Analyzing Financial Reports

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Financial reports tell the story of an organization within a fiscal year. Annual financial reports are extremely valuable to government organizations because they give both the administrators in the organization and the public who are funding the organization a sense of where revenue is going. The Assignment 1-2 pages:

1.Write a brief description of the EPA

2.Then, provide an analysis of that organization’s AFR.

3.In your analysis, explain what the report tells the stakeholders of the organization and the value of the report to the organization.


This Chapter is attached

Mikesell, J. L. (2018). Fiscal administration: Analysis and applications for the public sector (10th ed.). Boston, MA: Wadsworth.

  • Chapter 2, "The Logic of the Budget Process" (pp. 44-97)

Unformatted Attachment Preview 1 of 12 12/30/18, 8:15 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. An agency develops not only a cost estimate for providing the services it plans to deliver, but also a narrative justification for the requests. The estimate and its justification reflect the large number of program decisions the agency has made. The chief executive’s budget office gathers the requests made by many operating agencies and consolidates these requests. The budget office reviews budget requests for consistency with the policies of the chief executive, for reasonable cost and logical content, and for total consistency with spending directions. Often there are administrative hearings for reconciliation of an agency request and budget office adjustments. Finally, the executive budget document is transmitted to the legislature for its consideration. Law usually establishes the date of transmission to the legislature. The budget document, or executive budget, incorporates all agency requests into a government-wide request or plan. The requests by the agencies have been accumulated and aggregated according to the policy plan of the chief executive. Some legislative bodies, including the U.S. Congress, propose their own alternative budgets. Agency requests will almost always be reduced by the chief executive to produce an overall executive plan. And, of course, the expectation is that the vision or priorities of the chief executive will dominate the direction of the final plan. As is discussed later, the substantial changes made in agency requests before proposals are seen by the legislature reflect differences in attitudes and service clienteles of the agencies and the chief executive. Legislative Consideration In a government with distinct legislative and executive branches, the budget document is transmitted to the legislature for debate and consideration. The legislature typically splits that budget into as many parts as appropriation bills will ultimately be passed and submits those parts to legislative subcommittees. This consideration usually begins with the lower house of a bicameral legislature. In subcommittee hearings, agencies defend their budget requests, often calling attention to differences between their initial request and what appears in the executive budget. After the lower house has approved the appropriation, the upper house goes through a similar hearing process. When both houses have approved appropriations, a conference committee from the two houses prepares unified appropriation bills for final passage by both houses. Appropriation acts are the outcome of the legislative process. These laws provide funds for operating agencies to spend in a specified fashion in the budget year. The initial requests by the agency reflect the plans of that agency; appropriation converts these plans (or portions of them) into law. The chief executive normally must sign the appropriation bill before it becomes law, and thus gives operating agencies financial resources to provide services, but not all executives have the same options. Some executives may sign parts of the bill, while rejecting others (called item-veto power); others must approve it all or reject it all, thus returning the bill to the legislature. Most state governors have item-veto power, but the president does not. Some observers feel the item veto provides a 2 of 12 12/30/18, 8:15 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. useful screening of projects that political clout, rather than merit, has inserted in the appropriation bill. Others are skeptical about such power because of its use for executive vendettas against selected groups, legislators, or agencies.26 In a non-profit organization, it is normal for the executive director to prepare a budget for entity operations in the upcoming year, using the same logic as previously outlined for governments. In its preparation, the director will ideally discuss problems and opportunities with organization stakeholders, and then will present the budget to the organization’s executive board for approval. Of course, the approved budget does not constitute an adopted law, but it does provide a guidance for operations of the agency. Execution During execution, agencies carry out their approved budgets. Appropriations are spent, and services are delivered. The approved budget becomes an important device to monitor spending and service delivery. Although there are other important managerial concerns during execution, spending must proceed in a manner consistent with appropriation laws. Law typically forbids (often with criminal sanctions) agencies from spending more money than has been appropriated. The Anti-Deficiency Act of 1906 is the governing federal law; similar laws apply at state and local levels and in other countries with welldeveloped fiscal systems. Spending less than the appropriation, although a possible sign of efficient operation, may well mean that anticipated services have not been delivered or that agency budget requests were needlessly high. Thus, finance officers must constantly monitor the relationship between actual expenditures and planned/approved expenditures (the appropriation) during the fiscal year. Failure to spend the full appropriation is not necessarily a good achievement. A standard tool used to analyze the quality of budget processes is to compare the amounts approved for government services with the amounts actually spent on delivery of those services. The question is: was the adopted budget actually executed? Central budget offices (the Office of Management and Budget for the federal government) normally handle the monitoring and release of funds during execution of the budget. Most governments have some pre-expenditure audit system to determine the validity of expenditures within the appropriation and some controls to keep expenditures within actual resources available. It is normal that funds will be maintained in a single treasury account rather than being distributed among separate agency bank accounts. That means that an agency pays for its purchases by ordering 3 of 12 12/30/18, 8:15 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. the central treasury to issue the payment, rather than having the agency itself make payment. The single treasury account provides better protection of public funds and reduces the need for carrying high cash balances to meet the flow of payments. Spending is the direct result of appropriations made to carry out the service envisioned in the agency’s initial budget plan.27 However, because expenditures can involve the purchase of resources for use both in the present and in the future, it would generally be incorrect to expect the expenditure to equal the current cost of providing government services. Some of the current expenditure will provide services in later periods. (In simplest terms, part of the road salt purchased this year may be used next year, but much of the difference between expenditure and service cost will be caused by purchase of capital assets, such as buildings, trucks, computers, etc.) The cost of government would equal the amount of resources used, or consumed, during the current period—some resources coming from expenditure in that period and some from previous expenditures. Focus on expenditure thus renders an inaccurate view of the cost of government. Figure 2–4 outlines the flow of transactions and accompanying management information requirements between budget authority and service cost: (1) budget authority provides funding (the appropriation law approves agency Z’s plan to publish an information bulletin), (2) obligation occurs when an order is placed (agency Z orders paper from business A), (3) inventory is recorded when material is delivered (business A delivers the paper to agency Z), (4) outlay occurs when the bill is paid (agency Z pays for the paper), and (5) cost occurs when the materials are used (agency Z prints an information bulletin on the paper). Some reference to the federal structure may help clarify. Budget authority—provided through appropriation, borrowing authority, or contract authority—allows agencies to enter into commitments that will result in immediate or future spend-ing.28 Budget authority defines the upper limit for agency spending without obtaining additional authority. Figure 2–5 illustrates the relationship between budget authority and outlays envisioned in the 2017 federal budget. The budget plans outlays of $4,147 billion. Most of the outlays are based on proposals in this budget ($3,329 billion), but $818 billion (19.7 percent of the total) is based on unspent authority enacted in prior years. Therefore, budget authority in a particular year differs from outlays for the year; outlays may result from either present or previous budget authority. Figure 2–4 Financial Information for Management 4 of 12 12/30/18, 8:15 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Figure 2–5 Relationship of Budget Authority to Outlays, 2017 Operating agencies should have managerial flexibility in the use of funds, allowing them to change the particular mix of inputs they purchase, so long as they can provide the level of service to the public that was envisioned in the adopted budget. Agencies almost certainly know more about new technologies, changes in prices of inputs that could allow cost savings, and emerging problems than does the legislature or the budget agency. Hence, locking agencies to the line-item details of the proposed and adopted budget usually inhibits efficiency and innovation. Ideally, the operating agency should be responsible for budget totals and agency results, not the details of exactly how money was spent (within laws of theft and corruption). Audit and Evaluation An audit is an “examination of records, facilities, systems, and other evidence to discover or verify desired information.”29 The audit seeks to discover deviations from accepted standards and instances of illegality, inefficiency, irregularity, and 5 of 12 12/30/18, 8:15 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. ineffectiveness early enough to take corrective action, to hold violators accountable, and to take steps to prevent further losses. The audit may be internal (in other words, the auditors are subordinate to the heads of the departments being audited) or external (the auditors are outside the structure being audited and, for governments, are ultimately responsible to the citizenry). In general, the auditors verify the assertions made by the audited entity. Information is documented on the basis of a sample of transactions and other activities of the entity—a judgment about purchasing practices, for instance, is made from a review of a sample of transactions, not from an examination of all invoices. Post-expenditure audits determine compliance with appropriations and report findings to the legislature (or to a judicial body if laws have been violated).30 At the federal level, the Government Accountability Office (GAO), an agency of Congress, supervises audits of agencies, although the actual auditing is typically done by agency personnel.31 States frequently have elected auditors or independent agencies that audit state agencies and local governments. Local governments sometimes have audits done by independent accounting firms as well as by government bodies, although some such governments have not frequently had independent audits.32 Government audits may be classified according to their objectives into two types: financial and performance. Financial audits include financial statement audits, which “determine (1) whether the financial statements of an audited entity present fairly the financial position, results of operations, and cash flows or changes in financial position in accordance with generally accepted accounting principles, and (2) whether the entity has complied with laws and regulations for those transactions and events that may have a material effect on the financial statements,”33 and financial-related audits, which “include determining (1) whether financial reports and related items, such as elements, accounts, or funds are fairly presented, (2) whether financial information is presented in accordance with established or stated criteria, and (3) whether the entity has adhered to specific financial compliance requirements.”34 These audits test financial records to determine whether the funds were spent legally, receipts were properly recorded and controlled, and financial records and statements are complete and reliable. They concentrate on establishing compliance with appropriation law and on determining whether financial reports prepared by the operating agency are accurate and reliable. The financial audit still must determine, however, whether there has been theft by government employees or their confederates, although this part of the task should be minor because of 6 of 12 12/30/18, 8:15 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. protections created by controls within the agency (internal controls). But if nothing else has provided the protection, it is expected that the financial audit will protect public resources and see that thieves get dealt with appropriately by the judicial system. Performance audits similarly encompass two classes of audits: economy and efficiency audits, which seek to determine “(1) whether the entity is acquiring, protecting, and using its resources (such as personnel, property, and space) economically and efficiently, (2) the causes of inefficiencies or uneconomical practices, and (3) whether the entity has complied with laws and regulations concerning matters of economy and efficiency,”35 and program audits, which examine “(1) the extent to which the desired results or benefits established by the legislature or other authorizing body are being achieved, (2) the effectiveness of organizations, programs, activities, or functions, and (3) whether the entity has complied with laws and regulations applicable to the program.”36 Economy and efficiency audits might consider questions of procurement, safeguarding of resources, duplication of effort, use of staff, efficiency of operating procedures, management to minimize cost of delivering appropriate quantity and quality of service, compliance with laws governing use of resources, and systems for measuring and reporting performance. Program audits emphasize the extent to which desired results are being achieved, what factors might inhibit satisfactory performance, whether there might be lower-cost alternatives for obtaining the desired results, and whether there may be conflict or overlap with other programs. Some states link performance audits with sunset reviews: “a set schedule for legislative review of programs and agencies and an automatic termination of those programs and agencies unless affirmative legislative action is taken to reauthorize them. Thus, the ‘sun sets’ on agencies and programs.”37 States with such legislation typically include a performance audit as part of the preparation for action on agencies or programs eligible for termination. A simple example may illustrate the focus of each audit. Consider a state highway department appropriation to purchase road salt for snow and ice removal. A financial audit would consider whether the agency had an appropriation for salt purchased, whether salt purchased was actually delivered, whether approved practices were followed in selecting a supplier, and whether agency reports showed the correct expenditure on salt. An efficiency and economy audit would consider whether the salt inventory is adequately protected from the environment, whether the inventory is adequate or excessive, and whether other methods of selecting a supplier would lower the cost. A program audit would consider whether the prevailing level of winter highway clearing is an appropriate use of community resources and whether approaches other than spreading salt would be less costly to the community. 7 of 12 12/30/18, 8:15 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Government Accounting and Financial Reporting Proper accounting and reporting makes government finances more transparent to constituencies, including public officials, the public, and the investment community. They should improve accountability to the public, including allowing the public to see whether current revenues are sufficient to cover current expenditures; they should make it possible to evaluate the operating results of the government for the year, including determining how financial resources are obtained and how they are spent; and they should help with assessment of the level of services that the government can afford to provide, including supplying information about the financial condition of the government. Standards Independent authorities or boards establish the standards (or rules) for accounting and financial reporting; in the United States, the Financial Accounting Standards Board (FASB) sets the standards for the private sector, the Federal Accounting Standards Advisory Board (FASAB) issues standards and guidance for federal accounting, and the Governmental Accounting Standards Board (GASB) sets them for the state and local governments. Similar bodies do the work in other countries. These standards establish the practices that the accounting system will implement and allow any interested party to understand the finances of the government and to make certain comparisons of finances across governments. However, the accounts, even when prepared according to recognized or “generally accepted” standards, are not statements of scientific validity, as anyone even slightly familiar with the Enron experience of rigged accounts that showed profitability as the company went bankrupt in 2001 will understand. At best, they seek fair representation, not unassailable truth or scientific validity. The accounting system allows the manager to assemble, analyze, and report data for the essential work expected of the budget process. The data must be complete, accurate, timely, and understandable for all public constituencies. The focus of the system is on revenues and expenditures, on financial balances, and on financial obligations of the government. The financial reporting system is expected to provide understandability (reports should be sensible to the general public as well as to experts), reliability (reports should be comprehensive, verifiable, and without bias), relevance (information provided should meet the needs of users), timeliness (reports should be issued shortly after the close of the fiscal year), consistency (the basis should be the same for all transactions and across fiscal years), and comparability (it should be possible to compare reports across governments). The accounting system is expected to provide the framework for financial control, but it is also expected to be a ripe source of information for government decision makers and the public. The full accounting system combines several elements: 1. Source documents: These are the receipts, invoices, and other original details of transactions. 2. Journals: These are chronological summary lists of all transactions. 8 of 12 12/30/18, 8:15 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. 3. Ledgers: These are reports at varying levels of detail that present the balance in any revenue, expenditure, or other account. 4. Procedures and controls: These are the forms and instructions for classifying, recording, and reporting financial transactions in the source documents, journals, and ledgers. Government accounting focuses on cash flows and improved transparency, control, and accountability to constituencies rather than the profit-and-loss emphasis of private sector accounting. This difference brings several normal practices in government accounting: 1. Governments use fund accounting to permit compliance with legal restrictions on the use of revenue and to facilitate strong financial administration of multiple government operations. 2. Debt is segregated. Bonds to be repaid from general financial resources of the government are reported as obligations of the entire government; bonds to be repaid from specific funds (bonds issued to build a parking garage being repaid through parking garage revenue, for instance) are reported as such. 3. The budget of a government is at the heart of its system of “checks and balances.” Demonstrating compliance with the adopted budget is a critical part of the accounting and reporting process. In the private sector, budgets are more on the order of an initial flexible plan, not an adopted appropriation law. Nonprofit organization budgets are somewhere in between. Governments have historically made little attempt to account for fixed assets in their financial records. They built an infrastructure for the operations of general government, but did not account for its condition in their financial records. That meant that any balance sheet of the government’s assets did not accurately portray the true financial situation of the government. It did not reflect depreciation and deferred maintenance of these critical assets. Accordingly, financial reports could portray a misleading sense of the condition of the government: failure to maintain infrastructure eventually adds to the costs of operation, can lead to more borrowing than would be otherwise necessary, can cause previous capital investment to be wasted if not adequately protected, can cause economic development in the community to be impeded because of low-quality government services, and misleads about the total cost of providing services. A GASB standard (GASB 34) now requires larger governments to account for these infrastructure costs in their accounts, and the standard will eventually extend to all governments.38 The change is driven by the effort to ensure that governments provide information about the full cost of 9 of 12 12/30/18, 8:15 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. providing government services, something that the omission of a reflection of cost from the existing infrastructure has prevented in the past. How critical this omission might be is open to dispute: there is little reason to know the “going concern” value of a government because nobody is going to buy or sell it. The value of most physical assets owned by governments is particularly speculative because they are so specialized for governmental service that they lack a meaningful market value, and nobody should make much of those values in considering annual reports. Funds In private sector accounting, a single set of accounts reports all material transactions and details of financial condition. Government accounting, however, segregates funds or accounts because there are legal restrictions on the use of government revenues and on the purposes of government expenditure. Mixing money prevents a clear demonstration of compliance with restrictions. Therefore, distinct funds (“cookie jar accounts”) provide the necessary controls. They have much in common with the “envelope system” presented by personal finance guru Dave Ramsey as a tool for managing household finances. Governments prepare financial reports in a number of separate funds or accounting entities that are expected to be self-balancing (equal credits and debits across accounts). Generally accepted accounting principles (GAAP) define funds to be interrelated accounts that record assets (revenues) and liabilities (expenditures/obligations) related to a specific purpose. Municipal accounting divides funds into three basic types: governmental funds, proprietary funds, and fiduciary funds, each with subcategories. 1. Governmental Funds a. General fund: general revenues to the government, including taxes, fines, licenses, and fees. Most taxes and expenditures are in this fund. There is only one general fund. b. Special revenue funds: account for operations of government that are supported by dedicated revenue sources—dedicated taxes, fees, or intergovernmental assistance. Transportation trust funds are one example. c. Debt service funds: account for payment of interest and repayment of principal due on longterm debt. d. Capital projects funds: include resources used for construction and acquisition of capital facilities or major capital equipment purchases. The fund is dissolved when the project is completed. e. Permanent funds: account for resources held in trust, where earnings, but not principal, may be used for public purposes. 2. Proprietary Funds a. Enterprise fund: includes the financial records of self-supporting operations, like water or sewer utilities. Accounts for business-type activities of the entity, which are operated for the general benefit of the public, but are expected to support themselves from their own revenue. b. Internal service fund: includes the financing of goods or services provided by one agency or department to other agencies or departments of the 10 of 12 12/30/18, 8:15 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. government on a cost-reimbursement basis, like the operations of a motor vehicle maintenance department. 3. Fiduciary Funds: account for assets held by a government as a trustee for others. Fiduciary funds include (1) pension funds that are used to pay public employees’ retirement benefits and (2) trust funds that are used to pay for management of resources. Their use is usually tightly controlled. In a mature fiscal system, an independent auditor prepares an evaluation of government financial operations at the end of the fiscal year. If the auditor renders a so-called clean opinion, then the way that the government prepared its financial report is considered to have been fair and accurate. Among other things, the auditor’s report requires that the agency’s statements be prepared according to GAAP. Clean budget processes also bring all government operations together, regardless of the fund structure, in order to preserve the comprehensiveness of public financial decisions. Accounting Basis: Cash or Accrual The accounting basis—the method of matching revenues and expenditures over time—may be cash (revenue posted when cash is received, expenditure posted when cash payment is completed), full accrual (revenue posted when earned, expenses posted when good or service is used), or modified accrual (revenues posted in period in which they are measurable and available, expenditure posted when liability is incurred). The traditional standard, cash accounting, records money inflows when received and spending when money is disbursed, generally following the flows of the government checkbook. Those flows can substantially lag changes in the true condition of the government, and capital assets (buildings, highways, etc.) require a cash payment when they are acquired, but no purchase payments over their many years of useful life. GAAP requires a modified accrual basis for governmental accounting, in which inflows are called revenues, not the receipts of cash accounting, and outflows are called expenditures, rather than the disbursements of cash accounting. The revenue measure requires an estimate of taxes owed, but not yet paid; the expenditure measure requires inclusion of purchases for which payment has not yet been made. Expenditure is recorded when liability is recognized, generally meaning when the good or service is delivered to the purchaser and normally well before any check is written to pay for the purchase. GAAP also requires that individual government operations expected to be self-supporting use full accrual accounting, the method of the private sector. In full accrual, outflows, called expenses, are recorded in the period in which benefit is received from the resource.39 11 of 12 12/30/18, 8:15 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. 12 of 12 12/30/18, 8:15 PM 1 of 13 12/30/18, 8:16 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. The accrual basis provides more information for decision makers and for managers, particularly in regard to the distribution of cost over time, and is not susceptible to end-of-year cash manipulations. It has the capacity to place costs properly in the relevant period. Only a handful of national governments around the world prepare financial statements on an accrual basis, although that is the evolving pattern for American state and local governments, and even fewer provide for depreciation of their capital assets in their accounts.40 The federal government does prepare the Annual Financial Report of the United States Government and that is done on an accrual basis, but it is not clear that the report matters much to either the public or government decision makers. The cash basis controls flows of cash and does not distribute cost accurately to periods, but it is less complex than the accrual system and is less subject to fundamental manipulation for impact on financial statements. As The Economist summarizes, cash “is far harder to disguise or invent.”41 Either system can be functional, depending on the needs of the entity.42 Comprehensive Annual Financial Report (CAFR) and Monitoring Financial Performance The public, government officials, those lending money to governments, and others doing business with government all want to understand the financial well-being of the government. Will it be able to sustain its operations, to provide services, and to pay its bills in the future? Future obligations will include service on outstanding debt (interest and repayment of amounts borrowed), pension and other benefits promised workers when they retire, costs associated with infrastructure for provision of public services, and so on; it is important that these financial requirements do not take up so much of revenue available in the future that provision of services to that population is endangered. A single year snapshot of finances—the flow of expenditures and revenues within the year—cannot provide the whole story. Also, neither perform out-year analysis in a medium-term financial forecast. Although there is no single indicator that can answer those questions of fiscal health and sustainability definitely, some elements of the government’s current financial condition do offer some guidance. However, the annual report tells where the government has been 2 of 13 12/30/18, 8:16 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. recently; that is what accountants do well. It does not tell where the government is likely to be headed in the medium or long term. The CAFR is a general-purpose report prepared annually according to the standards promulgated by the GASB to meet the information needs of public officials, citizens, auditors, bond rating agencies, and investors. It is expected to be a publicly available document that encompasses all funds and accounts controlled by the government entity. The CAFR should provide a comprehensive, reliable, and internally consistent source of information about the finances and structure of the government, with financial data presented according to generally accepted accounting principles, so that an external observer can understand the situation of that government without having to do additional research on definitions or context. It is comprehensive in depth and breadth, reported in sufficient detail to provide full disclosure. States and many larger cities, counties, school districts, and special districts post their CAFRs on their websites, and you can easily trace the sections noted below in that document. The report includes three sections: 1. An introductory section that seeks to explain the structure of the government, the nature and scope of its activities, and the specific details of its legal environment. 2. A financial section that provides a comprehensive overview of the government’s operations and includes an independent auditor’s report on the finances. The section will provide a balance sheet for the end of the period and statements of revenues, expenditures, and changes in fund balances over the period. The balance sheet will provide the value of assets owned by the government (the value of cash, equipment, buildings, etc.) and of liabilities (the value of its obligations to be paid). It pays attention to liabilities that lurk in the future, such as benefits eventually to be paid to pensioners. The difference in these values equals net assets, which measures the government’s financial position at a point in time. Just as the revenues and expenditures making for the budget position of deficit or surplus are based on some critical assumptions about conditions in the upcoming budget year, portions of both assets and liabilities are based on assumptions about future conditions. But the balance sheet takes a longer view. Some assets can be converted to cash to pay bills quickly (they are liquid) and others cannot.43 3. A statistical section that provides details on government operations and its major financial trends. The section will provide details on the tax base (particularly property tax for local governments), the condition of the ambient economy, outstanding debt, and often information about government operations. 3 of 13 12/30/18, 8:16 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. This report gives a complete overview of finances, prepared according to GAAP, and is critically interesting to those involved in public capital markets. In other words, people who might be loaning money to the government really want to know what the financial condition of the government is, and the CAFR gives them the basic information they want to find out. The budget reflects the plans of the government and recent history of fiscal operations, whereas the CAFR gives a picture of government finances at a point in time past and considers some estimated future obligations that may not be reflected in the government’s budget. Anyone using a CAFR has to read the footnotes because governments have options with regard to how they treat some transactions, and it is not possible to understand the full financial situation without knowing exactly what options have been taken. There have been efforts to use balance sheet and related data about state and local governments to provide fiscal condition indexes that give a concise overall assessment of the condition of that government, both at present and as it promises in the future. If it were possible to capture the salient elements into a simple index, that would be useful for formation of government policy, for citizen assessment of the quality of government operations, and for those who might be inclined to loan money to that government, among other uses. However, there is no single indicator, and analysts employ different data elements in producing their condition indicators. Table 2–4 provides one set of factors recently used in evaluating the fiscal conditions of the fifty states, but there are other approaches in use.44 Indeed, the Canadian province of Nova Scotia prepares a Fiscal Condition Index for each of municipalities so that municipal councils and the public can have a better idea of financial operations and challenges.45 The dimensions of that index include revenue, budget, and debt and capital. Although the indicators are thorough, the province warns: “The FCI is not a substitute for a comprehensive examination of a municipality’s financial performance.”46 Looking backward is not necessarily a good way to see where one is headed in the future. Table 2–4 Financial Condition Analysis: Measures for Estimating Four Types of Solvency Cash Solvency Ability to pay bills on time, tests liquidity and effectiveness of cash management system. Measured Cash Ratio: (cash + cash equivalents + investments) / current liabilities Quick Ratio: (cash + by cash equivalents + investments + receivables) / current liabilities Current Ratio: current assets / current liabilities Budget Solvency Ability to meet current year spending obligations without deficit Measured Operating Ratio: total revenue / total expenses by Surplus (Deficit) per capita: change in net assets / population Long-Run Solvency Ability of the government to pay all its costs, including those that may occur into the future Measured Net asset ratio: restricted and unrestricted net assets / total assets Long-term liability ratio: by long-term (noncurrent) liabilities / total assets Long-term liability per capita: long-term (noncurrent) liabilities / population Service Level Solvency Ability to provide and pay for level and quality of services required to meet community’s general health and welfare needs Measured Tax per capita: total taxes / population Revenue per capita: total revenues / population by Expenses per capita: total expenses / population Note: Data for ratios would be taken from annual financial reports of each entity. 4 of 13 12/30/18, 8:16 PM Source: Xiaohu Wang, Lynda Dennis, and Yuan Sen (Jeff) Tu, “Measuring Financial Condition: A Study of U.S. States,” Public Budgeting and Finance, 27 (Summer 2007): 1–21. 5 of 13 12/30/18, 8:16 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Budgets and Political Strategies Most of this text aims to provide technical skills required for work in and around public finance and budgeting. Much of it strives to organize the best evidence to help guide decisions toward the best interests of the community. However, spending and taxing decisions emerge from an intensely political process. They do not spin out of an analytic “black box” programmed by purveyors of information technology and program analysis. Presidents, governors, mayors, and other public executives cannot ignore political forces when they develop their fiscal proposals, and legislators certainly do not ignore these forces as they pass budget laws.47 Understanding the budget process is vital for shaping public policy, and so is the analysis necessary to innovate and implement programs most likely to be in the public interest. But budget proposals do need to be delivered and defended in a political environment: truth and beauty alone will not save the day. There will be negotiations, and some participants in the process will be less than straightforward in their participation. (Yes, they might lie.) Hence, an understanding of some strategic behavior is important for practitioners of the budget process. 6 of 13 12/30/18, 8:16 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. The Incrementalist Insight The incrementalist concept holds that budgeting is mainly a process of political strategy. It downplays the service-delivery attitude of models from public finance economics and the attempts at rationality from policy analysis. As outlined by Aaron Wildavsky and Naomi Caiden, The largest determining factor of this year’s budget is last year’s. Most of each budget is the product of previous decisions. The budget may be conceived of as an iceberg; by far the largest part lies below the surface, outside the control of anyone. Many items are standard, simply reenacted each year unless there is a special reason to challenge them. Long-range commitments have been made, and this year’s share is scooped out of the total and included as part of the annual budget.… At any one time, after past commitments are paid for, a rather small percentage—seldom larger than 30 percent, often smaller than 5—is within the realm of anybody’s (including congressional and Budget Bureau) discretion as a practical matter. The beginning of wisdom about an agency budget is that it is almost never actively reviewed as a whole every year, in the sense of reconsidering the value of all existing programs as compared to all possible alternatives. Instead, it is based on last year’s budget with special attention to a narrow range of increases or decreases, i.e., changes in service response plans. General agreement on past budgetary decisions combined with years of accumulated experience and specialization allow those who make the budget to be concerned with relatively small increments to an existing base. Their attention is focused on a small number of items over which the budgetary battle is fought. Political reality, budget officials say, restricts attention to items they can do something about—a few new programs and possible cuts in old ones.48 Incremental budgeting is handy for lazy government, lazy administrators, and lazy lawmakers. Each agency receives roughly the same amount as it did the year before with only marginal changes. The temptation to behave incrementally is huge. Leaving the base largely alone minimizes conflict, and nobody has to make difficult choices. Resources do not get moved to deal with problems or opportunities that have developed. Absence of substantial change requires less admission of past errors and gives the impression of prudence. It preserves flexibility for the future. Administrators are comfortable but the citizenry has every reason to believe that it has been short-changed as the important choices do not get made. Dramatic changes in federal expenditure programs, beginning with the end of the Cold War, the Republican Contract with America in the mid-1990s, the beginning of wars in Iraq and Afghanistan, the Katrina hurricane disaster, the Great Recession of 2007–2009; dramatic changes in leadership of some state governments; and other political and economic changes in the recent past have raised some questions about whether government budget processes are as simple as Wildavsky and Caiden claim. Recent research by Anderson and Harbridge questions the basic argument of incrementalism: “This year’s spending may very well be a function of last year’s 7 of 13 12/30/18, 8:16 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. spending, but [our] analysis shows that the changes are surprisingly large… [There] is little stability in year-to-year budgeting, especially at the subaccount and appropriations bill levels.”49 More than half of budgetary changes are more than 10 percent, and more than one-fifth are greater than 50 percent. There have been dramatic fiscal changes within extremely short time periods. The fact remains that some policies—and resulting expenditure and revenue implications—do remain in place over the years; that most spending agencies at all levels of government do begin their new budget development by considering their approved budgets and the changes that should be made to them to adjust to new operating conditions; that the facilities of the agency are established in certain locations and are not going to be moved quickly; that budget comparisons in central budget offices, in legislative committees, and in the media are made between the proposed and prior-year budgets; and that the most rational place to get insights about the near future is from the immediate past. Information from looking at incremental change—positive or negative, big or little—ought not to be ignored simply because there have been major shifts in the direction of government spending, especially federal. Looking at change is a tool, not a religion, after all. Indeed, some states and many local governments build budgets from percentage increments to the historical budget base (the prior-year budget) in accord with some notion of fair shares to each agency—the ultimate in operational laziness. In many administrative systems, the base is assumed when the next budget cycle begins.50 Of course, some local governments are so poorly staffed that they really don’t know how to do anything better than build the budget by making additions to the existing line items. They really have no capacity to plan a response to anticipated conditions, and adding some percent to recent spending is all they are up to. Roles, Visions, and Incentives Service-delivery choices in the budget process involve several roles, each with different approaches and biases. Participants in the budget process recognize and expect those approaches and are aware of the errors, incentives, and organizational blind spots inherent in each. The major attitude orientations are those of operating agencies, the office of the chief executive, and the legislature. All participants in the budget process seek to provide service to the public (except for the lazy, time-servers noted in the previous section). Each, however, works from different perspectives, resulting in different incentives and different practical definitions of that objective. A full understanding of the budget process obviously requires recognition of those roles. 8 of 13 12/30/18, 8:16 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. 1. Operating agencies. Operating agencies (e.g., the Fish and Wildlife Service, the Department of Parks and Recreation, or Immigration and Customs Enforcement) spend money for the delivery of government services. These agencies focus on the clientele they serve. The agency will not be concerned with services provided by other agencies or be interested in relative priorities among other agency services. The agency probably is not much concerned with comparisons of service cost with service value. The agency recognizes the value of services it provides to its clients and ordinarily tries to increase those services regardless of overall budget conditions of the government. There will be a virtually limitless expanse of service opportunities, many of which go unfunded simply because other uses of public resources are of higher priority to those making fiscal choices. Agencies, however, seldom recognize those competing uses and often complain about their own lack of resources. Large agencies have both operating people who have little direct contact with the budget and budget people who have little direct contact with service delivery. Both groups, however, can be expected to have essentially the same point of view and clientele orientation. Operating agencies usually have identifiable proponents in the legislature—particular people who support the agency in hearings and in committee deliberations—but it is seldom appropriate for the agency to make direct proactive contact with those people to go around budget decisions made by the chief executive. In most situations, the operating agency is not responsible for raising the revenue that it spends for delivery of services and accordingly can be excused for regarding those resources as free. Service to clientele is the principal focus. 2. Chief executive. The office of the chief executive, whether that of president, governor, mayor, or whatever, has budget specialists acting on its behalf. The offices have different names (federal: Office of Management and Budget; state: state budget agencies; etc.), but their function and role are the same regardless of name. Analysts in that agency conform to the chief executive’s priorities, not their own. The analysts pare down requests from operating agencies until total spending is within available revenue. Reductions are typical for items (1) not adequately justified, (2) not closely related to achieving the agency’s objective, and (3) inconsistent with the chief executive’s priorities. Whereas agencies have a clientele orientation, the chief executive (selected by the entire population) must balance the interests of the total population. Thus, priorities for an individual agency should not be expected to coincide with those of the chief executive because specific client-group priorities seldom match those of the general public. The interests of Corn Belt farmers, for instance, are not the same as those of the general population. And the chief executive is going to be responsible for raising revenue, so she is going to be doing some balancing that simply is not part of the operating agency viewpoint. 3. Legislature. The priorities of elected representatives can be expected to follow interests of their constituents. Representatives are concerned with 9 of 13 12/30/18, 8:16 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. programs and projects serving the people who elect them. Representatives focus on a specific subset of the population, as is the case for operating agencies. Representatives, however, are oriented to a region rather than a specific client group. A legislator with a particular constituent interest can be particularly helpful when he or she is the chair of an important committee in the legislature. Forsythe offers another guide for chief executives in understanding the budgetary vision of legislators: “assume that legislators will apply a simple calculus in reviewing your budget proposals: they will want to take credit for spending increases and tax cuts, and they will want to avoid blame for budget cuts and tax increases.”51 The rule may not work all the time in every legislature—sometimes legislators take an ideological stand that all government is bad and happily cut spending—but otherwise it is a reasonable beginning assumption. It is particularly difficult to find legislators in favor of tax increases, especially of broad-based taxes that are not entwined in a complex package. Fiscal responsibility in practice seldom resonates with the general public. Strategies Budget proposals must be championed within operating agencies to be included in the agency request, within the administration for inclusion in the executive budget, and within the legislature to receive appropriation. A number of strategies, defined by Wildavsky and Caiden as “links between intentions and perceptions of budget officials and the political system that both imposes restraints and creates opportunities for them,”52 are regularly used in these processes at every level of government and, indeed, in many different countries. They may also be considered devices for marketing and communicating the agency position. Two ubiquitous strategies are always in use for the support of budget proposals. The first is cultivation of an active clientele for help in dealing with both the legislature and the chief executive. The clientele may be those directly served (as with farmers in a particular program provided by the Department of Agriculture) or those selling services to the particular agency (such as highway contractors doing business with a state department of highways). The best idea is to get the client groups to fight for the agency without having the agency instigate the action when the chief executive proposes the reduction; such instigation would look like insubordination, and the agency might ultimately suffer for it. Agencies unable to develop and mobilize such clientele find defending budget proposals difficult. The media can also deliver the support indirectly, but only with some preparations; agencies normally 10 of 13 12/30/18, 8:16 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. get coverage because they have bungled something.53 A strategy can help: “Try to stay in the news with interesting stories that do not put the agency in a bad light and that help you maintain good relations with reporters. Then, when you come close to budget time, you can give them press stories that show how well the agency has done with limited resources, and how well its pilot programs are working. Unstated is the premise that with a little more money you could do wonderful things and that if you are cut the public will lose valuable services.”54 The National Aeronautics and Space Administration (NASA) is a master at using the media to deliver its story through the budget process and serves as a model for any agency interested in learning how the strategy is played. It even has its own cable television channel, a delivery system that bypasses the media. With the exception of some reporters for the national papers of record—New York Times, Washington Post, and Wall Street Journal, in particular—journalists are mostly uninformed about government finances and are susceptible to manipulation by interest groups and agencies. Websites, including those offering blogs, are often more specialized, and their writers may have great expertise, but they often have considerable political bias and are subject to no editorial supervision, so they can be both valuable and dangerous. A second ubiquitous strategy that an agency may use is developing confidence in the agency among legislators and other government officials. To avoid being surprised in legislative hearings or by requests for information, agency administrators must show results in the reports they make and must tailor their message’s complexity to their audience. All budget materials must clearly describe programs and intentions. Strategically, budget presenters develop a small group of “talking points” that concisely portray their program. If results are not directly available, agencies may report internal process activities, such as files managed or surveys taken. Confidence is critical because, in the budget process, many elements of program defense must derive from the judgments of the administrators, not hard evidence. If confidence has been developed, those judgments will be trusted; if not, those judgments will be suspect. Contingent strategies depend on whether the discussion concerns (1) a reduction in agency programs below the present level of expenditures (the budget base), (2) an increase in the scope of agency programs, or (3) an expansion of agency programs to 11 of 13 12/30/18, 8:16 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. new areas. Some strategies seem strange or even preposterous; they are used, however, and should be recognized because the budget choices involved are vital parts of government action.55 It cannot be emphasized enough, however, that strategy and clever rhetoric alone are not sufficient; they do not matter at all if the basics of the budget—its logic, justifications, mathematics, and internal consistency— are faulty. Several strategies are applied as a program administrator responds to proposals for reduction in base (if a program may be terminated or reduced from its existing level of operation). These include the following: a. Propose a study. Agency administrators argue that rash actions (such as cutting their programs) should not be taken until all consequences have been completely considered. A study would delay action, possibly long enough for those proposing cuts to lose interest and certainly long enough for the program administrator to develop support for the program. b. Cut the popular programs. The administrator responds by proposing to cut or eliminate programs with strong public support. By proposing that the school band or athletic programs be eliminated, for instance, the administrator hopes to mobilize sufficient outcry to ensure no budget cuts. c. Dire consequences. The administrator outlines the tragic events—shattered lives of those served, supplier businesses closed, and so on—that would accompany the reductions. For instance, a zoo in Boston threatened to euthanize its animals if it didn’t get more state funding.56 d. All or nothing. Any reduction would make the program impossible, so it might as well be eliminated. e. You pick. The administrator requests that those proposing the cut should identify the targets, thereby clearly tracking the political blame for the cut and hopefully scaring away the reduction. f. We are the experts. The agency argues that it has expertise that the budget cutter lacks. The reduction is shortsighted, based on ignorance, and thus should not occur. g. The Washington Monument. A time-honored strategy of program administrators is to respond with a dramatic gesture. In other words, the federal National Park Service says that it will close the Washington Monument, a popular tourist attraction, if the relevant appropriation bill is not passed by Congress (as it did for two days every week in 1969 to deal with a budget battle), or the local police department proclaims that it will no longer respond to vehicle break-ins because its fuel budget is being exhausted. Another example: when a 2015 request for additional subsidy from participating local governments by the Washington Metropolitan Area Transit Authority was denied, the Authority responded by a threat to cut all bus service to all 12 of 13 12/30/18, 8:16 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. 13 of 13 12/30/18, 8:16 PM 1 of 14 12/30/18, 8:14 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. What Is a Budget? A budget is a critical document in the operation of any modern public organization; this includes both governmental and non-profit organizations. It has an explicit meaning, and it has several expected components. In simplest terms, a budget is a financial plan that carries forward the financial implications of carrying out a particular planned response to the anticipated operating conditions in a future period, normally a year. It has been prepared to fit expenditure programs within the constraint of revenues available in that future period. Fitting programs into available resources is the heart of budgeting; everything else is subservient to that effort. The budget takes a policy plan for provision of physical services and translates it into the cost of providing that plan. It is not a forecast of future spending by the organization, but it represents the intended response of that organization to the conditions that the organization expects to face in the future. It isn’t a projection of government spending and revenue collections, and it isn’t a target. It isn’t a wish list of what the organization would like to do if it had no limits on its resources. And it isn’t a shopping list of the things that the organization intends to purchase in a future year. A good budget says, in essence, these are what we believe are likely to be the operating conditions in the budget period (sorts of problems that will emerge, level of prices that the organization will have to pay for what it purchases, resources that we expect to have available within the period, etc.), and here is what we intend to do about the problems and opportunities. The expected operating conditions may not materialize as we have expected, but if they do, here is our operating response. If they don’t, we will make adjustments on the fly. The first rule of budgeting is simple: the ideas (policy) always precede the numbers. If you don’t have the ideas, the numbers are just fluff. Here are the blunt facts: If a program manager knows what she is doing and intends to do, she will be able to produce a budget. If she doesn’t and is just filling a chair, she won’t be able to do it. If she believes that producing a budget is keeping her away from the important tasks of running the operation, she should be relieved of duties before she creates any more damage. If she works with budget numbers without first devising her operating plan for the budget year, she doesn’t know what she is doing. And she ought to be happy about doing the plan because that offers her a way of communicating her good ideas for service to the public. If you know what you are doing, you can do a budget and can and should use it as an important tool for management, evaluation, and communication. The complete budget will include at least three distinct segments: a financial plan that reflects expenditures intended to carry out the planned response to the operating conditions expected in the budget year, a revenue forecast that reflects how much revenue the government expects to collect in the budget year based on the anticipated state of the economy and the revenue structure that the government intends to have in place, and a plan for managing any difference (surplus or deficit) between the expenditure plan and the revenue forecast. The budget begins with a narrative discussion of what the government expects and how it plans to deal with those expectations; it then moves to a financial section that provides budget 2 of 14 12/30/18, 8:14 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. numbers. Later chapters of this text will go into considerable detail about the meaning of the sections of the budget, the methods used to prepare each section, and the tools used to analyze the sections. Later chapters will also discuss the revenue side of the budget process, including the development of revenue policies and revenue forecasts. Federal, state, and larger local governments divide responsibility for pieces of the full budget. For instance, state budget managers seldom are directly involved in the revenue forecast, but they will be operating within revenue constraints developed by others. However, managers in smaller local governments and nonprofit organizations will need to be intimately involved in all parts of the budget. Our first emphasis is on the expenditure portion of the budget, but keep in mind that this is only one element of the full public budgeting and finance process. Budget Process and Logic The market allocates private resources without a need for outside intervention; price movements serve as a signaling device for resource flows. In the public sector, decisions about resource use cannot be made automatically from price and profit signals because of four special features of government decisions, as discussed in Chapter 1. First, public goods, the primary service focus of governments, are difficult, if not impossible, to sell, and, even where sales may be feasible, nonrevenue concerns may be as important as the cash collected. For instance, national parks may serve a conservation purpose in addition to being a recreation facility. In that case, money collected from recreation charges would not be a complete guide to decisions about those facilities. Profit can neither measure success, nor guide resource allocations, nor serve as an incentive to efficient operations. When markets have failed, it is a mistake to try to use simple market information as a first guide for decisions. Second, public and private resource constraints differ dramatically. Whereas earnings and earnings potential constrain spending of private entities, governments are limited only by the total resources of the society.10 Resources are privately owned, but governments have the power to tax. There are obvious political limits to tax extractions, but those limits differ dramatically from resource limits on a family or a private firm. Third, governments characteristically operate as perfect monopolies. Consumers of government services cannot purchase from an alternate supplier, and, more important, the consumer must pay whether the good provided is used or not. Again, this makes market-proxy data based on traditional government operations suspect as a guide for resource allocation. Finally, 3 of 14 12/30/18, 8:14 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. governments operate with mixed motives. They are trying to achieve more goals than the single objective of maximizing value of the firm that characterizes private business decisions. In many instances, not only the service provided but also the recipients of the service (redistribution) or the mere fact of provision (stabilization) is important. For example, the federal Supplemental Nutrition Assistance Program (SNAP, formerly the food stamp program) seeks to make healthy food available to low-income families by supplementing the money these families have to buy food. But the program is administered by the U.S. Department of Agriculture. In other words, it seeks to help low-income families, but it also aims to increase the income of American food producers (farmers), even though there may be more economical means of achieving either of these objectives by itself. Accordingly, more may hinge on the provision of a public service than simply the direct return from the service compared with its cost. Because these multiple and mixed objectives cannot be weighed scientifically and because achievement of objectives cannot be easily measured across programs, the budget process is political, involving both pure bargaining or political strategies and scientific analysis. The Parts of the Public Expenditure/Public Revenue Process Government spending must be financed: receiving the benefits of a good or service is linked in the private sector to paying for it (you have to buy it before you can use it), whereas in the public sector what the government provides does not determine how its operations will be financed. When a business makes shirts, it knows exactly from whom the financing will be received: the people to whom it sells those shirts. If people don’t buy the shirts, the business is in trouble. But when the federal government decides to increase its provision of national defense, it must make another decision: Who will pay? It isn’t going to sell the service; there is no link between who receives the service and how it will be financed. That means that there will be two separate planning processes: public expenditure and public revenue. Payment for a government service is not a precondition for benefiting from that service; if the mosquito abatement district has seen to its job, both those who pay taxes to the district and those who don’t will be free of mosquito bites. There are two distinct components of public finance. The expenditure side of budgeting should set the size of the public sector, establishing what is provided, how it is provided, and who gets it. The revenue planning side, on the other hand, determines whose real income will be reduced to finance the provision of the budgeted services. Although the total resources used must equal the total resources raised (including current revenues, borrowing, and, for national governments, the creation of new money to spend), the profile of government expenditure does not ordinarily indicate how the cost of government should be distributed. In some instances—for example, the Holland Tunnel that connects New York and New Jersey under the Hudson River—it is feasible to identify the direct beneficiaries of the public service 4 of 14 12/30/18, 8:14 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. and to charge them to finance the tunnel, thus causing the operators of the facility to be more like a private business than a government, but the range of public services for which such financing would be practical is limited. (Charge financing is discussed in Chapter 12.) More often than not, government services are more like mosquito abatement than the Holland Tunnel, and revenue planning will be distinct from decisions about spending. Figure 2–1 shows how dollars, resources, and public services logically flow from the revenue system to the procurement process to service delivery. The public procurement process involves exchange transactions (purchase on the open market) and, with few exceptions (eminent domain purchase of property and military draft being two), is economically (but possibly not politically) comparable to procurement by private firms. That is, it matters in the political process what firm the government does business with, not just the quality and cost of the product being sold, sometimes for apparently benign reasons (a requirement that all firms selling resources to the government must be American) and sometimes for less honorable and usually illegal reasons (a requirement that all firms must donate to the right political campaign). And legislators at all levels of government seek to bring government business to their own constituencies, often with minimal regard to whether that is the most efficient way of delivering services to the public as a whole. The unique public sector features of the flow involve revenue-generation and service-delivery decisions, the concerns of the following chapters. Governments devote much of their attention to the part of the budget process that deals with expenditure and servicedelivery processes; the next several chapters examine this part of the budget. Revenue planning is examined in later chapters. The basic communication device of the process is the budget, a government’s plan for operation translated into its financial implications. Governments prepare budgets as a means for (1) elaborating and communicating executive branch intentions, (2) providing legislative branch review and approval of those plans, (3) providing a control-and-review structure for implementation of approved plans, and (4) providing a template for external review of the legality of what the government has done with funds entrusted to it.11 Nonprofit organizations prepare budgets for all those reasons, and they also need the budget to show prospective and actual funders how their money is being used. Budgets are forwardlooking and action-oriented. Although they ideally will also contain some historical information to provide a foundation for the budget proposals, their real focus is on the future for the government or other organization. The budget—by explicitly spelling out provisions for spending and identifying responsibility for all money to be spent—provides the first and most critical defense against public corruption. Governments can use the budget to communicate their program intentions for the future to the public, although not enough governments think of the budget in such terms and the public is not accustomed to looking at budgets at all.12 The media can serve as a useful device for that communication, but budgets have insufficient glitz to capture the attention of many traditional outlets, despite the significance of government program intentions for the public. Figure 2–1 Service-Delivery and Revenue Systems as Separate Planning Processes 5 of 14 12/30/18, 8:14 PM 6 of 14 12/30/18, 8:14 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Budget Classification, Structure, and Presentation Years The expenditure side of government budgets deals with plans for spending to deliver services to the public. Logically, the agency develops plans to provide services and estimates the cost of purchasing the resources necessary to execute those plans. In that respect, government operations are similar to those of private business: resources are acquired and used to deliver a valued output. The public agency’s budget is its business plan for the next year, subject to the approval of certain representatives of the people. The information in that plan can be organized in various ways to facilitate policy formulation, resource allocation, fiscal discipline, and compliance with the law. Three fundamental categorizations are: 1. Administrative. An identification of the entity that is responsible for management of the public funds and for provision of public services with those funds. In other words, the budget would be classified according to funds to the police department, the fire department, and so on in the city government. This classification is critical for identification of responsibility and for ongoing execution of the budget. 7 of 14 12/30/18, 8:14 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. 2. Economic. An identification of the type of expenditure: compensation of employees, utilities to be purchased, supplies, and so on. This classification is also called line item (the items in a purchase list) or object of expenditure. This represents something like a shopping list for the government and may be built with varying levels of detail (i.e., it may list “utilities,” or it may have separate lines for each utility: “electricity,” “water,” “gas,” etc.). 3. Functional. An identification of spending according to the intended purposes and objectives of the government. This classification organizes government operations into their broad purposes (such as education or national defense) without regard for the entity responsible for the resources. It is a classification particularly suitable for fundamental resource allocation choices. The three classifications are independent of each other, and many governments present all three in their budget document in an effort to provide for full transparency of finances. The Budget of a City Police Department: Organization, Items, and Years The most basic (and most traditional) classification is economic or line item, with its focus on inputs to the flow of service provision, that is, on the resources (line items or inputs)—labor, equipment, supplies, and the like—purchased by the government in the course of responding to the demand for service. Each administrative unit prepares its own budget to provide control and responsibility. The budget for the police department of the city of Kirkland, Washington, for 2015–2016 illustrates that classification (Figure 2–2) and provides an excellent starting point for understanding budget presentation.13 Kirkland uses a biennial budget system, so it does its budgeting in two year rather than one year blocks. The 2011–2012 column reports the most recent budget execution, the 2013–2014 budget columns represents the expected amounts that will be spent during the current biennium (when the 2015– 2016 budget is being adopted) and the amounts budgeted for that period, and the proposed budget for the 2015–2016 biennium. The 2013–2014 estimates column reports how budget execution is proceeding (some categories have had to be increased, either by internal transfers or by more money being approved by the legislative body), and the 2015–2106 column represents the program plan for the upcoming fiscal period. The budget items are for expenditures to be made (purchases) by the department. This format is the basic structure for budget development in that it is the template an agency would use for estimating the cost of carrying out its plan for service. The presentation gives the line items for the department as a whole and totals distributed to each of the divisions of the department. 8 of 14 12/30/18, 8:14 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Figure 2–2 City of Kirkland, Washington, Budget Summary for Police Department, 2015–2016 9 of 14 12/30/18, 8:14 PM 10 of 14 12/30/18, 8:14 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. The budget in Figure 2–2 demonstrates some important features. First, this display is for the police department. There will be a similar budget component for each administrative agency of the city. Budgets to agencies provide a mechanism for control and responsibility in the process. Administrators of the police department are responsible for this appropriated money. Second, the budget display includes information for the upcoming budget period (the plan). But it also includes comparable information for the current year—in this instance, both the initially budgeted amounts and the amounts revised to reflect likely actual execution—and for the most recently completed period. This presentation of these years provides a basis for the analyst (or for an inquisitive member of the general public) to get an idea of what changes might be in store for the city in the next year.14 Multiyear presentations are standard for government budgets. Unfortunately, nonprofit organizations frequently submit only single-year budgets to their boards to get approval of plans. It is not clear what these boards are supposed to do with only a single year. Possibly check the math? Third, the budget provides details on the amount spent by each of the divisions of the police department. That gives information about the resources being devoted to the several different services provided by the department. Fourth, this budget provides a distribution of staffing in the department, a useful presentation in light of the high share of total spending devoted to salaries and wages. Not all budgets provide this detail, but it does contribute to better understanding the operations of the department. The full budget document (not reproduced here, but available at the city website []) also provides a statement of the mission of the department, a description of the functions of each division of the department, and a short identification of what program changes (plans) are reflected in the budget request. The years appearing in a budget logically are these: 1. The budget year. The document focuses on the budget year (or years if the process is biennial), 2015–2016 in this example. These numbers reflect what the agency plans for operations, what it has requested for approval by various stages of review, and what resources will be required for the execution of these plans. These columns are the action items for consideration and legislative approval and, once enacted into law, become the template against which the agency will be held responsible. Some executive budgets will report what the agency requested initially, along with the amount recommended by the executive; this one does not. The Kirkland budget also presents the percentage change for the budget period in comparison with the prior period budget. 2. The progress-report year. The budget for 2015–2016 will have been considered during the 2013–2014 budget period. The 2013–2014 columns in this budget report what was budgeted for that biennium and what the actual result is likely to be. (Frequently, only the likely result for the current year is reported; the figures initially adopted are not reported.) 11 of 14 12/30/18, 8:14 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. 3. The final-report year. This column reports the fiscal figures for the most recently completed fiscal year, 2011–2012 in this illustration. These figures provide a standard for comparison. 4. Out-years. Some budgets (but not the one in Figure 2–2) also carry figures for out-years, or years beyond the budget year in the request cycle. Some governments prepare a multiyear financial framework with budget estimates for from three to five years into the future so that a longer perspective on finances is possible. However, these out-years are not part of the basic budget appropriations, and the extent to which they make much difference in the decision process varies widely across organizations. In many instances, those forecasts aim to produce warning signs that induce actions which are intended to actually make the forecast wrong. For example, a forecast of expanding deficits in the out-years may induce current actions to reduce programs that would be contributing to those deficits, thus making the forecasts wrong. Out-year numbers are almost always wrong as indicators of eventual outcomes. The federal government has recently used a budget year plus four years in executive budget summary presentations.15 However, the Obama administration’s first budget framework, A New Era of Responsibility, Renewing America’s Promise, returned to a ten-year horizon in its budget summaries, a horizon that was used in presidential budgets from 1997 through 2002. The longer horizon reflects a concern with future implications of fiscal decisions, even though specific actions on those future figures seldom will be taken in that particular cycle. Nor should those fiscal choices be locked in early; priorities, needs, and fiscal circumstances may well change. The earliest multiyear presidential budget presentations date from the Reagan administration. Skeptics suggest that these were developed so that control over the federal deficit could be shown eventually, although the deficit reductions were only in years at considerable distance from anything actually proposed in the budget. Later Obama budgets provide a five-year horizon in most presentations. Both Congress and the administration do work with a ten-year horizon even if most attention is given the current budget year. Administrative and Functional Classification Budget classification in functional form provides the same budget proposal as an administrative presentation, but it organizes the information to highlight resource allocation choices as opposed to highlighting the entities that are to be responsible for the funds. Table 2–3 illustrates the point with information from the federal budget. Federal outlays are organized according to function in the left side of the table and according to administrative department in the right. Total spending for both sides of the table is the same, just categorized differently. The functional classification identifies spending for provision of a particular service or purpose category, without regard for the responsible entity. So spending to provide service for support of natural resources and the environment is considerably different from spending by the Environmental Protection Agency because a number of agencies are involved in supporting services for natural resources and the environment. And so it is with each function and for most agencies—several agencies contribute to the functions and single agencies are contributing toward multiple functions. The functional classification gives a view of fundamental resource allocations to deal with the array of public problems.16 12 of 14 12/30/18, 8:14 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Table 2–3 Federal Outlays by Function and by Administrative Organization, Fiscal 2013 Superfunction and Function National Defense Human resources Education, Training, Employment, and Social Services Health Medicare Income Security Social Security (On-budget) (Off-budget) Veterans Benefits and Services Physical resources Energy Natural Resources and Environment Commerce and Housing Credit (On-budget) (Off-budget) Transportation Community and Regional Development Net interest 13 of 14 $ Million Department or $ Million Other Unit 633,385 Legislative Branch 4,334 2,417,949 Judicial Branch 7,063 72,808 Department of 155,872 Agriculture 358,315 Department of 9,140 Commerce 497,826 Department of 607,800 Defense—Military Programs 536,511 Department of 40,910 Education 813,551 Department of 24,670 Energy 56,009 Department of 886,291 Health and Human Services 757,542 Department of 57,217 Homeland Security 138,938 Department of 56,577 Housing and Urban Development 89,997 Department of the 9,607 Interior 11,042 Department of 29,745 Justice 38,145 Department of 80,307 Labor 0 Department of State 25,928 −81,286 Department of 76,322 Transportation −1,913 Department of the 399,068 Treasury 91,673 Department of 138,464 Veterans Affairs 32,336 Corps of Engineers 6,299 —Civil Works 220,885 Other Defense Civil 56,811 Programs 12/30/18, 8:14 PM (On-budget) (Off-budget) Other functions International Affairs General Science, Space, and Technology Agriculture Administration of Justice General Government Allowances 326,535 Environmental Protection Agency −105,650 Executive Office of the President 185,174 General Services Administration 46,418 International Assistance Programs 28,908 National Aeronautics and Space Administration 29,492 National Science Foundation 52,601 Office of Personnel Management 27,755 Small Business Administration ......... Social Security Administration (OnBudget) 9,484 380 −368 19,740 16,975 7,417 83,867 477 109,849 PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. 14 of 14 12/30/18, 8:14 PM 1 of 12 12/30/18, 8:15 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Undistributed −92,785 Social Security Administration 757,542 offsetting receipts (Off-Budget) (On-budget) −76,617 Other Independent Agencies (On-Budget) 28,180 (Off-budget) −16,168 Other Independent Agencies (Off-Budget) −1,913 Total, Federal outlays 3,454,605 Allowances .......... Undistributed Offsetting Receipts −249,450 (On-budget) −127,632 (Off-budget) −121,818 Total outlays 3,454,605 SOURCE: Office of Management and Budget, Budget of the Government of the United States, Fiscal Year 2015, Historical Tables. (Washington, D.C.: U.S. Government Printing Office, 2014.) Alternative classifications of budgets, including the strengths and weaknesses of each classification, are discussed in greater detail in later chapters. However, behind any budget classification lurks some “grocery list” of inputs that will be needed for the service plan regardless of the vision or strategy for providing services that has produced that plan. Just as a cook has to decide whether to bake cherry pies or angel food cakes before preparing a grocery list (the inputs), a government executive needs to have a service plan before creating the list of inputs to be purchased. And both the cook and the government executive will eventually need a grocery list to carry out the plan. Hence, the input classification is the most basic and durable format of all. In many small governments and nonprofit organizations, it is the only classification structure for the budget. However, this grocery list should not be the focus of budgetary analysis. The focus should be on what the agency does with the resources it has purchased. 2 of 12 12/30/18, 8:15 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. What the Budget Process Should Contribute Governments exist to provide services. The budget process provides a time for decisions about the services desired by the public and the options available to the government for providing these services. A traditional expectation is that properly working budget processes act to constrain government and to prevent public officials from stealing. Indeed, public budgeting in the United States developed first at the municipal level to prevent thievery, pure and simple. Budgets should do that, but they should also do more, particularly with regard to seeing that governments fulfill their appropriate role in delivering the services demanded of them by businesses and individuals through choices made in the democratic process and that resources available to government are reasonably used. The process allocates resources among government activities and between government and private use. The great struggle in the budget process is between “needs” and “availability.” On one hand, the resources available to the government are limited by economic conditions and the extent to which the government is willing to apply its fiscal authority to draw revenue from the private economy. On the other hand, agencies and departments of government have commitments and opportunities to deliver services to the citizenry. Long-term fiscal sustainability—the ability of the government to maintain its operations on behalf of the public without deterioration of services or dramatic increases in taxation —requires that actual spending be within resource availability. That means continuing tension because opportunities for service always exceed resource availability. The budget process has to work that out as part of the agenda for sustainability.17 Budget presentations that extend several years into the future, well beyond the term of current budget proposals, are primarily documents for fiscal sustainability. Public financial managers expect budget procedures to (1) provide a framework for fiscal discipline and control, (2) facilitate allocation of government resources toward uses of highest strategic priority, and (3) encourage efficient and effective use of resources by public agencies as they implement public programs.18 They also expect budget procedures to be the primary mechanisms for creating transparency in the fiscal operations of the government, an objective made much easier by the ability to post significant documents on a government website for anyone to see. The procedures work through budget planning and development, budget deliberations, budget execution, and audit. The processes of analysis and management apply equally to government and nonprofit organizations, although they are usually more highly developed and more routine in governments. 3 of 12 12/30/18, 8:15 PM PRINTED BY: Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. 1. Fiscal discipline and control. The expenditure-control function in budgeting restrains expenditures to the limits of available finance, ensures that enacted budgets are executed and that financial reports are accurate, and preserves the legality of agency expenditures. The control function—making sure that expenditures agree with the legal intent of the legislature—helps develop information for cost estimates used in preparation of future budgets and preserves audit trails after budget years are over.19 Much of the control comes from within the spending unit, to ensure that funds are being spent within legal intentions because it is better to prevent misuse than to try to punish it after it has occurred. Sending public officials to jail may provide some satisfaction, but it won’t bring the stolen resources back. It is better to have a framework in place to prevent theft than to concentrate on punishing violators after it has happened. Budgeting and appropriating given dollar amounts to purchase given quantities of goods or services simplifies the fundamental external audit questions: Do financial statements of the agency tell the truth, is the agency sufficiently protective of public resources, and did the agency use the resources provided it in the intended way? If the appropriation was for the purchase of 10 tons of gravel, was that gravel actually purchased and delivered in a responsible manner, was the gravel adequately protected while it was in the agency’s hands, and do the agency’s financial reports accurately reflect the gravel transaction? Restructuring the notion of control away from inputs purchased toward services provided presents a great challenge for government responsiveness. Unfortunately, the definition of accountability in government has remained relatively constant over the past fifty years: “limit bureaucratic discretion through compliance with tightly drawn rules and regulations.”20 If government is to be flexible, responsive, and innovative, narrow control and accountability to the legislature and within the operating agencies almost certainly must change from internal operations to external results. 2. Response to strategic priorities. The budget process should work to deliver financing to the programs that are of greatest current importance to the citizenry. Governments face many fruitful opportunities for providing useful services. Their resources are limited, so they must choose among useful options, recognizing that their choices both influence and must be influenced by community, state, and national environments. They should not have to work around legal or administrative constraints that protect certain activities without regard for their relative importance. All 4 of 12 12/30/18, 8:15 PM PRINTED BY: Printing i...
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