Some Easy Ways of Measuring Municipal Financial Health

Submitted by:

Susan Hockenberry

Local Government Academy, Executive Director

Phone: 412-237-3171

E-mail: shockenberry@localgovernmentacademy.org

In this entry of LGA Lyceum, we provide some ways to consider the fiscal health of municipal governments in Pennsylvania. While there are some excellent tools to do such analysis comprehensively, such as the International City Management Association’s Evaluating Financial Condition Handbook, the purpose of this list is to offer something less in-depth and to initiate further discussion of financial performance and good government.

1. Start with good data – Local governments in Pennsylvania are not required to utilize generally accepted accounting principles (GAAP), and this limits our ability to make sound judgments about the financial condition of municipalities--both over time and in comparing communities. Required annual financial reporting for local governments in Pennsylvania takes the form of the annual Municipal Audit and Financial Report. Two major short comings exist when relying on this information: (1) the report doesn’t require reporting on the basis of fund types (see discussion below) and (2) the level of professionalism applied to its preparation is lacking (it is not required that an independent CPA prepare the form).

Further limitations of the Municipal Audit and Financial Report also exist. The most significant of these is that it doesn’t require municipalities to state their beginning and end of year fund balance (see fund balance discussion below). Additionally, it doesn’t require the reporting of any post employment benefits, or depreciation of capital assets. This renders it less than useful for making judgments on fiscal health.

The important lesson: information available from statewide sources is limited and is best used for comparisons of income and expenses—not judgments of financial condition. Furthermore, adhering to a more rigorous financial reporting standard by municipalities would benefit all because it would accurately reveal the problems that exist.

 

2. Distinguish fund types:  As stated above, the annual municipal audit and financial report does not require reporting on the basis of fund type. This is important because knowing the activities in major fund categories is crucial to understanding the operations of a government.

Governments segregate funds for a variety of purposes. Most operations are recorded in the general fund—which, as the name implies, tracks all of the general activity of a municipality. But some monies a government receives must be tracked separately, and some governments, for management purposes, may record some income and expenses independent of the rest of the operation. Analysis on each individual fund can be tedious, as such good financial reporting compiles this information into “fund types.”

For the usual and customary operations of the government—like the police, streets, general administration--the Governmental Fund Types are the most revealing. For activities that may be funded by fees or in some way operate like a for-profit enterprise—the Proprietary Fund Types are most useful. Pensions and other trustee relationships should be presented in a third fund type--a Fiduciary Fund Type. All of this information when presented in total depicts an important picture. But understanding that picture sometimes requires digging deeper—and that means looking at operations on a fund type level.

This is especially true as it relates to the reserve funds. Many municipalities use reserve funds to accumulate resources and then spend it in another. When this happens, the transfer from the reserve fund to the general fund is not considered revenue to the general fund (the revenue being recognized in the past when the proceeds were originally received). However, the spending of these reserved monies IS considered an expense. The result: when spending down a reserve, a municipality has a deficit and that may be just according to plan. The issue to be concerned about in regard to reserve funds is the appropriateness of their use. Should municipalities accumulate resources in a fund segregated from their general fund? Does that serve to protect public assets or obfuscate excessive taxation? These are important questions about the use of reserve funds for which we should be concerned. Such questions are the subject of a review by the Governmental Accounting Standards Board, and a LGA round table was convened with the local chapter of the Government Finance Officers Association last year.

3. Know the fund balance - A deficit occurs in an accounting period if expenditures exceed revenues. But a deficit in and of itself doesn’t speak to the solvency of a municipality. For that, one must consider the equity of the organization.

Just like private sector organizations, fund equity is, simply put, the difference between assets and liabilities. Not all equity is spendable. Fund balance represents that equity which is subject to appropriation. Even within fund balance, a portion may be designated or earmarked for certain priorities or commitments.

Clearly a negative fund balance is a problem, but when a fund balance exists, how much should it be? Municipal finance officers have long deliberated over this. The Government Finance Officers Association has offered some assistance in its publication “An Elected Officials Guide to Fund Balance ” stating the following potential means to measure the appropriateness of a fund balance level:

 

· Municipal bond rating agency “rules of thumb” indicate 5% of annual operating expenditures OR

· No less thank one month’s operating expenditures (8.3% of expenditures)

But even at that, this doesn’t tell the whole story. Prudent municipal officials should not necessarily rely on assumptions or rules of thumb, but assess the needs of their communities. How reliable is the tax base? What are the capital needs of the community? Does the municipality have any known threats it should be preparing for like a lawsuit or other large payment? Answering these types of questions help municipalities determine how much fund balance it should have.

 

4. Know the municipality’s debt position – even when all of the long term liabilities are not known because no GAAP financial statements are being prepared, the debts of a municipality can be known.

The schedule of payments for all debt issues can be overlapped to get a total amount of debt service payments each year, as well as the outstanding amount. Readers of that information should consider whether that amount is an appropriate percentage for the economic conditions of the community. Rules of thumb indicate 10% of expenditures is likely wise, but the same advice about using of rules thumb for fund balance exist for determining the appropriate level of debt service—don’t over rely on them. Evaluate the fiscal conditions of the community.

Debt capacity should be considered. Legally, before a community can borrow funds it must determine its borrowing base—an average of its total revenue less intergovernmental revenue, interest and other one-time revenues—and multiply that by 250% to determine its debt capacity. How much of that capacity has been consumed? Is that acceptable given the conditions, needs and expectation of the community?

Knowing a community’s debt position is a good way to understand its financial condition.

 

5. Know the municipality’s tax capacity - Simply put, this relates to the combination of tax rates and tax base. A community close to maxing out in either its rates or base is facing fiscal difficulty.

Most municipalities, depending on the Code under which they operate, are limited in terms of their real estate tax rate. Likewise the property values must be stable or growing to avoid service cuts. When evaluating the financial health of the community, consider to what extent the municipality has tapped its tax rate and to what extent real property values are steady or rising (bearing in mind any limitations of the real estate assessment system). Likewise, most municipalities are limited to charging a .5% earned income tax (the exception being home rule municipalities). To evaluate whether or not a community can generate revenues sufficient to fund operations, consider the trends in taxpayer incomes—are they rising, holding steady, falling? This type of data should inform judgments about the financial health of a community.

Nothing about this list is exhaustive. In fact, many professionals spend many hours of study developing their understanding and expanding the base of knowledge on evaluating municipal financial condition and we stress that these indicators are not exclusive. But hopefully, this list provides the some ideas about what to consider when making judgments of fiscal health.

Update:

LGA provides comments to GASB on proposed standards contained in the Exposure Draft, Fund Balance Reporting and Governmental Fund Type Definition.