Payroll $38,912 $1,1335/24/1999 MDMH Revenue $39,218 $40,3516/7/1999 Payroll $38,912 $1,439

6/21/1999 MDMH Revenue $39,218 $40,6577/5/1999 Payroll $41,810 -$1,153

7/19/1999 MDMH Revenue $39,218 $38,0658/2/1999 Payroll $41,810 -$3,745

8/16/1999 MDMH Revenue $42,546 $38,8018/30/1999 Payroll $40,810 -$2,0099/13/1999 MDMH Revenue $42,546 $40,5379/27/1999 Payroll $40,810 -$273

10/11/1999 MDMH Revenue $42,546 $42,27310/25/1999 Payroll $38,912 $3,36111/8/1999 MDMH Revenue $42,546 $45,907

11/22/1999 Payroll $38,912 $6,99512/6/1999 MDMH Revenue $42,546 $49,541

12/20/1999 Payroll $38,912 $10,62912/29/1999 MDMH Revenue $42,546 $53,1751/15/2000 Payroll $38,912 $14,2631/30/2000 MDMH Revenue $42,546 $56,8092/15/2000 Payroll $38,912 $17,8972/28/2000 MDMH Revenue $42,546 $60,4433/15/2000 Payroll $38,912 $21,531

.

List cash adjustments 0End of period projected balance: $21,531

Cas

h Fl

ow P

roje

c tio

n

Forecast Types• Qualitative Forecasts• Univariate Forecasts• Multivariate Forecasts

Qualitative Forecasts• Forecasting techniques where the method is

implicit or intuitive• Use either no data, or qualitative data• Use in control forecasts

– Used in setting goals and objectives– Representative of decision-makers intentions

• Use in process forecasts– To make predictions about some variable– E.g. Georgia revenue forecasts historically based on the

expert judgement of one expert

Qualitative Forecasts• Strengths

– Inexpensive– Quick– Could be reasonably accurate– Best for control forecasts, value judgements

• Weaknesses– Quality is only as good as the expert– Errors may be random or systematic– Hard to make judgements about accuracy attributable to

the method

Univariate Forecasts

• Time series• Use historical information as the source of

data about the prediction phenomenon• Use no other variables to predict outcomes• May introduce corrections for ‘randomness’

Univariate (time series) Forecast

• Key issues for employing time series– Past history must be a good predictor of the

future– Principal objective of the forecast must be to

predict, not to analyze why past is a good predictor of future (e.g. revenues or expenditures)

Univariate (time series) Forecast

• Cash flow projection: Process forecast for which a univariate method is appropriate– Primary objective is accurate prediction– Intervention requires no underlying causal

understanding• Exception: When cash flow is consistently short

– e.g. NYC in the mid 1970s– e.g. HNHS in the early 1990s

Univariate (time series) Forecast

• Strengths– Consistently the most accurate method of

process forecasting of short and medium term phenomena

– Low data demands (just historical data)– Easy to complete

Univariate (time series) Forecast

• Weaknesses– Little information provided about underlying

causal structure– Cannot adjust forecast based on changes in core

assumptions• E.g. forecasting MARTA ridership from 1999 and

2000 using information from 1990-1999 but without adjusting for changes in gasoline prices

Multivariate Forecast• Models the relationship between the variable of

interest and several other factors that may be affecting it.

• Multivariate forecasts come in two forms– Stochastic process models

• Allow for random variation in process– Deterministic models

• Assume direct relationship between explanatory variables and variable of interest– Expenditure forecasts for entitlement programs typically employ

deterministic models

Multivariate Forecast• Strengths

– Can provide sophisticated understanding of why certain phenomena are occurring and how they affect the outcome of interest• Better explanations to provide to decision-makers

– Allow for the introduction of random effects or “shocks” into the system observed

– Allow for the analysis of the impact of unforseen events

– Best for predictive forecasting

Multivariate Forecast• Weaknesses

– Requires much more data• Historical series, data on all independent variables

– Resource hungry– Time

• Recommendations– Start with the simplest models first– Increase complexity only as it becomes apparent that

prediction error is reduced– E.g. OLS, 2SLS, 3SLS, REMI...

Forecasting Problems• Searching for an unknown value• Less tolerance for errors in prediction than in

estimation– Prospective focus means decision makers are relying

upon this data for policy choices– Large amounts of funds involved make small error

rates important• Small fund areas are more numerous and errors offsetting• e.g. general fund vs. license funds

General Fund Licenses Courts Recreation

Predicted $46,500,000 $112,000 $215,000 $43,000Actual $45,570,000 $109,200 $220,375 $40,850Error $ -$930,000 -$2,800 $5,375 -$2,150Error % -2.04% -2.56% 2.44% -5.26%

Prediction Error in Government Fund GroupsGovernment Revenue

Fund Group

Forecasting Problems• Forecasts are only as good as the assumptions that

feed them• Many factors that influence the volume of

revenues and expenditures are not easily quantifiable or knowable– Shifts in attitudes, preferences, expectations– Political factors

• Actions and choices of decision makers• Influence of interests

Forecasting Problems

• Technical expertise is in methods of forecasting, not in formulating and revising assumptions

• All forecasting includes subjective judgements– The most sophisticated methods may

incorporate very large numbers of assumptions• Periodicity

Prediction Error

• The prediction error is the difference between the predicted value and the actual value

• Error = XXe ˆ

Dealing with Prediction Errors• Organizations strategies:

– Contingency planning• Savings, “rainy day funds”• Response plans

– Lobbying, advocacy• Political strategies

– Use knowledge of bias as basis for contingent agreements (“If revenue is X we spend on Y”)

– Assure bias is open, consistent and not politically motivated

– Consensus forecasting (deliberative technique)

Dealing with Prediction Errors

• Methodological considerations– Sample size– Data quality– Incorporating errors from previous predictions

• Introduction of systematic bias– Consistent use of lower revenue projections and higher

expenditure projections– Preference for explicit adjustment or decision rules

Evaluating Forecast Accuracy• Seek measures of prediction error which

ignore direction• Mean absolute deviation (MAD)

– Mean of the summed absolute values of the errors

• Mean square error (MSE) – Mean of the sum of the squares of the errors

ne

MAD ||

nMSE

e2

Forecasting Methods

• Note: Endogeneity of bias for projections of government revenue and expenditure– Governments not only predict but determine

what revenues and expenditures will be– Local governments and districts may determine

revenue needs and levy to meet them• Forecasting may facilitate projections of collection

and appeals rates

Forecasting Methods

• Time Series Techniques– Trendline: Predict value of Xt+1 based on Xt, Xt1, Xt-2...

• Assumes no error or change• Constant unitary growth

Xt+1= Xt+k, where k = units of growth/period• Constant rate of (exponential) growth approach

Xz= Xt*rz, where r = (Xt/Xt-1)1/N and z = t+1, t+2, etc.

Forecasting Methods

• Time Series Techniques– Moving Average

• Predicted value is the average of the N most recent period values

• Emphasis placed equally on all observation periods• Most reasonable where the inter-period variation is

not significant– Even if some growth

Moving Average

NNttt yyyf ...

t21

Example: Forecasting pork tax revenues (with 2000 outbreak of Mad Pig Disease)

• Fixed number (five) years used for each prediction

• Set of years advances (moves) each year to reflect the same distance from t (t-1,t-2…)

• Best for stable phenomena• Poor method when shocks are

present

Pork Tax Revenues (Millions)

Five Year Moving

AveragePrediciton Error

2000 $2,221.601999 $1,788.00 $2,366.00 32.33%1998 $2,265.00 $2,395.00 5.74%1997 $2,245.00 $2,453.00 9.27%1996 $2,385.00 $2,504.80 5.02%1995 $2,425.00 $2,577.40 6.28%1994 $2,510.00 $2,604.00 3.75%1993 $2,410.00 $2,672.00 10.87%1992 $2,535.00 $2,704.80 6.70%1991 $2,644.00 $2,749.20 3.98%1990 $2,788.00 $2,889.20 3.63%1989 $2,643.00 $2,950.20 11.62%1988 $2,750.00 $3,051.80 10.97%1987 $2,699.001986 $2,866.001985 $3,488.001984 $2,948.001983 $3,258.00

Moving average

t yt ft=.5yt-1+.3yt-2+.2yt-3

0 91 112 123 16 .5(12)+.3(11)+.2(9)= 11.14 11 .5(16)+.3(12)+.2(11)= 13.85 17 .5(11)+.3(16)+.2(12)= 12.76 11 .5(17)+.3(11)+.2(16)= 157 15 .5(11)+.3(17)+.2(11)= 12.88 13 .5(15)+.3(11)+.2(17)= 14.2

Three Year Weighted Moving Average

Forecasting Methods• Distributed lag models include not only the

current but the lagged (past) values for the independent variables:

yt=a + b0Xt + b1Xt-1 + b2Xt-2 + et

• Autoregressive models include one or more lagged values of the dependent variable as independent variables.

yt=a + bXt + dyt-1 + et

Forecasting Methods

• Time Series Techniques

– Exponential smoothing methods• Weight forecast values based on the size and

direction of the previous prediction errors

– Key is value attributed to a

)*(ˆ11 ttt eXX a

Exponential Smoothing

• The predicted value for each period is adjusted to correct for the error from the previous period

• The weight placed on the previous error can be set to reflect how rapidly changing the phenomenon is that is being forecast

• Alpha weight is set to minimize the error

Exponential Smoothing

• Moving Average where weight on past observations decline exponentially

• Weights based on a single parameter called the smoothing coefficient (alpha)

• 0 <= a <= 1• Small alpha generates an average using

more historical data, a larger alpha uses less historical data

Simple Exponential Smoothing

• alpha = 1 is the same as the Naive model• Simple Exponential Smoothing

• Or, for estimation purposes…

ttt yyy ˆ)1(ˆ )1( aa

ttt yyyy )ˆ(ˆˆ )1( a

Calculation of SES• Y(t) = a Y(t-1)+a(1-a) Y(t-2)+a(1-a)2 Y(t-3)+ ... +E(t)• Data(t) = MODEL(t-1) + ERROR(t)• FORECAST(t) = MODEL(t-1)• F(t)=aY(t-1)+[a(1-a) Y(t-2)+a(1-a)2 Y(t-3)+ ...]• F(t) = a Y(t-1)+(1-a) F(t-1)• F(t) = F(t-1) + a [Y(t-1) - F(t-1)]• F(t) = F(t-1) + a e(t-1)

All are mathematically equivalent!

Exponential Smoothing

Exponential Smoothing: Alpha tablesa= 0.01 0.1 0.25 0.5 0.8t-1 0.0100 0.1000 0.2500 0.5000 0.8000t-2 0.0099 0.0900 0.1875 0.2500 0.1600t-3 0.0098 0.0810 0.1406 0.1250 0.0320t-4 0.0097 0.0729 0.1055 0.0625 0.0064t-5 0.0096 0.0656 0.0791 0.0313 0.0013t-6 0.0095 0.0590 0.0593 0.0156 0.0003t-7 0.0094 0.0531 0.0445 0.0078 0.0001t-8 0.0093 0.0478 0.0334 0.0039 0.0000

Forecasting Methods• Simple regression

yt=a + bxt +et

• Multiple regressionyt=a+bx1+bx2…+bxn+et

Where: y=predicted observation, b=coefficient, x=independent variable(s), a=constant, e=error term, t=time period

• Non-linear regression modelsln(yt) =e bxt+et

Regression

• Identifying the contribution of individual factors when predicting the given value of a phenomenon

• Simple regression bases the values of y on the values of x– Based on the historical relationship between

truck weight and road repairs, we could predict road expenses based on average truck weights

Regression

• Excel tip: Use the function “forecast” to find predicted values using simple regression

• =forecast(x,Y,X)x = value corresponding to predicted yY=range of dependent variablesX=range of independent variables

RegressionYear

Average Truck Ton Miles per day

(Millions of Tons)Road Repair

Costs (Millions)

Predicted Road Repair Costs

(Millions) Error

2000 51.23 ? $3941999 51.23 $382.90 $394 $11.461998 49.48 $376.50 $383 $6.561997 47.85 $381.50 $373 ($8.97)1996 44.87 $377.40 $353 ($24.11)1995 41.02 $345.00 $328 ($16.57)1994 39.11 $303.50 $316 $12.591993 42.12 $350.10 $336 ($14.57)1992 41.56 $348.50 $332 ($16.59)1991 42.45 $320.60 $338 $17.061990 39.84 $304.60 $321 $16.211989 37.54 $301.49 $306 $4.461988 36.21 $291.80 $297 $5.561987 35.89 $287.90 $295 $7.401986 34.84 $261.50 $289 $27.021985 35.14 $284.40 $290 $6.061984 36.19 $292.00 $297 $5.241983 33.184 $290.10 $278 ($12.28)1982 32.15 $290.00 $271 ($18.85)1981 31.87 $277.00 $269 ($7.66)

Models of Trends

• Simple Linear Trend in Time– f(t) = a + bt + Error(t)

• Quadratic Trend in Time– f(t) = a + bt + ct2 + Error(t)

• Exponential Trend in Time – – Log(F(t)) = a + bt + Error(t)

)()( terrorbtetf a

Trend ExamplesExamples of Different Forms of Trend

0

50

100

150

200

250

300

Time

Data

Linear

Quadratic

Exponetial

Pork Tax Revenues

Predicted Value

Prediction Error

Predicted Value

Prediction Error

Predicted Value

Prediction

ErrorPredicted

ValuePrediction

Error

2000 22221999 1788 2366 578 2264 476 2532 744 2285 4971998 2265 2395 130 2259 -6 2562 297 2113 -1521997 2245 2453 208 2390 145 2597 352 2346 1011996 2385 2505 120 2433 48 2620 235 2343 -421995 2425 2577 152 2501 76 2642 217 2614 1891994 2510 2604 94 2424 -86 2657 147 2291 -2191993 2410 2672 262 2547 137 2684 274 2430 201992 2535 2705 170 2657 122 2701 166 2507 -281991 2644 2749 105 2775 131 2707 63 2941 2971990 2788 2889 101 2653 -135 2698 -90 2540 -2481989 2643 2950 307 2745 102 2704 61 2802 1591988 2750 3052 302 2699 -51 2699 -51 2542 -2081987 2699 2699 26991986 28661985 34881984 29481983 3258

MAD= 211 126 225 180

Comparing Forecast Accuracy

Five Year Moving Average

Exponential smoothing a=0.90

Exponential smoothing a=0.1

Constant Growth Rate

Forecasting

• Pick the method that matches the decision need and phenomenon– Methodological complexity does not

necessarily correspond with accuracy• State assumptions and biases explicitly• Remember that forecasts are (almost)

always wrong!

POLS 7830: Public Financial Management

Lecture 7: Managing public investments

Managing public investments

• Principles and terms• The financial environment• The Yield Curve• Interest Rates• Investments• Pension funds

Basic Principles of Investment

• Safety/Risk• Liquidity• Yield• Propriety

Safety: Minimizing Risk

• Cash in secure banks (Banks vs. S&L)• Short term investments in low risk

securities– (Hierarchy of risk)

• Maintain oversight (auditors, officials, public)

• Maintain procedural safeguards

Hierarchy of Risk for Government Investments

• U. S. Treasuries• Cash in Banks• State and Local General Obligation Bonds• Government Investment Pools• State and Local Revenue Bonds• Commercial Paper• Private Bonds and Equities

Liquidity: Ease of cash conversion

• Cash in banks• Certificates and depository notes• Treasury securities• Equities• Receivables• Inventory• Fixed Assets• Intangibles

Yield• Financial return on invested funds

– Expressed as an annualized percentage of the invested funds

– E.g. A short term note from another government pays $120,000 in 90 days on principal of $12 M. The annualized yield is 4%:

Y=Annualized yield (in percentage) i=interest payment received in periodn=number of periods per yearP=amount of principal

• Economies of scale create incentives for governments to pool investments

100**

PniY

Propriety• What are the appropriate vehicles for public

investment?– Generally low risk and low return– Revenue constraints have increased the risk tolerance of

public funds managers over time• How can the appearance of impropriety be avoided?

– Is the public benefit pursuit clear, unambiguous and realistic?– Do the transactional relationships foster an appearance of

impropriety?• Developing relationships with fiduciary beneficiaries is unavoidable• Policies can stop relationships from impeding governments from

getting the best returns• Skill and information asymmetries exist

Financial Markets• Markets

– Securities: Stocks, bonds, etc.– Money and capital markets– Primary and secondary markets– International markets

• Well functioning financial markets– Lead to efficient allocation of resources– Offer investors necessary information to value

investment alternatives

Financial Institutions• Facilitators in the financial market • Brokers • Intermediaries

– Banks, credit unions, – Insurance companies– Mutual and pension funds– Municipal bond underwriters

• Consumers– Holders of municipal securities, paper and agreements

Terms• Default

– Failure to make an contracted payment on time– Technical default may occur for reasons other than

bankruptcy or project shortfalls• Maturity

– Length of time between security sale and the date when its last cash flow is due to be made

• Duration– Average cash weighted term to maturity of cash flows

in a security (typically a corporate or municipal bond)• Used as a measure of relative interest rate risk between bonds

Measuring Duration

Interest Rates

• Crucial in investment decision making • Depend on demand and supply of money• Affected by

– Federal reserve policy– Federal deficits and foreign trade balance

• Interest rates change over time• Interest rates on different instruments move

in tandem

Determinants of Interest Rates

• Real risk-free rate– rate we would charge to be compensated for

deferring our consumption• Observed interest rates carry premiums for

– Inflation – Default and liquidity risk– Maturity

Inflation Premium

• Nominal vs. real interest rates• Have $100. Can buy 100 burgers at $1

each.• Lend $100 to earn 4% (real rate) so I can

buy 104 burgers next year.• Expect inflation of 3% per year.• Nominal rate? (This is the rate we observe)

Inflation Premium

• Approximation: 4%+3%=7%.– Why approximation?: Get $107. Burger price

$1.03. # of Burgers=107/1.03=103.88• Accurate calculation:

7.12%rate nominal7.12%13%)(14%)1(

rate)inflation (1rate) real(1 rate nominal1

Risk Premium

• Interest rates depend on the riskiness of the security (likelihood of repayment)– Higher interest rate on corporate debt than from

bank deposits – Lower interest rate on municipal debt than from

corporate debt

Risk Structure of Interest Rates

risk ofunit per premium risk rate freeRisk return Expected

-

Risk

ExpectedReturn

rf

Maturity Premium

• Interest rates depend on the time over which the loan will be paid back– Examples: Car and mortgage loans– Observed in the Treasury Yield Curve

Yield Curve

• The expected yield to maturity of bonds increases as the length of the maturity grows

Normal Yield Curve

Term

Yield %

Yield Curve over Time

• In 1981, short term Treasury bills were over 20% while 30 year Treasury bonds yielded over 14%

• In 1993, bills were around 3% with bonds at 5.75%

Steep Yield Curve

• Typically the yield on 30-year Treasury bonds is (approx.) three percentage points above the yield on three-month Treasury bills

• When this spread rises much greater than that long term investors may be signaling that they expect the economy to improve in the near term– Steep yield curve

Steep Yield Curve

Normal Yield Curve

Term

Yield %Steep Yield Curve

April, 1992

Inverted Yield Curve

Normal Yield Curve

Term

Yield %Steep Yield Curve

August, 1981

Inverted Yield Curve

Inverted Yield Curve

• Paradox: Why would long-term investors settle for lower yields than some short-term investors while short-term investors take so much less risk?

• Recession fears convince bond traders to lock in higher rates– Anticipating rate decreases from the federal

reserve

Inverted Yield Curve

February 18, 1999

Hedges

• Financial positions assumed in order to minimize the risk associated with other investments in the event of changing markets

• E.g. Bonds are considered a ‘hedge’ against a falling stock market because bond prices tend to rise when stock prices fall

• Derivative products are typically used as hedges

Term Structure of Interest Rates

• Interest rate = f (time to maturity)• Theories of term structure

– Expectations theory

6% 8%?

%72

%8%6?

rates short term ofmean rate termlong

%99.6?%)81%)(61(?)1( 2

Term Structure (Contd.)• Why ? Arithmetic mean ignores compounding• Use geometric mean:

– Liquidity premium theory• Investors expect higher returns from longer term securities

– Market Segmentation theory• Long and short term markets are segmented• Markets for municipal securities are segmented

Questions?

• What is the relationship between interest rates and financial market performance?

• Why does the stock market go up on the news of unexpectedly high unemployment?

• Why do investors move towards municipal bonds in periods of equity market volatility?

Individual Tax Factors and Financial Markets

• Taxable income– Wages minus allowable expenses

• Tax rate– Progressive tax rates

• Taxation of investment income– Municipal bonds– Dividends vs. capital gains

Corporate Taxes and Financial Markets

• Taxable income– Interest payment is an expense– Dividend payment is not

• Tax rate– Progressive tax rates

• Losses– Carry back/forward

Securities

• Debt: Bonds, notes and commercial paper• Equity: Common stock• Debt vs. equity

* Lender vs. owner * Fixed vs. residual claim* Seniority in the event of financial distress

Fixed Income Securities

• Treasuries • Mortgage Backed Securities• Corporate Bonds• Municipal Bonds• SBA Loans • Preferred stock• Annuities contracts

Bonds and Notes• Terminology:

Face valueCoupon rateCoupon payment dates

Maturity dateMarket price

Example: IBMs02 priced at $997

6/98 6/99 12/99 6/00 12/00 6/0112/98 12/01 6/02 12/02

$45 $45 $45 $45 $45 $45$45 $45 $45$1000+

$45

$997

Bonds and Notes (Contd.)

• Special features: Callability, convertibility, collateral, seniority

• Risk: Interest rate, marketability, default• Rating: Investment grade vs. junk • Discount: Sold at discount based on today’s

prevailing interest rates

Common Stock

• Stockholder rights* voting* value (return on investment)

• Returns (12.67% average for S&P 500)* Cash dividends (4.57% average for S&P 500)* Capital gains (7.81% average for S&P 500)

• Risks: Economy, industry, company

Annuity

• Special case of many cash flows* Equal dollar amounts* Equally spaced* First amount one time period from now

X X X X

43210

Annuity Example• Interest rate = 8% per year. PV?

– Use discount factors or calculator

$400 $400 $400 $400 $400

0 1 2 3 4 5

205971$400$6810400$7350

400$7940400$8570400$9260PV

.,..

...

Annuity Example (Contd.)

* Use annuity factor (Appendix B)

• Annuity factors are sums of discount factors!

$1,597.20400$9933PV

.

Annuity (Contd.)

• The amount that, when multiplied by the cash flow in an annuity, gives the PV of the annuity is known as an annuity factor* Annuity factors are listed in back of packet for

select interest rates (k) and number of cash flows (n)

* In general,

nk)1(11

k1factorannuity

Annuity (Contd.)

• Annuities are encountered quite often• Some examples

* Auto loan* Home mortgage* Bond interest payments* Stock dividends (in many cases)

Perpetuity

• Annuity that goes on forever

X X X X

43210…

kXPV

Perpetuity Explained• Why ? Because,

kXPV

n

1k)1(

11lim n

n

0k)1(

1lim n

because

Perpetuity Explained

kXPV So, because

nk)1(11

k1factorannuity

k11

k1factorannuity

And as n approaches then

Perpetuity Example• Stock is expected to pay dividends of $0.60

per quarter for the foreseeable future. Discount rate=3% per quarter. Value?

$0.60 $0.60 $0.60 $0.60

43210…

20$0.03

$0.60PV

Growing Perpetuity

• A perpetuity where cash flows grow at a constant rate

X X(1+g) X(1+g)2 X(1+g)3

43210…

gkXPV

Growing Perpetuity Example• Stock is expected to pay dividend of $0.60

next quarter. Dividends are expected to grow at 1% per quarter. Discount rate=3% per quarter. Value?

$0.60 $0.606 $0.612 $0.618

43210…

30$0.010.03

$0.60PV

Public Pension Funds• About 9,000 PERS in the United States• 50% in MN, FL, IL, MI• 71 % in cities• 12% in counties• 10 % in special districts• 4 % in states• 80% have fewer than 100 members• Plans represent more than 4 million persons• Of $99.4 billion received by PERS in 1987, 59%

came from investment earnings

Types of Public Pension Funds• Defined Benefit Plans

– Retirees entitled to a specific ‘defined’ benefit– Benefit is based on a formula that gauges length of

service and final salary– Employer is obligated to set aside and manage funds to

assure adequate benefits• Defined Contribution Plans

– Retirees entitled to a certain contribution to their retirement accounts

– Employers obligation ends upon depositing funds– Employee manages retirement account until she retires

and withdraws the funds.

Pension Benefit Formulae• Flat benefit formulas

– Retirement benefit based upon some flat percentage of compensation

– E.d. 50% of retirement salary after 20 years of service– FBF represent a small portion of pension funds

• Unit benefit formulas– Retirement benefits equal the ‘unit benefits’ that have

accumulated over employment multiplied by the employees final average salary• Single rate unit formula: Benefit rate is fixed• Step rate formula: Benefit rate changes over years of

employment (e.g. 1.5 for years 1-10, 2.0 after)• Final average salary

• Average during last 3-5 years, or highest 3-5 years

Public Pension Fund Administration• Statutorily established administrative and

governance procedures• Key personnel

– Retirement board (trustees)• Policy making body for the fund• Approve/adopt interest-rate and mortality tables for actuarial

calculations• Approve methods for system control and financial reporting• Establish investment policy

– System administrator (executive director)• Operations management• Recruits and supervises fund personnel• Deals with constituencies (members, taxpayers, legislature,

investment houses, etc.)

Public Pension Fund Administration• More key personnel !

– Consultants• Legal counsel• Actuaries

– Determine liability of the fund using demographic techniques – Render judgement about funds ability to meet these liabilities– Propose benefit and contribution amendments

• Investment advisors• Auditors• Custodians

– Bonded keepers of cash and securities

Actuarial Variation

• Pension funds can finance their obligations through one of two methods– Pay-as-you-go approach

• Appropriate all of the pension payments as the obligations become due each period

– Reserve funding approach• Appropriate some portion of the needed funds when

the amount due is known and invest funds to meet the obligation when it come due

Reserve Funding Methods

• About 80% of PERS use reserve method• Relies upon an actuarial procedure

– Expected value of future benefits estimated• Actuarial present value of total projected benefits

– Expected value apportioned to past, current and future time periods

– This process determines the necessary contributions to adequately fund the plan over time

Actuarial Funding Concepts

• Actuarial present value (APV): The present value (on the actuarial value date) of the projected benefits (discounted by the probability of payment)– APV is the amount necessary to invest as of the

actuarial value date to pay the total projected benefits under the system

Actuarial Funding Concepts• Normal cost: The portion of APV of total benefits

attributable to a given year• Actuarial accrued liability (AAL): Sum of the

costs assigned to years before the valuation date (plus interest accrued on those costs)

• Unfunded actuarial accrued liability (UAUL)=AAL-Total plan assets– Must be funded by future contributions

• Current pension fund expense = Normal cost + amortized portion of UAUL

Actuarial Funding Methods

• Unit Credit Actuarial methods:– Accumulated benefit approach credits benefits

using the employees service and salary history as of the valuation date, presuming all salary years equal the last year

– Credited projected benefit approach credits benefits using the employee’s service history as of the valuation date and the projected salary on which the benefits will be based

Actuarial Funding Methods

• Entry-age-Normal method:– Computes the total cost of funding projected

benefits (including future service obligations) and allocates the cost to the years of past credited service and expected future service• Allows a fixed percentage of payroll to be dedicated

to this purpose

Actuarial Funding Methods

• Aggregate Actuarial Cost method: – The difference between the APV of projected

benefits for the group and the AV of assets is allocated on a level basis between valuation date and the projected exit date of the group• No unfunded actuarial liability under this method

Actuarial Assumptions

• Conservative actuarial assumptions help to avoid surprises (fiscal disaster)– Assume modest rates of return (typically lower

than prevailing rates on ten year treasury bonds)

– GFOA survey found plans assuming average salary increases at 5.92%, well below cost index for S&L government workers

Actuarial Valuation of Assets• Cost method

– Investment return is calculated as the sum of ordinary income plus capital gains and losses during the investment period

• Market method– Investment value taken at market price on date of

actuarial valuation• Moving average method

– Captures projected long-term growth based on value during previous selected periods

Pension Fund Issues• Allocating adequate resources to meet APV• Use of more aggressive investment strategies• Use of arbitrage

– (NJ) Governor Whitman borrowed $2.8 billion in taxable municipal bonds (6/97) to invest in the stock market to meet pension obligations• Included $590 Million for the present and following year

pension contributions• Issues related to shifts toward defined contribution

plans– Equity considerations in preparation of employees– Equity considerations in conversion

POLS 7830: Public Financial Management

Lecture 8: Accountability, Control and Ethics

Ethics• What constitutes ethical behavior in financial

management?• Misfeasance

– Wrongful exercise of legal authority• E.g. Selecting vendors without bidding

• Malfeasance– Unlawful acts, official misconduct– Misuse of fiduciary funds

• Impropriety– Improper comments or conduct, or those which a reasonable

person would construe as improper• Judgement errors• “Are you an ethical public employee?”

– What explains the apparent disconnect between students and practitioners?

Human Motivation and Incentives

• Public sector employees commonly altruistic and service oriented– Even altruists focus on how actions affect them

personally– Individuals brings their own ideals and goals

• Incentive structures may encourage compliance with organizational goals– Policy guidelines, rewards and penalties

Ethics statements, policies & codes• Prescription

– What actions are necessary for ethical behavior? – How can these actions be assured?

• Proscription– What actions constitute misfeasance, malfeasance,

impropriety or judgement errors?– How can these actions be avoided?

• Nordstrom: “Each employee shall exercise her (his) best judgement…”

Ethics statements, policies & codes• Key professional organizations• Key elements of codes

– Competence– Confidentiality– Integrity – Objectivity/Independence

• National Association of State Treasurers• Government Finance Officers Association (GFOA)• National Association of Accountants (NAA)

– Only code to specifically mention competence

Positions, Power and Hubris• Financial Management is an arcane area with

much significance in government– Terminology and concepts are opaque and jargonistic– Premium on education and position skills separates

financial managers, analysts from others– Natural culture tends to be exclusionary

• Can create arrogance and distance from organization and the citizenry

Elements of Financial Management Control Systems

• Audit• Personnel• Separation of functions• Authorization• Adequate documentation• Proper procedures and policies• Physical safeguards• Bonding• Vacations and duty rotations• Independent checks

Control Systems (cont.)• Monitoring

– Policy compliance– Administrative procedures– Transactions– Incentive structures– External perceptions of internal activity

• Performance Measurement– Process measures are important!– Outcomes

POLS 7830: PUBLIC FINANCIAL MANAGEMET

Lecture 9: Variance Analysis

Variance Analysis• Variance analysis investigates differences

(variances) between planned and actual results. It helps managers:– prepare budgets for the coming years– control results in the current year– evaluate the performance of operating units

• Variance analysis focuses on material differences to help managers correct problems and capitalize on opportunities

Some Variance Terms• Variance analyses can be prepared for costs, revenues,

and profits/(losses)– Variances are favorable when they work to the

organization’s benefit. Lower than expected costs are favorable as are higher than expected revenues or profits• Favorable variances are designated with a capital “F”

– Variances are unfavorable if they do not work in the organization’s favor. Higher than expected costs are unfavorable as are lower revenues or profits• Unfavorable variances are designated with a capital “U”

Variance Mechanics

Example: The budgeted and actual costs and the resulting month and Year-to-Date variances for the Hospital for Ordinary Surgery illustrate an unfavorable cost variance

Month Year-to-Date MonthYear-to-

Date MonthYear-to-

DateDirect Expenses

PersonnelTechnologist III $7,250 $21,750 $7,250 $21,750 $0 $0Technologist II $6,250 $18,750 $7,813 $16,425 $1,563 U -$2,325 F

Physician $47,917 $143,751 $51,317 $169,318 $3,400 U $25,567 U

Nurse, RN III $6,886 $20,658 $8,413 $25,239 $1,527 U $4,581 UNurse, RN II $9,829 $29,487 $9,896 $29,688 $67 U $201 UNurse, RN I $4,719 $14,157 $4,719 $14,157 $0 $0Nurse, LPN $10,131 $30,393 $10,541 $31,623 $410 U $1,230 U

Actual VarianceBudget

Hospital for Ordinary SurgeryMonthly Budget (Variance) Analysis

Period Ending March 31, 1999

Orthopedics Department

Department and Line Item Variances

• Variances at most levels of an organization represent aggregations of variances from other levels

Example: total organizational expense variances represent the sum of departmental variances, while departmental variance are made up of line item variances

Month Year-to-Date MonthYear-to-

Date MonthYear-to-

Date

Histology 76,890 230,670 78,812 244,318 1,922 U 13,648 UNeurology 120,000 360,000 121,468 364,403 1,468 U 4,403 UObstetrics 254,319 762,957 260,295 810,562 5,976 U 47,605 UOrthopedics 92,982 278,946 99,948 238,200 6,966 U -40,746 FOtolaryngology 115,000 345,000 119,071 297,678 4,071 U -47,322 FPediatrics 196,450 589,350 207,058 628,505 10,608 U 39,155 UPolemics 23,516 70,548 23,516 76,427 0 U 5,879 U

Totals 879,157 2,637,471 910,169 2,660,092 31,012 22,621

Monthly Budget (Variance) AnalysisPeriod Ending March 31, 1999

Budget Actual Variance

Department Summary

Hospital for Ordinary Surgery

Flexible Budget Variance Analysis• Flexible variance analysis allows managers to

identify what portion of a total variance is due to:– differences between the budgeted and actual volume of

some output (Volume Variance)– differences between the budgeted and actual price (or

rate) of each unit of input or output (Price or Rate Variance)• Where is production on the average cost curve?

– differences between the budgeted and actual quantities of the resources used per unit of output (Quantity or Use Variance)

Volume, Price and Quantity

School Cost Example Hospital Revenue Example

Total cost of textbooks Total Patient Revenue

Volume

Quantity

Price

Number of third grade students

Number of textbooks per third grade student

Cost per textbook per third grade student

Number of oncology patients

Days of stay per oncology patient

Price per day of stay per oncology patient

Conducting Flexible Budget Variance Analysis

Monthly Budget (Variance) Analysis for March

Actual Budget VarianceBooks $120,000 $100,000 $20,000 U

Budget calls for $50 of books per student and expected 2000 students to enroll, hence $50*2000= $100,000. $105,000 would have been budgeted for an enrollment of 2,100 students.

Monthly Budget (Variance) Analysis for March

ActualFlexible Budget

Original Budget

Books $120,000 $105,000 $100,000 U

$15,000 U $5,000 UVolume Variance

$20,000 UTotal Variance

Town of Millgridge High School

Flexible Budget Variance

Investigating the Flexible Budget Variance

• Once the volume variance is accounted for, the remaining variance is a result of price and quantity

• Our next step is to investigate the flexible budget variance (in this case $15,000) to determine what causes it

• Now we must calculate the price and quantity variances

Flexible Budget Notation (Expense Variances)

BPi: Budgeted price per unit of inputBQi: Budgeted quantity of input for each unit

of outputBQo: Budgeted quantity of outputAPi: Actual price paid per unit of inputAQi: Actual quantity of input for each unit of

output producedAQo: Actual quantity of output

Millbridge HS Flexible BudgetBPi: $20 per textbook BQi: 2.5 textbooks per studentBQo: 2,000 studentsAPi: $22 per textbookAQi: 2.597 textbooks per studentAQo: 2,100 students

Note: We must have these 6 pieces of information to conduct the flexible budget variance analysis

Step 1: Calculate the original budgetBQi * BPi * BQo2.5 * $20 * 2,000 = $100,000

Step 2: Calculate the flexible budgetBQi * BPi * AQo2.5 * $20 * 2,100 = $105,000

• Difference between the original budget and the flexible budget due to a difference in the number of students (Volume Variance)

Flexible Budget

Original Budget

BQi * BPi * AQo2.5 * $20 * 2100

$105,000 $100,000

$5,000 UVolume Variance

BQi * BPi * AQo2.5 * $20 * 2000

Step 3: Compare the Flexible Budget to the Actual Spending

ACTUAL COSTAQi * APi * AQo2.597 * $22 * 2,100= $120,000

• The difference between the flexible budget and the actual cost is the Flexible Budget Variance

Flexible Budget

Actual Cost

BQi * BPi * AQo2.5 * $20 * 2100

$105,000 $120,000

$15,000 UFlexible Budget Variance

AQi * APi * AQo2.597 * $22 * 2100

• The total variance is now expressed as the combination of the flexible budget and volume variance

Actual Cost

Flexible Budget

Original Budget

BQi * BPi * AQo2.5 * $20 * 2100

$120,000 $105,000 $100,000

$15,000 UFlexible Budget Variance Volume Variance

$20,000 UTotal Variance

$5000 U

AQi * APi * Aqo2.597 * $22 * 2100

BQi * BPi * AQo2.5 * $20 * 2000

Deriving a Subcategory• Flexible budget variance does not provide enough

information by itself to tell decision makers what is causing the variance

• Need to separate the flexible budget variance into its price and quantity components

• Deriving a subcategory allows us to separate the flexible budget variance into its price variance and quantity variance components

Step 4: Derive a Subcategory (Actual quantity of input per unit of output * budgeted price of input*output level)

SUBCATEGORYAQi * BPi * AQo2.597 * $20 * 2,100= $109,000

Step 5: Find the Price Variance• If the subcategory calculation is compared

to the actual costs, the price variance can be determined (Actual vs. budget price is the only difference):

AQi * BPi * AQo2.597 * $20 * 2100

AQi * APi * AQo2.597 * $22 * 2100

SubcategoryActual Cost

$120,000 $109,000

Price Variance $11,000 U

Step 6: Find the Quantity Variance• If the subcategory calculation is compared

to the flexible budget, the price variance can be determined (Actual vs. budget quantity is the only difference):Flexible

BudgetAQi * BPi * AQo BQi * BPi * AQo

2.597 * $20 * 2100 2.5 * $20 * 2100$105,000$109,000

$4,000 U Quantity Variance

Subcategory

AQi * BPi * AQo BQi * BPi * AQo2.597 * $20 * 2100 2.5 * $20 * 2100

$105,000

$4,000 U Quantity Variance

$15,000 U

AQi * APi * AQo2.597 * $22 * 2100

SubcategoryActual Cost Flexible Budget

Flexible Budget Variance

$120,000 $109,000

Price Variance $11,000 U

Step 7: The truth is revealed

AQi * BPi * AQo BQi * BPi * AQo2.597 * $20 * 2100 2.5 * $20 * 2100

$105,000

$4,000 U $5,000 U Quantity Variance Volume Variance

$15,000 U

AQi * APi * AQo2.597 * $22 * 2100

SubcategoryActual Cost Flexible Budget

Flexible Budget Variance

Original Budget

$120,000 $109,000

Price Variance $11,000 U

BQi * BPi * AQo2.5 * $20 * 2000

$100,000

$20,000 UTotal Variance

Investigating Flexible Budget Revenue Variances

Example: The Hospital for Ordinary Surgery (HOS) expected to remove 100 gall bladders at an average revenue of $3,000. The performed 90 surgeries at an average revenue of $3,100. Actual Revenue was $279,000 (90 cases * $3,100). HOS can use flexible budget variance analysis to investigate the $21,000 variance.

Flexible Budget Notation (Revenue Variances)

BPo: Budgeted price per unit of outputBQo: Budgeted quantity of outputAPo: Actual price paid per unit of outputAQo: Actual quantity of output

Flexible Budget Notation (Revenue Variances)

Hospital for Ordinary Surgery (HOS)BPo: $3,000BQo:100APo: $3,100AQo:90

Price Variance$9,000 F

Original BudgetBPo * BQo

Flexible BudgetBPo * AQo

ActualAPo * AQo

$3,000 * 90$270,000

$3,100 * 90$279,000

Total Variance$21,000 U

$3,000 * 100$300,000

Volume Variance$30,000 U

POLS 7830: Public Financial Management

Lecture 10: Long term financing concepts

Capital assets

• Useful lives of more than one year• Low-cost long-life assets not subjected to

capital budgeting analysis• Cost creates need for long-term financing

through capital campaigns, mortgages, loans, leases and equities offerings

• Decision to use long-term financing depends on size of the organization

Capital budgeting rationale

• Mistakes are costly with large investments• Capital purchases commit the organization

for the long term• Operating budgets do not have a long-term

focus• The cost of long term borrowing a key

component of the budget and budget process

Simple and Compound Interest• Simple interest is the basis for all time value of

money calculations. It is the interest that one earns in each period on the original amount of an investment.

• Compound interest includes simple interest (the interest on the amount of the original investment) but it adds to the principal the interest from all intervening interest payments.

• The calculation of compound interest requires that you know the interest rate being paid and the frequency of interest payments.

Compounding and Discounting• Compounding finds the value at some point

in the future of a dollar invested today at a given rate of interest

Starting Principal (Present Value)

Compound Interest

Calculation

Ending Compound

Value (Future Value)

Ending Simple Interest Value

$100.00 $100 * 1.12 = $112.00 $112.00$112.00 $112 * 1.12 = $125.44 $124.00$125.44 $125.44 * 1.12 = $140.49 $136.00$140.49 $140.49 * 1.12 = $157.35 $148.00

Compounding

Discounting

Time value of money• A dollar received at some point in the future

is worth less than a dollar received today.• Example: The Museum of Technology is

considering buying computers for a new special exhibit. The computers will cost $40,000 today and will generate $10,000 in admission fees in each of the next four years. What should management do?Period 0 Period 1 Period 2 Period 3 Period 4

$10,000 $10,000 $10,000 $10,000

-$40,000

Time value of money• What should management do?

– The money received years down the road is less useful than that in hand today

– Management gives up the use of the $40,000 that would otherwise earn some return

– So, the $40,000 annuity is worth less than $40,000– How much less depends on returns from alternative uses of

these funds!– Key: Find the (“discounted”) present value of this annuity

Present Value and Future Value

• Present Value is the value of an investment at the starting point (or any point before the end) of the investment.

• Future Value is the compound value of any investment for any point beyond the starting point.

Present Value and Future ValuePresent Value

Future Value

$100.00 = $112.00$112.00 = $124.00$125.44 = $136.00$140.49 = $148.00[100*(1+.12)*(1+.12)*(1+.12)] * (1 + .12)

Interest Calculation

100*(1+.12)[100*(1+.12)] * (1+.12)

[100*(1+.12)*(1+.12)] * (1+.12)

Present Value Future Value

FVr

PV n *)1(

1

PVrFV n *)1(

Present Value and Future Value

$100.00 = $112.00$112.00 = $125.44$125.44 = $140.49$140.49 = $157.35[100*(1+.12)*(1+.12)*(1+.12)] * (1 + .12)

100*(1+.12)[100*(1+.12)] * (1+.12)

[100*(1+.12)*(1+.12)] * (1+.12)

Present Value Future Value

FVr

PV n *)1(

1

PVrFV n *)1(

PV and FV Using a Calculator

• Four variables, so enter any three to find the fourthPV= Present ValueFV= Future ValueI/Y=Interest rate per compounding periodN= Number of compounding periods

• Adjust I/Y and N according to the number of periods per year in your application

A Present Value Example• Suppose someone offered to pay you

$237,699 in forty years and you could invest your money at 8% with quarterly compounding. How much would that future payment be worth today?

Time line for single cash flow

0 2% 1 2 3 … 160

? $237,699

A Present Value Example• Suppose someone offered to pay you

$237,699 in forty years and you could invest your money at 8% with quarterly compounding. How much would that future payment be worth today?

• PV=?• FV= $237,699• I/Y=8% or 2% per quarter• N=40 years or 160 quarters

FVr

PV n *)1(

1

000,10$237699*)02.1(

1160

Multiple Cash Flows• Often capital investments generate more than one

cash flow. In these cases you calculate the PV or FV for each flow and sum them. – If the cash flows are equal you can annuitize them!

• Example: You have convinced your boss that you can achieve annual savings of $3,000, $5,000 and $7,000 in each of the next three years by purchasing new notebook computers for your staff. The cost of borrowing is 10% for your organization. How much can you afford to spend?

How much can we afford to pay?

0 10% 1 2 3

PV=? $3,000 $5,000

FV= 3000 FV= 5000 FV= 7000I/Y=10% I/Y=10% I/Y=10%N=1 N=1 N=1

PV =$2,727 PV =$4,132 PV =$5,259

= $12,118

$7,000

Annuities• If cash flows are equal you can annuitize them• An annuity is a special case of multiple cash flows. In an

annuity all of the cash flows are equal and they are paid or received at equidistant intervals.

• Examples:– Lottery payments of $250,000 per year for 20 years– Car-loan payments of $299 per month for 48 months– Five year 50 per month donor pledges– Pension payments of $2,000 per month for (what’s left of) life

Annuities• Example: Computer related revenues

• Assume a discount rate of 8% compounded annually. Find the PV for this annuity:– PVAF (4,8%)=3.3121 (.926+.857+.794+.735)– 10,000*3.3121=33,121

• So, at 8% compounded quarterly, this set of cash flows is only worth $33,121 today

Period 0 Period 1 Period 2 Period 3 Period 4$10,000 $10,000 $10,000 $10,000

-$40,000

Annuities• Example: Computer related revenues

• So, at 8% compounded quarterly, this set of cash flows is only worth $33,121

Period 0 Period 1 Period 2 Period 3 Period 4$10,000 $10,000 $10,000 $10,000

-$40,000

Future and Present Values of Annuities• Future Values and Present Values can be

calculated for any annuity– The Future Value of an annuity is the amount that a

stream of fixed payments will be worth at the end of some period. • Example: the future value of a stream of $1,500 monthly

deposits into an IRA for thirty-five years would be the amount that was available for retirement

– The Present Value of an annuity is the value today or a stream of future payments. For • Example: the cost of a car financed with a five year car loan

Annuities, You and Your Calculator• The usual suspects; PV or FV, I/Y,N• PMT= the amount of one of the (equal)

payments• To find any of the four variables, enter the

other three and compute the missing item.• Compounding periods and interest rate must

be adjusted if interest is compounded more than once per year

Annuities, You and Excel• =PV(I/P,PMT,N,FV)• I/P =Interest rate per period• PMT=Payment per period• N=Number of periods• FV=Amount remaining at end of annuity

(typically 0)• Returns a Negative number for positive

cash flows. Why?

Example: Future Value of an Annuity• So your deposits clerk has been embezzling

$2,000 every June for the past thirty five years and putting it in an IRA at 12%. How much money will she have available in the future to pay for her legal defense?

0 12% 1 2 3 … 35

(2,000.00) (2,000.00) (2,000.00) (2,000.00)

FV=$863,327

Finding the Future Value

• You can find the answer by calculating the Future Value of each of the 35 cash flows separately and adding them up. OR you can use an FVAF table or a calculator.

PMT= -2,000I/Y=12N=35Compute FV= $863,326.99

Solving for the payment

• You decide that you want $863,327 at retirement, but you only have 30 years left and assume you will get only 9% average returns on your investments.– How much money should you save each year in

order to reach that goal?– Solve for PMT– PMT = -6,333.67

Solving for the payment• Congratulations! You have saved $863,327 and

you have retired at age 65. – How much money will you have to live on each month

for the 7 years until you die at age 72?Solve for PMTPV=863,327I/Y = 9%/12N=7*12Compute PMTPMT = -$13,890.14

Long Term Financing• Used to obtain the resources to pay for capital

assets when capital costs exceed the cash available from operations– Capital Campaigns: fundraising drives aimed at

raising money to pay for long-lived assets.– Long Term Debt: borrowed money with a maturity of

more than one year. Short term debt refers to borrowed money that must be repaid within one-year.

– Leases: contracts to make fixed payments in return for the right to use a capital asset.

– Equity: additions to the permanent capital of a for-profit organization

Mixed Cash Flows• It is not uncommon to find situations where the

cash flows generated by capital investments result in combinations of annuities and unequal cash flows. Now we will have three steps:– Use the annuity calculations to find the PVs or FVs of

the annuities, then– Use the single payment calculations for PVs and FVs of

all other cash flows– Add them up!

Mixed Cash Flows

• Example: Your friendly broker offers to sell you an investment that pays you $2,000 at the end of five years, and $500 at the end of years 2,3 and 4. You must pay $2,500 for this investment and you could get 10% in prevailing interest rates. What should you do?

Mixed Cash Flows

0 10% 1 2 3 4 5

$500 $500 $500 $2,000

Three year annuity of $500

Single payment of $2,000

Finding the PV of the Mixed Cash Flows• First, find the PV of the three year annuity as of

year 1.PV=? PMT=500 I/Y=10% N=3PV=$1243.43 in year 1

• Next, find the PV of that amount in year 0PV=? FV=$1243.43 I/Y=10% N=1PV = $1130.39

• Third, find the year 0 PV of the single cash flow in year 5PV=? FV=$2000 I/Y=10% N=5PV = $1241.84

• Add up the year 0 PVs!Total PV=$1130.39+$1241.84= $2372.23

Type of Long-Term Debt

• Long-Term Notes- unsecured loans• Mortgages -loans that are backed by a

security-interest in land and/or buildings that are owned by the borrower

• Bonds- standardized loan arrangements between borrowers and lenders

PV, FV and Capital Investments

• Four principles of Capital Investment Analysis– Include all cash flows in the analysis– Adjust cash flows for the time value of money– Consider the riskiness of the investment and the

cash flows from the analysis– Rank the projects in accordance with the

organization’s goals

Net Present Cost Method

• Used to evaluate alternative ways of meeting organizational needs

• The present value of the costs of each alternative are calculated

• The alternative with the lowest net present cost is selected

A Net Present Cost Example• Meals for the Homeless is considering

buying one of two refrigerators for their kitchen. Either unit meets their needs. Which model should they select?

Year Kelvinator 2000 Frost QueenPurchase 0 $105,000 $60,000Annual Outlay 1 10000 20000

2 10000 200003 10000 200004 10000 200005 10000 20000

Total Cost $155,000 $160,000

Finding the Net Present CostsKelvinatorPMT=10,000I/Y=10%N=5 PV?PV of the 5 year annuity is

$37,908Add the purchase price

$37908+105000NPC=$142,908

Frost QueenPMT=20,000I/Y=10%N=5 PV?PV of the 5 year

annuity is $75,816Add the purchase price

$75816+60000NPC=$135,816

Using the Annualized Cost Method• Used to evaluate alternative ways of meeting an

organizational need when the useful lives of the equipment differ.

• First calculate the net present cost of each alternative

• Then ‘annualize’ that amount by finding the value of the annuity payment that is equal to the net present cost over the useful life of each piece of equipment.

• Select the alternative with the lowest annualized cost.

An annualized cost example• Perhaps the two refrigerators under

consideration by MFH have different lives. Which model should be selected?

Year Kelvinator 2000 DominatorPurchase 0 $105,000 $60,000Annual Outlay 1 10000 20000

2 10000 200003 10000 200004 10000 200005 10000 -

Total Cost $155,000 $140,000

Annualized Cost CalculationsKelvinatorPMT=10,000 I/Y=10%N=5PV is $37,908. Add

purchase price $37,908+ $105,000NPC=$142,908• Annualize the cost:

PV=142908 I/Y=10% N=5

PMT=$37,699

DominatorPMT=20,000I/Y=10% N=4PV is $66,398. Add the

purchase price $66398+60000

NPC=$135,816• Annualize the cost:PV=135816I/Y=10% N=4PMT=$38,928

Using Net Present Value• NPV is used to evaluate capital investment

alternatives that generate cash inflows (revenues) and cash outflows (costs)

• Find the net cash flow in each year of the investment for each alternative by subtracting cash outflows from cash inflows. [Note: We do not use revenue and expense on an accrual basis for these calculations. Why???]

Using Net Present Value

• Find the present value of the net cash flows generated by each investment

• If the Net Present Value is greater than zero, make the investment. If choices have to be made, rank the investments in order of their net present values.

A Net Present Value Example• HOS is considering a $5 million investment

in a new lab. The lab is expected to generated costs and revenues as displayed below. If the cost of funds is 10%, should they undertake the project? (Numbers in thousands)Year: 0 1 2 3 4 Total

Cash in $2,700 $2,800 $2,900 $3,000 $11,400Cash out $5,000 $1,000 $1,300 $1,400 $1,600 $10,300

Total ($5,000) $1,700 $1,500 $1,500 $1,400 $1,100Present Value ($5,000) $1,546 $1,240 $1,127 $956 ($132)

Internal Rate of Return• The Internal Rate of Return (IRR) method is an

alternative method of evaluating capital investments that generate both cash inflows and outflows.

• It tries to find out how much the organization earned on a percentage basis on its investment in the project.

• The IRR is defined as the discount rate that sets the present value of the cash inflows generated by the investment equal to the cash outflows required to fund the investment.

Calculating the IRR • If the cash inflows are an annuity, the IRR is the

interest rate in an annuity calculation.

• Example: PV=$3250 PMT=1500 N=3 I/Y=?

Year: 0 1 2 3Cash inflow: $1,500 $1,500 $1,500

Cash outflow: $3,250

Calculating the IRRPV Outflow= $3250PV Inflow= ? Where PMT=$1500, N=3 I/Y=?(By definition):PV Outflow=PV Inflow at IRR, so PV Inflow=$3250, PMT=$1500 N=3, I/Y=?IRR= 18.22% per year• When the cash flows are unequal, calculating IRR

is a more complicated, iterative process– Use a spreadsheet or a calculator like the BAII Plus

(note: limits)

Limitations of the IRR

• IRR assumes that all cash flows are reinvested at the rate of return generated by the project

• The IRR method may misrank mutually exclusive projects if they differ greatly in size

• The method can produce multiple solutions

The Payback Method• Used to select among investment alternatives that

generate both cash inflows and outflows• Seeks the alternative that returns the original

investment to the organization in the shortest period of time

• Shortcomings– PM ignores all cash flows after the break even is

reached– PM ignores the time value of money

• Since the break-even period is a rough measure of project risk, it can be useful as a tie-breaker, especially if the discounted break-even method is used.

Payback Method, Example(using 10% discount rate)

YearCash

Flow ACash Flow A (Discounted)

Cash Flow B

Cash Flow B (Discounted)

Cash Flow C

Cash Flow C (Discounted)

0 -$1,000 -$1,000 -$1,000 -$1,000 -$1,000 -$1,0001 $100 $91 $900 $818 $100 $912 $900 $744 $50 $41 $100 $833 $100 $75 $200 $150 $700 $5264 $1,000 $683

Total: $100 -$90 $150 $9 $900 $383

2 NEVER 3 3 4 4Years to Payback:

Other issues in capital budgeting and analysis

• Selecting the appropriate discount rate -problems in finding the ‘cost of capital’ for not-for-profit and public organizations

• Adjusting for inflation when the impact of inflation differs by the type of cash flow

• Allowing for the uncertainty in forecasted cash flows

Types of Long-Term Debt

• Long-Term Notes- unsecured loans• Mortgages• Bonds• Capital leases ???

Long-Term Debt

Calculating Mortgage Payments

• Mortgages call for equal periodic payments which repay the amount borrowed and pay interest to the lender.

• Early mortgage payments are mostly principal while later ones are mostly interest

Understanding Mortgage Payments

• Since Mortgage payments are equal in size and paid at evenly spaced time periods, they are annuities. Here’s how payments are calculated for a 30 year mortgage:

$500,000.

1%

Year: 0 1 2 3 … 359 360

Interest: ($5,055) ($5,053) ($5,052) $100 $52Principal: ($88) ($90) ($91) ($5,243) ($5,195)Payment: ($5,143) ($5,143) ($5,143) ($5,143) ($5,143)

Bond Characteristics• Bond agreements specify:

– the amount borrowed called the stated, face or maturity value of the bond,

– the maturity date when the money must be repaid,– the rate of interest, called a coupon rate, which will be

paid on the face value if the bond, and– the time intervals at which the interest must be paid.

Usually every six months!• These factors are fixed for the life of the bond

Typical Coupon Bond Cash Flows• Bonds are an example of mixed cash flows!

Here is the timeline for a ten year, $1,000,000 bond that bears an interest rate of 10% per annum and pays interest every six months.

$1,000,000.

Year: 0 1 2 3 … 19 20

Interest: ($50,000) ($50,000) ($50,000) ($50,000) ($50,000)Principal: ($1,000,000)

Valuing a Bond• Normally, bonds can be sold by their owners. But,

interest rates fluctuate on a daily basis.• Since the cash flows from bonds are fixed, bond

prices vary with changes in interest rates.• Here’s the general rule. Bonds are worth the

present value of the stream of cash flows that they generate discounted at the current market rate of interest.

• Suppose that we own a $1,000,000, 10%, 10 year bond and want to sell it in a market where interest rates have risen to 12%. What will the bond be worth?

The Cash Flows Are Fixed!

• Regardless of the market interest rate, the cash flows from the bond are fixed! To value the bond we only change the interest rate used in the PV calculations to reflect the current market rate!

The Calculations• First, calculate the PV of the $50,000 annuity

using the 12% market interest rateN=20, i=6%, PMT=$50,000 PV = ?PV=$573,496

• Second, calculate the PV of the $1,000,000 repayment of principal.N=20, I=6% FV=$1,000,000 PV = ?PV = $311,805

• Then, add the two PVs to get the value of the bond.Value of Bond=$573,496 + $311,805=$885,301

Leases• Types of Leases

– Operating Leases– Capital Leases

• Possible Advantages of Leasing– Flexibility and protection against obsolescence– Lower costs from pass-throughs of interest, equipment

cost, and tax related savings• Possible disadvantages of leasing

– Tendency toward higher costs• Capital lease obligations are valued at the PV of

the remaining future lease payments

Lease Pools• Lease pools designed to

– Allow smaller governments to capture economies of scale by leasing centrally with others

– Capture the lowest long term borrowing rates for the participants

POLS 7830: Public Financial Management

Lecture 11: Municipal Bonds

Municipal Bonds

1. Municipal bond basics2. Security types3. Issuance process4. Interest Costs5. Bond calculations6. Current topics in bond issuance

Municipal Bond Market facts• State and local municipal debt: $1.3 trillion• Volume of municipal bond issuance (in

billions)– 1980 $ 76.2– 1984 $ 128.8– 1996 $ 226.6– 1998 $320.8

YearShort-Term

Long-Term Total Year

Short-Term

Long-Term Total

1980 27.7 48.5 76.2 1990 34.8 128 162.81981 37.4 47.8 85.2 1991 44.8 172.8 217.61982 44.8 79.1 123.9 1992 43 234.8 277.81983 36.9 86.8 123.7 1993 47.5 292.5 3401984 20.8 108 128.8 1994 40.3 165.1 205.41985 23.1 222.2 245.3 1995 37.9 160 197.91986 22.2 151.6 173.8 1996 41.5 185.1 226.61987 20.5 105.1 125.6 1997 46.2 220.7 266.91988 23.7 117.3 141 1998 34.6 286.2 320.81989 29.6 125 154.6

Source: Securities Data Company

Municipal Bond Issuance1980 - 1998 ($ Billions)

Municipal Bonds, Basics

• Tax exempt status lowers interest rates• Tax exempt status raises price• Prevailing interest rates and bond prices are

inversely related• Bonds, Coupons, Indentures

#of Total # of Defaulted Long-Term Default

Period Issues Issues Rate 1940-49 79 40,907 .2% 1950-59 112 74,592 .2 1960-69 294 79,941 .4 1970-79 202 77,620 .3 1980-94 1,333 130,092 1.0

Total 2,020 403,152 .5

Source: Securities Data Corporation

Municipal Bond DefaultsBy Number of Issues

1940 -1994

Municipal Bonds, Players

• Government finance officers• Financial advisors• Bond counsel• Underwriters• Investors• Voters

Municipal Bonds, Investors

• Munis compete with other investments • Relatively low risk• Double Tax Exempt

– Interest income is free from federal taxes– Interest income is free from (issuing) state

income taxes• Before TRA 1986 mostly held by banks• Since TRA 1986 mostly held by individuals

Municipal Bond Holders• Before TRA 1986:

– 30% Commercial Banks– 6% Savings and Trusts– 35% Households & Mutual

Funds– 17% Insurance Companies– 3% Money Markets– 9% Other

• After TRA 1986: – 14% Commercial Banks– 7% Savings and Trusts– 56% Households &

Mutual Funds– 12% Insurance

Companies– 6% Money Markets– 5% Other

Source: Federal Reserve Banks, Bond Market Association

Municipal Bonds, Structure

• Face amount• Coupons (and ‘Zero’ Coupons)• Sources and uses• Trust indenture/ covenants• Maturity schedule

– Serial Bond Issues– Term Bond Issues

Municipal Bonds, Term structure

• Principal due at end of term• Coupon payments made semi-annually• Bonds vs. Bond Issues• Term bonds issues have multiple bonds with

same face amount and maturity date• Serial bond issues contain bonds with many

different face amounts that mature at different periods across the life of the issue

Municipal Bonds; Repayment Security

• GOULT • GOLT• Revenue• Double Barrel• Moral Obligation• Lease Rental• COPs

Municipal Bonds; Repayment Security

• Mortgage • Private Activity• Notes

Certificates of Participation (COPS)

4. COP payments (P&I) made

Payments/Proceeds

Tenant-lessee government

Non-Profit Public Benefit Corporation, Enterprise or Authority

Investors (Bondholders)

Trustee/Paying Agent

1.Tenant leases property from corporation

2. Lease assigned for collection and repayment of bondholders

5. Payments allocated to bondholders

3. Proceeds from sale paid (loaned) to corporation

Source: Mikesell, 1996

Steps in the Bond Sale Process• Consult capital improvement plan• Select a financial advisor

– line up investors or underwriters– prepare bid specifications

• Determine bond structure and characteristics

• Select bond counsel– get opinions on legal authorization– create official statement

• Obtain a rating• Select a Method of sale

Steps in the Bond Sale Process

Competitive sales• Publish bid specifications• Collect bids• Select a bidder

– Bid with lowest TIC prevails

Negotiated Sales• Issue RFP for

Underwriters• Select Underwriter•Negotiate sale

Steps in the Bond Sale Process: Obtaining a rating

• Moodys, Standard & Poors, Fitch• Rating factors

– economic– debt– administration – fiscal– management

• The Black Box

Steps in the Bond Sale Process: RatingsMoody’s S & P

Aaa AAAAa AAA ABaa BBBBa BBB BCaa CCCCa CC, CC C1

D

Choosing a Method of Sale:Terms

• NIC = Net Interest Cost• TIC = True Interest Cost• Basis point = 1/100th of a percentage point• Negotiated Sales• Competitive Sales• Reoffering Yield• Underwriter Spread

Negotiated Vs. Competitive Sales: The Underwriter Hypothesis

• Negotiated sales are less expensive – during volatile markets– for complex and “story” bond issues– for advanced refundings

• Underwriters work harder to pre-market• Restricting negotiated sales will create

inefficiencies that will inflate borrowing costs

Negotiated vs. Competitive Sales: Empirical Evidence

• All empirical studies except one, find cost savings through competitive sales

• Savings range from 16 to 72 basis points depending on the study and credit quality

• Studies conducted over 25 years in many different economic circumstances

Testing the Underwriter Hypothesis in New Jersey

• Scandal, $2.9 Billion, EO 79• Pre and Post “ban” observations• Pre-ban 79% Negotiated Sales• Post-ban 52% Negotiated Sales• Comp sales .47 bp < negotiated sales• On average (23 YTFM) $7.19 million in

savings ($4.3m NPV) per issue

Understanding the cost of borrowing

• Terms– Premium (price paid above face value)– Discount (price paid below face value)– Bond Year Dollars: (maturity weighted principal)

Principal * Average Maturity– Underwriter spread -Reoffering Yield– Net take-down - Sales Fee

Net Interest Cost

• One method of representing borrowing costs uses average coupon rates in a bond issue

(less premium or plus discount)Bond Year Dollars

Total Interest

NIC =

(less premium or plus discount)Total Interest

Principal * Average Maturity=

True Interest Cost• Another method of measuring the cost of

borrowing incorporates the time value of money

BP=Aggregate sum of bond proceeds received by the issuer (amount borrowed, less discount or plus premium)Ai = Annual principal in dollars repaid in period iI (assumes one interest payment per year)m=Years to final maturityi=number of years until a cash payment is made

TIC= True Interest CostIi=Aggregate interest payment in period Ii (assumes one interest payment per year)

m

ii

im

ii

i

TICI

TICABP

11 )1()1(

Example: Bond Issue Sold July 1, 1999 with intereset Payable on July 1 ThereafterBid amount: $39,920,000

Maturity Dates Amount (Bid)

CouponAnnual Interest

Bond Years

Bond Year Dollars

July 1, 2003 $5,000* 6 $300 4 $20,000July 1, 2004 $5,000 6.5 $325 5 $25,000July 1, 2005 $5,000 7 $350 6 $30,000July 1, 2006 $5,000 8 $400 7 $35,000July 1, 2007 $10,000 9 $900 8 $80,000July 1, 2008 $10,000 10 $1,000 9 $90,000

Par Value $35,000

Repayment Schedule Interest Principal Total

July 1, 2000 $3,275 $3,275July 2, 2001 $3,275 $3,275July 3, 2002 $3,275 $3,275July 4, 2003 $3,275 $5,000 $8,275July 4, 2004 $2,975 $5,000 $7,975July 5, 2005 $2,650 $5,000 $7,650July 6, 2006 $2,300 $5,000 $7,300July 7, 2007 $1,900 $10,000 $11,900July 7, 2008 $1,000 $10,000 $11,000

Total $23,925 $40,000 $63,925

* Dollar Amounts in ($1,000s)

Example: NIC Vs. TIC

23925+80280000

3275 3275 3275 8275 7975 76501+TIC (1+TIC)2 (1+TIC)3 (1+TIC)4 (1+TIC)5 (1+TIC)6

7600 11900 11000(1+TIC)7 (1+TIC)8 (1+TIC)9

TIC = 8.58645%

NIC = = 8.5732%

+ + + ++ ++

+ ++ ++++

$39,920 = + +

The NIC Problem

• NIC does not capture the time value of money

• This creates the possibility that two issues with very different PV cost impacts could receive the same NIC

• This could result in errors in bidding awards

Example: Bond Issue Sold July 1, 1999 with intereset Payable on July 1 ThereafterBid amount: $39,920,000

Maturity Dates Amount (Bid) CouponAnnual Interest

Bond Years

Bond Year Dollars

July 1, 2003 $5,000 6.00% $300 4 $20,000July 1, 2004 $5,000 6.50% $325 5 $25,000July 1, 2005 $5,000 7.00% $350 6 $30,000July 1, 2006 $5,000 8.00% $400 7 $35,000July 1, 2007 $10,000 9.00% $900 8 $80,000July 1, 2008 $10,000 10.00% $1,000 9 $90,000

Par Value $40,000 $3,275 $280,000

Repayment Schedule Interest Principal Total

July 1, 2000 $3,275 $3,275July 2, 2001 $3,275 $3,275July 3, 2002 $3,275 $3,275July 4, 2003 $3,275 $5,000 $8,275July 4, 2004 $2,975 $5,000 $7,975July 5, 2005 $2,650 $5,000 $7,650July 6, 2006 $2,300 $5,000 $7,300July 7, 2007 $1,900 $10,000 $11,900July 7, 2008 $1,000 $10,000 $11,000

Total $23,925 $40,000 $63,925

NIC = 8.573% TIC = 8.503354%

Example: Bond Issue Sold July 1, 1999 with intereset Payable on July 1 ThereafterBid amount: $39,920,000 Higher coupons in early years

Maturity Dates Amount (Bid) CouponAnnual Interest

Bond Years

Bond Year Dollars

July 1, 2003 $5,000 12.00% $600 4 $20,000July 1, 2004 $5,000 11.00% $550 5 $25,000July 1, 2005 $5,000 10.00% $500 6 $30,000July 1, 2006 $5,000 9.00% $450 7 $35,000July 1, 2007 $10,000 8.00% $800 8 $80,000July 1, 2008 $10,000 6.92% $692 9 $90,000

Par Value $40,000 $3,592 $280,000

Repayment Schedule Interest Principal Total

July 1, 2000 $3,592 $3,592July 2, 2001 $3,592 $3,592July 3, 2002 $3,592 $3,592July 4, 2003 $3,592 $5,000 $8,592July 4, 2004 $2,992 $5,000 $7,992July 5, 2005 $2,442 $5,000 $7,442July 6, 2006 $1,942 $5,000 $6,942July 7, 2007 $1,492 $10,000 $11,492July 7, 2008 $692 $10,000 $10,692

Total $23,925 $40,000 $63,925

NIC = 8.573% TIC = 8.682590%

NIC vs. TIC• Some state and local governments

(including the State of GA) still award bond sales on the basis of NIC!

• They argue that in cases of level debt service (equal payments across maturities) NIC and TIC result in the same award decision

• Are they right?

Problems with TIC

• Assumes discount rate equivalent to TIC– What is the appropriate social discount rate?

• May result in incorrect rankings as it ignores issue of scale

• Both are also criticisms of IRR

Reliability Issues with TIC• Some costs of issuance are included and some are

not• No standard practice exists for the inclusion of

costs, discounts, reserve fund payments• Some costs are paid by issuers, some by other

parties• NO STANDARDIZED MEASURE OF THE

GOVERNMENT’S COST OF BORROWING!

Solution: Internal Financing Rate!

Internal Financing Rate (IFR)

m

ii

iii

IFRWIPAIZBP

1 )1(

IFR= Internal Financing Rate

BP= Bond Proceeds (the Amount Borrowed Less a Discount orPlus a Premium)

Z= Other Financing Costs:Issuance CostsCapitalized InterestDebt Service Reserve Fund

AI= Accrued Interest

P= Principal Payments

I= Interest Payments

W= Other Cash Payments or BenefitsInterest Payments Made from Capitalized Interest andInterest Earned on Capitalized InterestPayments Made from the Debt Service Reserve FundInterest Earnings on the Debt Service Reserve Fund

i= Payment Period Minus (Plus) the Difference Between theClosing Date and the Initial Payment Period

m= Number of Periods to Final Maturity

Key Advantages of IFR

• Captures the time value cost of borrowing• Includes all costs of issuance• Includes related positive cash flows• Standardized to allow for comparisons• Can help keep track of impacts of structure

and sizing on interest costs– Particularly helpful for negotiated sales

Municipal Bond Mechanics

• Structure• Indentures• Sinking Funds• Bond valuation• Disclosure Provisions

Common Bond Features• A call feature allows the municipality to redeem

or call a debt issue prior to maturity. Bonds are most likely to be called when interest rates have declined. Why?

• A sinking fund requires the gradual retirement of the debt issue through repurchase or deposits to a sinking fund account.

• Some bonds are sold with with conversion provisions which give bond holders options on subsequent issues.

Special Bond Features• Coupon rates on new bonds are usually fixed.• Coupon rates are chosen so that the bond will sell

at or near par value when issued.• Some bonds have coupon rates that float with

treasury rates, LIBOR or commodity prices. These are rare.

• Original issue discount (OID) bonds are bonds issued with a coupon below prevailing rates. Zero coupon bonds are OID bonds that pay no interest at all.

A Typical Bond Trust Indenture• An indenture will include at a minimum:

– The par or face value of a bond. This is the amount the borrower owes the lender at maturity. Typically, $1000 or $5000.

– A promise to make coupon payments over the life of the bond. In the U.S., typically semiannual payments.

– A promise to repay the par value (principal) at maturity.– The time to maturity.– Other provisions, such as call features, sinking fund

requirements, restrictive covenants.

Sinking Funds

• Most bond indentures require sinking funds to assure that principal will be available to be repaid at the end of longer maturities

• Also used in re-financing non-callable issues (repayment funds)

Example: Sinking Fund Payments

• Gwinett County has just issued $10 million of facilities financing revenue bonds, each having a par value of $5,000 and a coupon rate of 4.5%. The bonds have a 25-year maturity and require that the County establish a sinking fund sufficient to retire 80% of the bonds by the time the bonds are scheduled to mature.

Example continued:• The first deposit into the sinking fund will

occur at the end of year 6. The firm will make 20 end-of-year deposits. Money deposited into the sinking fund is expected to earn 4.5% over the 20-year life of the fund. How much must the firm deposit into the fund each year to meet its sinking fund obligations?

Solution• Make deposits for 20 years.• Sinking fund must total $8 million.• N = 20, I = 4.5, PV = 0, FV = 8,000,000• Solve for: PMT = -255,009• Gwinett County must set aside $255,009

per year

Valuing Bonds• The value of a financial asset is based on the

expected cash returns it will generate.• The value of a financial asset is the present value

of the stream of expected future benefits discounted at an appropriate required rate of return.

• When large numbers of buyers and sellers are in the market, the price represents a consensus judgment about a security’s worth.

Valuing a Pure Discount Bond• A pure discount bond requires a single

payment at some future date • This is a zero-coupon bond• The value of a zero coupon bond that pays

FV in T years is: PV0 = FV / (1+r)T

Example: Zero Coupon Bond• Suppose a pure discount bond with a par

value of $100 and maturing in one year sells for $93.46 while a similar two-year discount bond sells for $84.17. What are the current one- and two-year spot rates of interest?

Solution• PV = FV / (1+r)T ==> r = (FV / PV) 1/T - 1• One - year bond:

r1 = ($100 / $93.46) -1 = 7%• Two - year bond:

r2 = ($100 / $84.17)1/2 - 1 = 9%

Valuing a Level-Coupon Bond• Most bonds have a coupon rate that stays

constant over the life of the bond.• On most municipal and corporate bonds,

coupon payments are made semiannually.• The annual coupon equals the coupon rate

multiplied by the par value of the bond.• The semiannual payment, C, equals half of

the annual coupon payments.

Bond Valuation

bond for the return of rate) g(prevailin rate required sinvestor' = rpayment principal = FV

maturity to time= T tat timepayment coupon the= C

mepresent ti at the bond theof luepresent va = PV)1()1(

:flows cash thegdiscountinby bonda of value theFind

d

t

0

1

0 Td

T

tt

d rFV

rCPV

Bond Valuation• Or you may use the formulas from the

tables:• PV0 = C (PVAF(r,N)) + F (PVIF(r,N))• Or you may use your calculator

Yield to Maturity• The YTM is the expected rate of return earned on

a bond purchased at a given price and held to maturity.

• Solve the above equation for r given values for PV, I/Y, FV, and N.

• For zero coupon bonds, YTM can be easily found.• If sold prior to maturity, the realized rate of return

for a bond will generally differ from its YTM. Variation in bond value is referred to as interest rate risk.

Example -- Bond Valuation• You are considering purchasing a NYC Transit

Authority bond. The bond has a coupon rate of 4.5%, interest payments are made annually, and the bond matures 20 years from today. If your required pretax rate of return is 6%, what is the maximum price you would be willing to pay for this bond?

• Would you purchase the bond if its current market price were $5,000?

Solution:• There are 20 years to maturity, the required rate of

return is 6%, coupon payments are $225 per year and the principal repayment is $5000 ==>

• N=20, I=6.0, PMT=225, FV=5000 ==> PV = -4139.76

• If the current price is $5000, then the yield to maturity is 4.5%. NO, you don’t buy because the YTM is lower than your required return.

• (N=20, PV=-5000, PMT=225, FV=5000 ==> I=4.50)

Example -- Bond Valuation with Semiannual Coupons

• You are considering purchasing a bond. The bond has a coupon rate of 10.5%, interest payments are made semi-annually, and the bond matures 20 years from today. If your required pretax rate of return is a nominal 8%, what is the maximum price you would be willing to pay for this bond.

Solution:• There are 40 periods to maturity, the

required rate of return is 4% per period, coupon payments are $52.50 per period and the principal repayment is $1000 ==>

• N=40, I=4, PMT=52.5, FV=1000 ==> PV = -1247.41

• You would pay up to $1247.

More on Discounts & Premiums• If a bond’s coupon rate is greater than the

required rate of return, the bond is trading at a premium.

• If a bond’s coupon rate is less than the required rate of return, the bond is trading at a discount.

• E.g., the bond in the previous example is trading at a premium.

Obtaining Bond Information• Check out the Wall Street Journal. New York and

American Stock Exchange bond trading is reported.

• Listings include coupon rate, maturity year, current yield, trading volume, closing price, and net change in price from the previous day.

• Additional information as indicated in footnotes.• Also, see Moody’s or Standard & Poor’s bond

guides.

Example: Computing the Yield to Maturity

• Consider: Cur Net Issr Coupon Mat Yld Vol Close ChgSoCaP&L 8-3/4 01 8.9 15 98 +1/4• Assume three years to maturity, semiannual

interest payments, starting in 6 months exactly, and par value = $1000. What is YTM?

Solution:• 6 semiannual coupon payments of $43.75

each• Principal repayment of $1000• N = 6, PV = -980, PMT = $43.75, FV =

$1000• ==> I = 4.76% for six months.• ==> 4.76% * 2 = 9.53% annual (nominal)

rate of return or Yield to Maturity.

Example: Yield to Maturity• Consider bonds maturing in December 2009

selling for 110 (110% of par of $1100) on July 1, 1998. The bondholder has a claim to the following cash flows:12/98 = $70, 6/99 = $70, 12/99 = $70 …..

12/08 = $70, 6/09 = $70, 12/09 = $1070• Find the relation between the price of the

bond and several discount rates.

Solution:• Semiannual bond • N= 23, PMT=70, FV=1000, I=? ==>

PV= ...PrevailingInterest rate Present Value 0% $2,6102% $1,9154% $1,4466% $1,1236.17% $11007% $10008% $896

Solution:• Plot this relation:

Semiannual discount rate

Bond PresentValue

$1000

7.0% 8.0%

Disclosure Provisions• Bonds traded in the secondary market are subject

to financial disclosure provisions• Municipalities must update the information they

provide about the financial position and management of their government

• MSRB identifies repositories which hold this information

• Issuers submit this information to the repository for the life of the issue

Issues in disclosure

• Who bears the burden of such regulation?

• Who is protected by disclosure provisions?

• What are the responsibilities of insurers, rating agencies and investors?

Conclusions

• Except for rare instances, competitive sales save money

• Issuers choose methods of sale based on other factors (relationships)

• Finance choices have implications for citizen trust and confidence in government

Municipal Bonds: Scandals

• Defaults• Pay-to-play• Yield Burning• Mark-Roos Financing• Many more coming soon to a municipality

near you!

POLS 7830: Public Financial Management

Lecture 12: Unique aspects of Non-profit and Government Accounting

Governments and Fund Accounting• Government reports center on a Primary Government

which is separately elected, legally separable and is fiscally independent of other state and local governments

• Primary Governments use fund accounting to record and report on its activities.– Governmental funds account for the operating activities of

governments– Fiduciary funds account for the government’s activities as

trustee and agent– Proprietary funds account for the “business-like” functions of

government– Account groups record and report the long term assets and

liabilities of the government. They are not funds.

The Governmental Funds• Governmental funds include:

– The General Fund that is used for the bulk of the day-to-day revenue and expenditures of the government.

– Special Revenue Funds that are used for the revenue and expenditures of specific activities that are subject to legal or management imposed restrictions

– Capital Project Funds that are used to account for major acquisitions of plant or equipment

– Debt Service Funds that are used to account for the accumulation of resources to pay for principal and interest on long-term debt

Proprietary Funds• The two primary types of Proprietary Funds are:

– Internal Service Funds which are established to account for elements of the government that provide services to other governmental units• Example: Central printing and duplication

– Enterprise Funds are established to track the activities of governmental units which provide goods and services to individuals and organizations outside of the government.• Example: Water and Sewer services

Fiduciary Funds

• There are two types of Fiduciary Funds:– Trust Funds are established whenever money is

given to a government under the terms of a trust agreement such as for an employee pension plan or an unemployment compensation fund.

– Agency Funds are used to account for money that a government is holding for some other operating entity like a volunteer fire department or another level of government

Account Groups

• Account Groups are not “Funds.” They are devices used to compensate for the fact that governments do not record long-term assets or liabilities on their Balance Sheets. There are two account groups:– General Fixed Asset Account Group - a list of

long-term assets– General Long-Term Debt Account Group -a list

of long-term liabilities

The Combined Balance Sheet• Governments produce combined balance sheets

– All of the funds and account groups of the government are listed

– The basis of accounting may differ by fund. Therefore caution is necessary when interpreting combined fund totals.

– Interfund accounts are shown on a gross basis and may overstate assets and liabilities

– Only the funds using accrual accounting show long-term assets and liabilities

General Fund

Debt Service Fund

Capital Projects Fund GFAAG GLTDAG

AssetsCash $68,000 $10,000 $20,000Property tax receivable $25,000State aid receivable $15,000Due from General Fund $18,000 $70,000General fixed assets $450,000Available in debt service fund $28,000Amount to be provided for retirement of LT liabilities $162,000

Total Assets $108,000 $28,000 $90,000 $450,000 $190,000

LiabilitiesAccounts payable $5,000Due to debt service fund $18,000Due to capital project fund $70,000Bonds Payable $190,000

Total Liabilities $93,000 $0 $0 $0 $190,000

Fund Balance $15,000 $28,000 $90,000 $450,000 $0

$108,000 $28,000 $90,000 $450,000 $190,000

Investment in General Fixed Assets (IGFA)

Total Libabilities, IGFA and Fund Balance

Town of Millbridge -- Balance SheetsAs of January 1, 2001

Statement of Revenues, Expenditures and Changes in Fund Balances

• Each fund is shown in a separate column• Other financing sources are shown

independently of revenue• The transfer from the general fund to the debt

service fund is shown in both funds and not shown net in a total column

• Principal repayments and building acquisitions are both shown as expenditures

Revenue General FundDebt Service Fund

Capital Projects Fund

Property tax $611,000State Aid $150,000Federal Aid

Total Revenue $761,000 $0 $0

ExpendituresSalaries $600,000Supplies $60,000Interest $15,000Principal $50,000Building Acquisition $270,000

Total Expenditures $660,000 $65,000 $270,000$101,000 ($65,000) ($270,000)

Other financing sourcesTransfers to debt service fund ($100,000) $100,000Proceeds of the issuance of bonds $200,000

$1,000 $35,000 ($270,000)

Fund Balance, beginning of year $15,000 $28,000 $90,000Fund Balance, end of year $16,000 $63,000 $20,000

Excess of revenues and other financings over Expenditures and other uses

Town of MillbridgeStatement of Revenues, Expenditures and Changes in Fund Balance

For the year ending December 31, 2001

Excess of Revenues over Expenditures

Statement of Receipts and Disbursements

• The statement of receipts and disbursements reports on cash flows of the organization

• Note the net $34,000 cash shortfall. Why did it occur? What can Millbridge do to meet the cash shortfall?

• How does this statement differ from the cash flow statement used by proprietary funds? How does that statement differ from that used by other public service organizations?

ReceiptsGeneral Fund

Debt Service Fund

Capital Projects Fund

Property tax $600,000State Aid $140,000Payment from General Fund $97,000 $63,000Proceeds from Issuance of Bonds $200,000

Total Receipts $740,000 $97,000 $263,000

Salaries $580,000Supplies $59,000Interest $97,000 $15,000Principal $63,000 $50,000Building Acquisition $270,000

Total Disbursements $799,000 $65,000 $270,000

($59,000) $32,000 ($7,000)Excess of Receipts over Disbursements

Town of MillbridgeStatement of Receipts and Disbursements

for the year ending December 31, 2001

The Bases of Accounting: Cash and Accrual

• Cash Accounting recognizes revenues when cash is received and expenses when bills are paid. (Focus on cash movement)

• Accrual Accounting recognizes revenue when goods or services have been provided and recognizes expenses when resources have been used. (Focus on when revenues are earned or resources are consumed)

The Third Basis of Accounting: Modified Accrual

• Governmental funds use Modified Accrual accounting. Expenditures are recognized when resources are received. Revenues are recognized within the accounting period -or shortly thereafter. (Focus on the flow of financial resources)– Financial resources are cash or assets that can

be translated to cash, less current liabilities

Inflow (Revenue) Recognition

Measurable and Available Earned Collected

Modified Accural Basis

Accural Basis

Cash Basis

Note: Governmental resource inflows are available if they are deemed to be collectable during or shortly after the end of the accounting period. This may happen before cash is received.

Payment has been received (or will be in this period).

Service has been provided.

Payment has been received.

Outflow (Expense or Expenditure) Recognition

Appropriation Encumbrance Delivery Use

Modified Accrual Basis

Accrual Basis

No Expense at this time -any basis

No Expense at this time -any basis

Expenditure Now

Expense NowExpense Now

Payment

Cash Basis

Authorization to spend money

Order has been placed

Order has been received Payment is madeItem is consumed

Accrual and Modified Accrual• Example: The Town of Millbridge buys and

receives some fireworks on January 15th that it intends to use on July 4th and receives a bill from the manufacturer for $50,000. How would the transaction be recorded by the Town under modified accrual accounting vs. accrual accounting?

Accrual and Modified Accrual

Debit Credit Debit Credit

Inventory - 50000Fireworks expense 50000 -A/P 50000 50000

Note: Transaction at acquisition

Debit Credit Debit Credit

Inventory 50000Fireworks expense 50000A/P

Note: Transaction at consumption

Modified Accrual Accrual

• Governments have the option of using either method for prepayments, materials and supplies

Long Term Liabilities

• When a government borrows money on a long term basis– No liability is created on the balance sheet!– Cash is increased and the fund balance is

increased!– The amount of the obligation is listed in the

General Long-Term Debt Account Group• How would a $1,000,000 loan be recorded?

Long Term Liabilities• How would a $1,000,000 loan be recorded?

• Note: The increase in the fund balance account is not an increase in revenue

Debit Credit

Cash 1000000Other financing sources 1000000

Modified Accrual

Fixed Assets• Funds Using Modified Accrual Basis

– When a government acquires a fixed asset• No long-term asset is recorded on the balance sheet• Cash decreases if the asset is paid for in cash and the fund

balance decreases to reflect expenditure.– GOVERNEMENTS DO NOT DEPRECIATE FIXED ASSETS

• The fixed asset is listed in the General Fixed Asset Account Group

• Funds Using Accrual Basis– Follow general accrual accounting rules (matching

principle) including recording the asset and depreciation.

Who Uses What Accural Basis

Cash Basis

Hospitals AllNot-for-profits Most Some

Governments Used in proprietary funds

Often used for budgets

For-Profit All

Used for all governmental and agency funds and some trust funds

Modified Accural Basis

Property Tax Transactions

• Millbridge issues $611,000 in property tax bills this year. Total collections for the year are $600,000 including $575,000 of this year’s taxes and $25,000 from last year’s tax bills. The remaining $36,000 is expected to be collected within 60 days of year end. It is “available.” How would these financial events be recorded?

Property Tax Transactions

Taxes Receivable 611000Tax Revenue 611000

Note: Recording the property taxes billed this year

Debit CreditCashTaxes Receivable 600000

600000Note: Recording the receipt of collected taxes

Recording an Interfund Transaction

• During the fiscal year the General Fund was supposed to transfer $100,000 to the debt service fund to cover interest payments on municipal bonds. Only $97,000 was transferred. How would this transaction be recorded?

Recording an Interfund TransactionDebit Credit

Cash 97000Due to Debt Service Fund 3000Other Financing- (Transfers to Debt Service Fund)

100000

Note: General Fund transactions

Debit Credit

Cash 97000Due from Debt Service Fund 3000Other Financing- (Transfers from Debt Service Fund) 100000

Note: Debt Service Fund transactions

A Debt Repayment Transaction

• The interest and principal due on Millbridge’s debt during the year were $15,000 and $50,000 respectively. The payments were made from the debt service fund. How would they have been recorded?

A Debt Repayment Transaction

• Both interest and principal are expenditures• No change in any liability account

Debit Credit

Cash 65000Interest Expenditure 15000Principal Expenditure 50000

Acquiring a Building

• The acquisition and financing of the building require transactions to be recorded in one fund and two account groups

• Example: Millbridge buys a building for $270,000. They pay $70,000 in cash and finance the rest through municipal bonds. How would the treatment of the acquisition be recorded?

Acquiring a building

General Fund General Fixed Assets Account GroupDebit Credit Type Type

Debit CreditCash 200000 AssetOther sources of financing 200000 FB Building 270000 Asset

Investment in general fixed assets 270000 FB

Note: Entries upon receipt of bond proceeds General Long-Term Debt Account Group

Debit Credit Debit Credit

Building acquisition expenditure 270000 Expdtr Amount to be provided 200000 AssetCash 270000 Asset Bonds Payable 200000 Liability

Note: Entries at the time of purchasing the building

Not-for-Profit Accounting

Statement of Financial Position

• Not-for-profit organizations do not have to segregate assets and liabilities into current and long term. They must– List assets in order of declining liquidity, or– Disclose relative liquidity in the notes

Statement of Financial Position• Not-for-profit organizations must segregate assets

that are subject to donor imposed restrictions– Fund accounting tracks each restricted pool of assets in

a separate entity– Restricted funds may not be commingled for operating

purposes but are for reporting purposes. • Only assets not available for current use are segregated for

reporting• Net assets must be divided into unrestricted,

temporarily restricted and permanently restricted categories. Self-imposed restrictions may also be shown.

Assets Liabilities and Net AssetsCash $100 Liabilities Marketable Securities $3,000 Wages payable $2,000Accounts Receivable (Net) $55,000 Accounts payable $2,000Inventory (LIFO basis) $2,000 Notes payable $6,000Prepaid expenses $1,000 Mortgages payable $16,000Property $40,000

$900 Total Liabilities $26,000Equipment (Net) $35,000Investments $8,000 Net Assets

Unrestricted $84,100Total Assets $145,000 Temporarily Restricted $4,900

Permanently Restricted$30,000Total Net Assets $119,000

Liabilities+Net Assets $145,000

Cash restricted for building acquisition

Meals for the Homeless

As of Decmber 31, 2001Statement of Financial Position

Statement of Activities

• Revenues and support are shown as increases in unrestricted net assets unless there are donor-imposed restrictions

• Expenses are reported as decreases in unrestricted net assets. Expenses must be reported separately from revenues. – ‘Netting’ is generally not permitted

Statement of Activities

• Gains and Losses on Investments are shown as changes in unrestricted net assets unless specific donor-imposed restrictions prohibit their use.

• As donor restrictions expire donations become unrestricted support.

Changes in Unrestricted Net Assets UnrestrictedTemporarily Restricted

Permanently Restricted Total

Revenues and SupportClient Revenue $11,000 $11,000City Revenue $20,000 $20,000County Revenue $10,000 $10,000Foundation Grants $60,000 $10,000 $70,000Annual Ball $12,000 $12,000Contributions $65,000 $5,000 $3,000 $73,000

Total Revenue and Support $178,000 $15,000 $3,000 $196,000

Net Assets Released from RestrictionsSatisfaction of Program Restrictions $10,000 ($10,000) $0Expiration of Time Restrictions $2,000 ($2,000) $0

Total Net Assets Released from Restrictions $12,000 ($12,000) $0 $0Total Unrestricted revenues and other support $190,000 $3,000 $3,000 $196,000

ExpensesMeals $67,000 $67,000Counseling $35,000 $35,000Administration, fund raising and general $75,000 $75,000Bad debts $4,000 $4,000Depreciation $10,000 $10,000

Total Expenses $191,000 $191,000

Increase/(Decrease) in Net Assets ($1,000) $3,000 $3,000 $5,000Net Assets at beginning of year $85,100 $1,900 $27,000 $114,000Net assets at end of year $84,100 $4,900 $30,000 $119,000

Meals for the Homeless -- Activity SheetFor the Year Ending December 31, 1999

Statement of Functional Expenses

• Functional Expenses must be presented either in the activity statement or the notes

• Voluntary health and welfare (VHW) organizations must report information by both function and nature in a separate Statement of Functional Expenses.

Expenses Meals Counseling G&AFund Raising Total

Salaries and Benefits $35,000 $35,000 $40,000 $17,000 $127,000Food $17,000Supplies and Brochures $2,000 $1,000 $1,000 $2,000 $6,000Office Expenses $1,000 $1,000 $1,000 $3,000 $6,000Rent $14,000 $1,000 $2,000 $1,000 $18,000Professional Fees $4,000 $3,000 $7,000Bad debts $10,000 $10,000DepreciationTotal expenses $83,000 $38,000 $47,000 $23,000 $191,000

Program Services Support Services

Meals for the Homeless --Statement of Functional ExpensesFor the year ending December 31, 2001

Fund Accounting• Fund accounting separates the organization into a

number of distinct entities called funds (not used for reporting, which presents the organization as a whole)– Unrestricted funds used to account for day to day

operations, and– Restricted funds, which correspond to pools of assets

given to the organization by donors who have restricted their use in some way• Endowments: use of earnings only• Custodial funds: held for another entity• Board designated funds (internally restricted). For reporting

purposes, these funds are unrestricted.

Donated Goods and Services

• Contributions, gifts and donations are recorded at the fair-market value at the time of donation

• Personal services are recorded as both support and an expense if– They create or enhance non-financial assets– The service requires specialized skill, and– They would need to be purchased if they were not

donated

Donated Goods and Services

• Which of the following services would be recorded as support and which as an expense? Why?– A parent who transports children to a school

soccer match– A corporate CEO who makes fundraising calls– A plumber who installs a new gas stove

Special Health Care Rules• Balance Sheet

– Health care organizations must show current and non-current assets separately.

– They must establish reserves for the likely amount of any future adjustments to amounts billed to third-party payers.

– Not-for-profit health care organizations use NFP reporting of Net Assets divided into unrestricted, temporarily restricted and permanently restricted net assets.

POLS 7830: Public Financial Management

Lecture 13: Financial Statement AnalysisFinancial Condition Analysis

Financial Statement and Condition Analysis

• Changes from GASB 34• Goals of the financial reporting• Financial Analysis Process

– Auditors letter– Notes– Statements– Ratios, ratios, ratios– Comparative Data

• Risk and Financial Condition

Changes from GASB 34• GASB 34 has dramatically reformed government

accounting• GASB 34 is presently being adopted• GASB requires implementation starting in FY

2001 for the largest governments• Full implementation for governments of all size

required by year ending June 30, 2004• Compliance required for GAAP imprimatur• Why comply?

GASB 34: Account Groups

• Long term assets and liabilities are not recorded on the financial statements under modified accrual accounting, instead:– GFAAG and GLTDAAG

• Once GASB 34 implemented, governments will not use these account groups for reporting

GASB 34: Operating Statements

• Pre-GASB 34: Government funds have Statement of Revenues, Expenditures and changes in Fund Balance (MACRS)

• Post-GASB 34: Government funds add column to this statement with the original budget figures listed

GASB 34: Entity Wide Perspective

• Pre-GASB 34: No entity wide statements with one common basis of accounting

• Post-GASB 34: New government-wide consolidated statements on a full accrual basis, plus – Government funds will still use MACRS– Proprietary funds will still use FACRS– Fiduciary funds will still use FACRS

• No more mixed basis combined balance sheet

GASB 34: Balance Sheet

• Balance sheets for government-wide financial statements must include all of the long term assets of the government

• FACRS implies depreciating these assets• Most of these assets have never had values

determined• What are the implications of such a reform?

GASB 34: Management’s Discussion & Analysis (MD&A)• Required supplementary information that must

accompany financial statements and includes– “…objective and easily readable analysis of the

government’s financial activities based on currently known facts, decisions or conditions.”

– Comparisons with previous year(s) • Including enough information to draw conclusions about

improvement or deterioration– Reports of significant changes in funds and budget

variances

GASB 34: Management’s Discussion & Analysis (MD&A)• Required supplementary information that

must accompany financial statements and includes– description of capital asset and long term debt

activity, and– conclusions with “description of currently

know facts, decisions, or conditions that are expected to have a significant effect on financial position or the results of operations.”

Objectives of Financial Reporting

• Accountability– Government-citizens– Management– Budget compliance

• Inter-period equity– Has government used current period revenues to pay

for current services?– MACR better at monitoring budget compliance– Accrual better at reporting inter-period equity

Financial Analysis• Financial analysis uses the financial statements and

other sources of information to:– help managers and outsiders understand an organization’s

financial condition– make decisions about the organization– compare an organization’s financial performance to its

peers• Financial analysis rarely gives a final answer. Rather,

it indicates where further analysis is needed

Financial Analysis• Financial analysis tries to answer a series of

questions about an organization’s mission, financial stability and operating results

– Mission• Is the organization

accomplishing its mission? • Doing too little or too much?• Does resource use match

goals?• Is the organization effective?

– Viability• Liquidity?• Solvency?• Income Concentration?• Matched maturities for sources &

uses of funds?• Efficiency? (Unit Costs)• Costs appropriate?• Other organization specific

considerations?

The Financial Statement Analysis Process• Read the auditor’s opinion, the notes to the

financial statements, and the financial statements themselves and extract as much information as possible. Look for significant issues!

• Prepare the appropriate ratios and analyze• Whenever possible get comparative data

– for the organization over time, and– for the organization’s peers– for the industry

• Organize the information and complete the analysis

Step One-Read the Auditor’s Opinion• The Auditor’s Opinion

– Describes the type of examination that the certified Public Accountant did• audit involves a statistical review of transactions and the

systems that the organization uses• compilations involve the preparation of the statements• review involve checking management prepared statements for

form and accuracy– May be either unqualified or qualified in some way

Step Two-Review the Notes

• The notes to the financial statement are an integral part of the statements. They:– describe the accounting policies that the

organization has used– highlight any unusual and material event that

may have occurred during the year– provide further detail in support of material

assets and liabilities– provide additional detail as required by GAAP

The Meals-for-the-Homeless Notes• In their notes, Meals states that it

– treats all pledges as restricted until collected,– uses substantial volunteer labor and recognized $80,000

in 1999 and $72,000 in 1998 as both support and an expense,

– uses LIFO for inventories– uses straight line depreciation– accounts for investments at fair value and shows the

composition of its investment portfolio

The Meals-for-the-Homeless Notes• Meals also:

– provided a short description of its operations and the volume of services that it delivered,

– has a defined contribution pension plan not a defined benefit plan

– described its lease obligations, and– described the restrictions on its temporarily

Restricted Net Assets

Step Three-Analyze the Statements

Assets 1999 1998 Current Assets

Cash $100 $3,100Marketable Securities $3,000 $3,000Accounts Receivable -Net $55,000 $38,000Inventory $2,000 $4,000Prepaid Expense $1,000 $0

Total Current Assets $61,100 $48,100

Long-Term AssetsCash restricted for LT Asset Acquisition $900 $900

Fixed AssetsProperty $40,000 $40,000Equipment -Net $35,000 $45,000

Investments $8,000 $12,000Total Long-Term Assets $83,900 $97,900

Total Assets $145,000 $146,000

Meals for the Homeless - Balance Sheet (Excerpt)

Step Four - Calculate the Ratios• What are ratios?• Why are ratios used?• Ratio Cautions

– No one ratio is sufficient!• Ratios must be used together and with the financial statement

data in a Mosaic approach.– comparisons may be difficult across organizations– ratios that are useful for non-profit organizations may

not always be appropriate for governments

Ratio cautions (continued)

– Use Common Sense!• Focus on the order of magnitude of the ratio - not

the exact value• Think about what the ratio means. Should it be

higher or lower than the average? Rising or falling?• What are the appropriate standards for comparison?

Are they available? Is there anything about this organization or its current circumstances that suggest that the ratios do not accurately reflect the condition of the organization?

Step Five - Get comparative data

• Compare the ratios to:– the organization over time– other comparable organizations

• mission• size• environment

– the industry

Step Five - Get comparative data

• Focus on trends:– should the ratio be higher or lower than average?– is it better for the ratio to be increasing or

decreasing?• Note: It is typically hard to find exact

comparables. Use common sense!

Step Six - Complete the analysis• Identify ‘red flags’ in the data• Organize the data to find patterns• Why you think that you see a problem, ask

why it is happening and find data to either support or refute your beliefs

• Periodically, step back and summarize what you have found

• Focus your final analysis on the big picture

Financial Condition Analysis• Financial condition analysis builds from financial

statement analysis, but it goes further:– it looks at whether a government will be able to met

both its financial obligations and its constituent service obligations;

– it includes a broader array of political and economic considerations than financial analysis;

– it is complicated by the use of modified accrual and fund accounting

– the financial condition of each fund may be made separately, with adjustments for interfund activities

Financial Condition Analysis:The CAFR

• The Comprehensive Annual Financial Report contains the financial statements of the government but often provides supplemental information:– the transmittal letter often contains an assessment of the

financial condition– the statistical section gives economic and demographic

trends, and trends in revenues, expenditures and debt– the financial statements provide information on

particular aspects of government operations

Central Issues in Financial Condition Analysis

• The economy (local and national) and demographics• The potential revenue base• Actual revenues and the public’s willingness to pay

more• The proportion of own source and intergovernmental

revenues• Demand for public services and the amount of

discretionary funding available after debt service, committed programs and entitlements

Financial condition analysis relies upon comparisons

• Financial condition analysis is based on comparisons– time series– comparisons with other jurisdictions

• Comparisons among governments are difficult!– Focus comparisons on both the specific and the aggregate

revenue and expenditures– make sure that the comparison governments are comparable– factor differences in demographics and economic conditions

into your analysis

Assessing risk through financial condition analysis

• Risk analysis in financial condition analysis involves looking at:– the reliability of individual revenue sources

(risk exposure)– the ability of the government to increase

resources in the event of a shortfall (tax leverage factor)

– the relative level of services provided by a government to its constituents

Measures of Financial Condition• Economy and demographics• Revenue Base• Revenues• Current and Capital Expenditures• Debt• Pension and Other Post-employment Benefits• Internal Resources

Ratio Analysis

Types of Ratios

• Common Size Ratios compare all of the numbers on a financial statement to one key number– Example: Asset items reported as a percentage

of total assets to reflect the asset distribution and how it has changed over time

Common Size RatiosPercent Percent Percent

Assets 1999 of Total 1998 of Total Change Current Assets

Cash $100 0.07% $3,100 2.12% -96.77%Marketable Securities $3,000 2.07% $3,000 2.05% 0.00%Accounts Receivable -Net $55,000 37.93% $38,000 26.03% 44.74%Inventory $2,000 1.38% $4,000 2.74% -50.00%Prepaid Expense $1,000 0.69% $0 0.00%

Total Current Assets $61,100 42.14% $48,100 32.95% 27.03%

Long-Term AssetsCash restricted for LT Asset Acquisition $900 0.62% $900 0.62% 0.00%

Fixed AssetsProperty $40,000 27.59% $40,000 27.40% 0.00%Equipment -Net $35,000 24.14% $45,000 30.82% -22.22%

Investments $8,000 5.52% $12,000 8.22% -33.33%Total Long-Term Assets $83,900 57.86% $97,900 67.05% -14.30%

Total Assets $145,000 100.00% $146,000 100.00% -0.68%

Meals for the Homeless - Balance Sheet (Excerpt)

Liquidity Ratios• Liquidity Ratios focus on whether an organization

has enough cash and liquid resources to meet near-term obligations. – How does the current ratio differ from the quick ratio?

• Current Ratio = Current AssetsCurrent Liabilities

– Rule of thumb: 2 to 1– Trend indicator: UP– Ratio placement: ABOVE THE MEDIAN

Liquidity Ratios• Quick Ratio measures how well the

organization can meet its current obligations out of liquid resources

Cash+Marketable Securities+A/RCurrent Liabilities

– Rule of thumb: 1 to 1– Trend indicator: UP– Ratio placement: ABOVE THE MEDIAN

QR =

Liquidity Ratios• Days of Cash on Hand (DCOH)

– Can the organization handle a collections crisis?– Rule of thumb: NONE– Trend indicator:UP– Ratio placement: ABOVE THE MEDIAN

365

_exp__

ondepreciatidebtsbadOperatingSecuritiesMarketableCash

Asset Turnover Ratios

• Asset-Turnover Ratios focus on efficiency.• How well does the organization convert

resources into revenues and collect those revenues?

• Income statements (flows) are related to balance sheets (stocks)– Should this be a concern?

Asset Turnover Ratios

• Receivables Turnover = (Revenues & Support-Cash Revenue)

Accounts Receivable

– Rule of thumb: NONE– Trend indicator: UP– Ratio placement: ABOVE THE MEDIAN

Asset Turnover Ratios

• Fixed Asset Turnover = Total Unrestricted Revenues & Support

Net Fixed Assets

– Rule of thumb: NONE– Trend indicator: UP– Ratio placement: ABOVE THE MEDIAN

Asset Turnover Ratios

• Average collection period (Aging) : How many days does it take to collect A/R?

365____ Receivables Turnover

– Rule of thumb: NONE– Trend indicator: DOWN– Ratio placement: BELOW THE MEDIAN

ACP=

Asset Turnover Ratios

• Total Asset Turnover: How much revenue does each dollar of total assets support?

Total Unrestricted Revenues and Support Total Assets

– Rule of thumb: NONE– Trend indicator: UP– Ratio placement: ABOVE THE MEDIAN

TAT=

Asset Turnover Ratios

• Inventory Turnover: How times per year does the organization consume its inventory?

Cost of Inventory Inventory

– Rule of thumb: NONE– Trend indicator: UP– Ratio placement: ABOVE THE MEDIAN

IT=

Asset Turnover Ratios

• Days of Inventory on Hand: How many days of inventory are on hand?

365 Inventory turnover

– Rule of thumb: NONE– Trend indicator: DOWN– Ratio placement: BELOW THE MEDIAN

DIH=

Leverage and Coverage Ratios:

• Focus on the use of debt and the organization’s ability to pay back that debt

• Capture the debt exposure of the organization and the degree to which assets are truly available to the organization

• Indicate whether enough money exists to pay interest expenses

Leverage and Coverage Ratios:

Total Debt Total Assets Debt to Assets=

– Rule of Thumb: .5 or less– Trend indicator: DOWN– Ratio Placement: BELOW THE MEDIAN

Leverage and Coverage Ratios:

Total Debt Total Net Assets Debt to Equity=

– Rule of Thumb: 1 or less– Trend indicator: DOWN– Ratio Placement: BELOW THE MEDIAN

Leverage and Coverage Ratios:

Income before interest expenseInterest expense Time Interest Earned=

– Rule of Thumb: at least 1 to 1– Trend indicator: UP– Ratio Placement: ABOVE THE MEDIAN

Leverage and Coverage Ratios

• Traditional Cash Flow Coverage: is income adequate to cover debt service and leases?

Income (before interest,rent,depreciation)Interest, rent, debt service

– Rule of thumb: 1:1 (at least)– Trend indicator: UP– Ratio Placement: ABOVE THE MEDIAN

TCFC=

Leverage and Coverage Ratios

• Revised Cash Flow Coverage: is cash flow adequate to cover debt service and leases?

Cash from operations+interest+rentInterest, rent, debt service

– Rule of thumb: 1:1 (at least)– Trend indicator: UP– Ratio Placement: ABOVE THE MEDIAN

RCFC=

Profitability Ratios

• Profitability ratios compare the various measures of profit with revenue and support. – Should NFPs and Govts. focus on profitability?– Can NFPs earn too much or too little?

Profitability Ratios

• Operating Margin: reflects the unrestricted earnings per dollar of revenues and support

Increase in Unrestricted Net Assets Total Unrestricted Revenues and Support

– Rule of Thumb: None– Trend indicator: UP (within limits)– Ratio Placement: Judgement call

OM=

Profitability Ratios

• Total Margin: reflects the total earnings per dollar of revenues and support

Increase in Net Assets Total Unrestricted Revenues and Support

– Rule of Thumb: None– Trend indicator: UP (within limits)– Ratio Placement: Judgement call

TM=

Profitability Ratios

• Return on net assets: reflects the earnings per dollar of net assets

Increase in Net Assets Net Assets

– Rule of Thumb: None– Trend indicator: UP (within limits)– Ratio Placement: Judgement call

RNA=

Program Expense Ratio

• Program Services Ratio: reflects the portion of expenses dedicated to operating programs.

Program Services ExpensesTotal Expenses

– Rule of thumb: None– Trend indicator: UP– Ratio Placement: ABOVE THE MEDIAN

PSR=

Tax Collection Ratio

• Tax collection ratio measures the portion of taxes billed in a given year that were collected

Taxes collected in year of levy Total tax levy for the year

– Rule of thumb: 1– Trend indicator: UP– Ratio Placement: ABOVE THE MEDIAN

TCR=

Risk and Capacity Ratios

• Risk Exposure Factor relates external to own source revenue

Investment revenue+IGG+transfersProperty tax revenue

– Rule of thumb: None– Trend indicator: DOWN– Ratio Placement: BELOW THE MEDIAN

REF=

Risk and Capacity Ratios

• Tax Leverage Factor relates local expenditures to own source revenue

Total Operating ExpendituresProperty tax revenue

– Rule of thumb: None– Trend indicator: UP– Ratio Placement: ABOVE THE MEDIAN

TLF=

Ratios in Financial Condition Analysis

• Liquidity Ratios are used (but fund accounting complicates their use)

• Because of the focus on present year receipts and disbursements, solvency ratios are not often used

• Focus on ratios that relate debt capacity to the taxable base (e.g. per capita debt), or ratios of debt service to receipts and disbursements– Are these measures more appropriate?

Ratios in Financial Condition Analysis

• Efficiency ratios are used by governments (particularly in enterprise funds)– more problematic in government funds

• Common size ratios are helpful for comparison with other governments

POLS 7830: Public Financial Management

Lecture 14: Auditing

Auditing

• Purposes• Actors• Locational Types• Functional Types• Procedures

Purposes of Auditing• Management

– To provide operations information– To determine efficiency and effectiveness– To satisfy legal conditions

• Planning– To use past performance as a planning tool– To identify key trends and constraints

• Control– To confirm that funds are used as intended– To minimize transaction errors

Auditing Actors

• Finance officer(s)• Accountants (internal and external)• Clerks• Analysts• Program Directors• Court officials(?)• AICPA, GAAP, GAAS, GASB, GAGAS !

Audit Types (Location Distinctions)

• Internal Audit– Audit conducted within the organization to

monitor and confirm the financial transactions and program activities of a government

– Examples:• Pre-Audit• Performance audit• Internal review• Pre-licensing

Audit Types (Location Distinctions)

• External Audit– Audit conducted by outside experts hired to

form an independent opinion about the financial transactions and activities of a government.

– Examples• Post-Audit• Performance audit• Compliance audit• Licensing/accreditation

Audit Types (Functional Distinctions)

• Financial and compliance audits– identify transaction error rates– determine the use of funds– measure compliance with regulation and GAAP– appraise financial condition– may be conducted by private firms

• e.g. Price-Waterhouse-Coopers, – may be conducted by public firms

• e.g. GAO audits

Audit Types (Functional Distinctions)

• Program and Performance Audits– identify and measure efforts in key activity

areas– create and apply performance measures– report on program achievements

Audit Types (Functional Distinctions)

• Efficiency and productivity audits– examine key economic criteria for evidence of

inefficiency • input/output ratios• labor productivity• work procedures• administrative procedures• use of automation

Auditing Procedures(Financial Audits)

• Audit request/approval– Pre-audit, audit preparation

• Audit plan– identifies steps, instruments, protocols

• Audit survey– identifies size and scope of activities– includes methods to sample for error rates– incorporates standardized protocols

• GAAP, GASB, GAGAS

Auditing Procedures(Financial Audits)

• Review and pre-test• Audit execution• Audit analysis and note compilation• Management letter

The truth about government auditing• Chaos prevails

– No uniform reporting standards, so no uniform auditing standards

– No audit of the federal government– First standards on government auditing issued in 1972– Many grant making agencies have different reporting

requirements making • Some subsidiary governments face dozens of conflicting

reporting and auditing standards

The truth about government auditing• Chaos remediation

– Federal grant recipients allowed to report by agency rather than grant (1979)• Audit requirements still varied based on grantor

– Single Audit Act (1984)• Requires audits of all programs with revenues over $100,000• Established uniform (federal) audit requirements

• Operational audits• Future trends in government auditing

– Consolidation– Performance measurement