Deferrals from the Perspective of the User of Government Financial Statements

The audited financial statements of state and local governments are intended to communicate with a wide variety of people who analyze government financial health, make decisions about government The audited financial statements of state and local governments serve as a vital communication tool for a wide variety of people, including those who analyze governments’ financial health, make decisions about government finances, and hold governments accountable. These users of financial statements have vastly different levels of experience and knowledge and are interested in a broad range of topics related to government finances.

Despite those differences, financial statement users share a common need for reliable and relevant governmental financial information. Another thing they have in common is confusion surrounding two unique features of government financial statements: deferred outflows of resources and deferred inflows of resources (referred to together as deferrals). This article focuses specifically on what deferrals communicate to users and how information about them can play a role in those users’ analyses, decisions, and accountability activities.

Different Types of Government Financial Statement Users

As “general purpose” financial statements, the audited financials that governments issue — which are based on generally accepted accounting principles as published by the Governmental Accounting Standards Board (GASB) — should be usable by and understandable to both seasoned technical experts and average citizens. No matter their prior knowledge or experience, a person who (1) has an interest in and need for government financial information, and (2) is willing to invest a reasonable amount of time in getting up to speed on government accounting basics and reading the report, should be able to use financial statement information meaningfully.

Users are categorized by the GASB into three groups:

• Investors and creditors
• Legislative and oversight bodies
• Citizens

Investors and Creditors

Investors and creditors play crucial roles in supporting governments by participating in the sale and purchase of municipal bonds and notes, as well as extending loans and providing goods and services on credit. Analysts at those entities generally evaluate a government’s creditworthiness — its ability to repay its debts on time. Rating agency analysts evaluate creditworthiness and assign governments credit ratings based on that analysis. As frequent and intensive readers of financial statements, those users are very familiar with the information they contain and understand the underlying accounting rules better than most other users.

Legislative and Oversight

Elected legislators, their staff, and governmental oversight entities (such as state education departments and state-appointed fiscal monitors) make up another category of users of financial statements. Elected legislators and their staff are particularly interested in allocating a government’s tax revenues and other scarce resources among competing public services through the budget process. They subsequently need to monitor actual experience against the budget and ensure that revenues and expenditures are balanced for the year. They also perform oversight functions, along with dedicated oversight agencies and commissions, through which they seek to hold governments accountable for the effective and efficient use of public dollars. Legislative users are generally knowledgeable about governments and government finances and are familiar with, but not knowledgeable about, government accounting. Oversight users have a comparable degree of knowledge about governments and are generally knowledgeable about accounting standards as well.

Citizens

The citizenry, comprising the largest group of potential users, often lacks knowledge about government accounting and is less likely to utilize government financial reports directly. However, staff at citizen groups and taxpayer associations, who are studying and reporting publicly on issues that are important to citizens, may have a basic knowledge of government accounting as necessary to understand those issues and report on them to the public. Similar to legislative and oversight users, a common interest of citizen users is holding governments accountable for the effective and efficient use of limited public resources.

Academics and Researchers

A fourth user category might include professors in colleges and universities who teach or conduct research on topics related to government finance, as well as people conducting research on such topics at think tanks and public policy groups. They may be knowledgeable about governmental accounting and generally are knowledgeable about governments and the governmental financial environment.

How Deferrals Inform Users’ Shared Interests

Differences in experience, knowledge, and primary focuses notwithstanding, the various kinds of users share some concerns about governments and need information about many of the same aspects of government finance. For example, information about a government’s level of indebtedness is potentially significant to all user types. However, the nature of their concern may diverge because of the different purposes for which they use the information:

• A legislative or oversight user may focus on how close the amount of outstanding debt is to the government’s state-imposed debt limit, perhaps to ensure the limit is not exceeded or to assess available legal borrowing authority to finance necessary infrastructure investments.
• A citizen group may concentrate on the government’s debt burden, the cost of repaying it, and the resulting property tax bills.
• A municipal bond analyst may evaluate the amount of outstanding debt in the context of the government’s financial capacity to repay existing debt and to afford to issue additional debt.

Degree of Indebtedness

Appropriately evaluating a government’s degree of indebtedness depends in part on having accurate information about its liabilities and assets. Some debt indicators are limited to bonds, notes, and loans, while some are more broadly inclusive of other amounts owed. These may include liabilities related to pensions, retiree health insurance (also known as other post-employment benefits, or OPEB), long-term leases, accrued vacation and sick leave to be paid in the future, claims and settlements, and costs associated with landfill closure.

One of the essential consequences of introducing deferrals to government financial statements was the reclassification of things that previously were reported as assets or liabilities but were not actually resources owned or amounts owed. Before the GASB required those items to be reported as deferred outflows of resources and deferred inflows of resources, they were generally indistinguishable from other assets and liabilities. The result was potentially overstated assets and liabilities, which could lead to inaccurately calculated indebtedness indicators, and therefore mistaken conclusions about a government’s ability to repay existing liabilities or to incur additional liabilities. In many cases, users were unaware they were incorporating faulty information into their analyses, decision-making, and accountability efforts.

Consider how the following typical indicators of indebtedness were affected before deferrals were removed from the assets and liabilities:

Indicators and Potential Effects on Government Perception

Before deferrals were introduced to governmental accounting, no “liability” was more notorious than “deferred revenues.” In a typical governmental fund, the amounts reported as deferred revenues liabilities could have included both amounts owed to others (customer fees and grants received in advance) and amounts waiting to be reported as revenues (grants with time restrictions and unavailable revenue).

Customer fees received before services are provided are reported as a liability because, if the government doesn’t provide the service, the money must be returned to the customer. The same can be said if a government never meets the eligibility requirements for grants it received in advance. On the other hand, grants with time restrictions but no further eligibility requirements aren’t liabilities because the government just needs to wait until the year when it is allowed to spend them. Lastly, unavailable revenue (a product of the modified accrual basis of accounting in governmental funds) represents amounts due to the government that were not collected during the year or soon enough after fiscal year-end to be used to pay this fiscal year’s expenditures.

It used to be common that deferred revenue was one of the larger liabilities in the governmental funds. To the extent that it contained items that were not really amounts owed, it caused total liabilities to be overstated and made a government look worse off financially, all other factors being equal. Compounding that problem, it was also common that unavailable revenue was the largest component of deferred revenue, sometimes larger than the other parts of deferred revenue combined.

Compare Revenues with Expenses

Various types of users also often compare annual revenues with annual expenses or expenditures for different purposes:

• Municipal bond analysts may view a government that raises enough revenue each year to cover its expenses as more creditworthy, all other factors being equal, than a government that spends more than it takes in and covers the difference by draining its reserves or pushing costs off to the future.
• Legislative and oversight users may be monitoring whether the government achieved actual budget balance for the year.
• Citizen groups may be attentive to holding the government accountable for living within its means each year, a concept the GASB calls interperiod equity.

Consider this example: Imagine that a city hires a company to build a public sports and entertainment venue and operate it on the city’s behalf for 25 years. As part of the deal, the company pays the city $50 million when the contract is signed, before construction has even begun. The decision about when that up-front payment should be reported by the city as revenue will directly affect a user’s analyses, decisions, and assessments of accountability related to the city’s finances.

If the entire $50 million is reported at once — for example, in the year when the contract is signed or in the first of the 25 years the company operates the facility — revenues may look substantially greater than expenses in that year but be unaffected in the rest of the years. From a user’s perspective, would that be an accurate depiction of whether the city is making ends meet in each of the next 25 or more years?

GASB standards view the $50 million up-front payment as part of the compensation the company is paying the city for the right to operate the venue (and, conceivably, to collect revenue of its own by doing so). Even though the city received the money all at once, it is “earning” the money over the 25 years during which the company has the right to operate the venue. That argues for reporting the up-front payment as revenue over the 25-year period, as the city earns it. When it receives the $50 million, it reports the cash and a deferred inflow of resources in that amount. It then reports the revenue in each of the 25 years, likely in equal amounts of $2 million, and reduces the deferral by the same amount.

Other Uses of Deferral Information

Deferral information is valuable to users for purposes beyond calculating accurate financial ratios and evaluating interperiod equity. Broadly, deferral information is useful and relevant in any circumstance in which it is important that revenues and expenses/expenditures be reported in the correct years and in the correct amounts. For example, several types of deferrals relate to governments’ liabilities for pensions and OPEB, and they are useful for understanding why those liabilities increase or decrease over time and how that will impact future expenses.

Want More Information?

For a deeper dive into deferred inflows of resources and deferred outflows of resources, we invite you to check out our Demystifying Deferrals e-book, which contains additional articles that address the issue at different depths for a variety of stakeholders, as well as links to short videos and other resources.

Have specific questions about deferrals? Reach out to your CRI advisor.