Among the long term items in this chapter, obligations are covered first, then assets. Four types of long term obligations or debt will be covered in this lesson and for each type there will be several explanatory subtopics. The four types of long term debt are:
The first two of the four will be given particular attention and will be analyzed under:
Other possible long term obligations include long term contracts and interjurisdictional funding agreements. Governments will somtimes enter into long term contracts with vendors or have annual obligations to pay a share of a regional operation such as transit authority. Thesea two are mentioned but not explored in the lesson.
With term bonds, all the principal is due at one time and the interest is paid while the principal is outstanding. With serial bonds, the principal is paid off at intervals; for example, an equal amount each year. Actually, there are various types of serial bonds, some with equal payments; others with unequal or varying payments. With deep discount bonds, all the interest and principal are paid off at one time. This means the government receives some money and does not have to pay back anything for a certain period, but then all the money (full principal and interest) must be paid at one time. A simple example is given for each type of bond.
Types of Bonds
TERM:
Interest for
Amount Due Interest Semi-Annual Payment
------ --- -------- -------------------
$1,000,000 10 years from now 8% $40,000
SERIAL:
Semi-Annual Payment
Amount Due Interest decreases each year
------ --- -------- -------------------
$1,000,000 $100,000 each year 8% $40,000
for ten years $36,000
DEEP DISCOUNT:
Collect Due no regular interest paid
and Payable but total interest =
ten years from now
------- ------------------ -------------------------
$463,190 $1,000,000 $536,810
In the first example, a term bond, the $1,000,000 is borrowed but the principal is not due for ten years. Semi-annual interest payments (i.e., each 6 months) amount to $40,000 (1,000,000*.08*1/2). For serial bonds, where equal payments of principal are made, the interest payment declines. Note, that as the principal is paid the interest declines from $40,000 (1,000,000*.08*1/2) to $36,000 (900,000*.08*1/2). In actuality the interest payment will decrease to $36,000 for the interest payment after the initial $100,000 is paid. With deep discount bonds the government gets, in this case, the present value of $1,000,000 discounted at 8% for the ten year period, or $463,190 (semiannual payments are considered irrelevant). In other words, if the $463,190 were invested at 8% and kept for ten years the resulting amount would be $1,000,000. When the government pays back the total $1,000,000, $536,810 is actually interest. Present value or more broadly time value of money is illustrated more systematically in exercises and demonstrations, under Time Value of Money, Introductory Discuss. The exercises and demonstrations are within the study aids.
In many cases, bonds can be used for legitmate reasons for major capital projects in government but in some cases the reasons for borrowing may be questionable on economic grounds. Sometimes a large capital project is not cost effective but is politically expedient. Typically, these are called pork barrel projects. A government that indulges in these will find that the community is not better off economically and tax revenues will not be able to pay for the bonds. Such practices can lead to cutting back on other service areas or even borrowing more, that is, refinancing, to pay the debt.
Although there are many types of bonds, the method for determining how much to save to pay back the bond is not very different. The method depends on facets of time value of money calculations. In the case of money invested to pay for principal due in the future one needs to understand annuities and compounding , or simply periodic investments and the interest that can be earned on the investment plus the interest earned on the interest. The fundamentals of these facets of time value of money are covered in exercises and demonstrations especially in the Introductory Discussion of Exercises and demonstrations and practical applications, Investing to pay back future debt. For a quick reference in the glossary see future value of $1 and future value of an annuity in the glossary.
One factor with a bond is that all or part of the principal is due sometime in the future. That may be one, two or even thirty years away. Of course, many bonds can be added together to come up with a total principal due in each year. In all these situations it would be prudent to figure out how much to invest each year so that when the principal comes due, sufficient money will be available to pay off the amount. In actuality, the political fortitude (just like the personal fortitude) to save may be more difficult than the calculations. Two sample calculations are given, one simple; one a bit more complex.
Time value of money tables can be helpful in solving this problem because these tables identify how much will be earned if $1 is invested periodically at a certain interest rate. In this case $1 invested at 5% for each of five years would yield $5.526. Technically, this is called the future value of an annuity since the same amount is invested each period.
The problem here however is how much to invest when the desired amount is $5,000,000, not what one gets from investing $1 each period.
A ratio can be set up to find out how much to invest at 5% for each of 5 years to yield a total of $5,000,000.
1/5.526=x/5,000,000In other words, if $1 invested under these circumstances can produce $5.526, how much (find x) must be invested under these circumstances to yield $5,000,000?
Solving for x, that is, multiply both sides of the ratio by 5,000,000, yields 5,000,000/5.526 or $904,813.60. A detailed, step by step approach to solve for x is given under algebraic solutions in exercises and demonstrations.
The government would have to invest $904,813.6 in each of the next five year to have $5,000,000 when the principal comes due. The effect of compounding is seen too since $904,813.6 times 5% (1.05) for five years does not equal $5,000,000; it equals $4,750,271.44. The compounding comes into play because the 5% interest in the second year is applied not to $904,813.6 but to $950,054.28 (i.e., the original $904,813.6 plus the 5% interest of $45,240.68).
The second problem is more complex but still involves the compounding effect of investing to pay off an amount borrowed. In this situation the government has $5,000,000 due in five years but has $250,000 already available. Assuming that the $250,000 is invested and will earn 5%, how much will that amount to at the end of five years? The amount not covered by the $250,000 plus the interest earned will have to be made up by other savings. The calculations are given below:
Save for a Future Amount when Some Dollars are already Invested amount on hand future value of $1 end value $250,000 1.2763 (5%, 5 years) $319,075 total amount to pay $5,000,000 end value of $250,000 $319,075 amount needed $4,680,925 amount needed future value of annuity annual investments ------ ----------------------- ------------------ $4,680,925 5.526 $847,073
Investing the $250,000 at 5% for 5 years yields $319,075. This is a one time investment so the future value of $1 (1.2763 * 250,000 = 319,075) is used to determine the amount available in five years. The $319,075 is subtracted from the total needed, that is, $5,000,000. The remaining amount needed is $4,680,925.
Since an amount will be invested each year to achieve this amount needed ($4,680,925) the future value of an annuity is used. It is divided by the amount needed to get the periodic investment amount of $847,073. Thus, in this second case, in addition to a one time investment of 250,000 at 5%, the government will also have to invest $847,073 for each of five years. A similar illustration with more details in given in exercises and demonstrations under Investing to pay future debt.
In these examples, two types of future amounts were used to estimate how much should be invested, the future value of $1 for one time investments and the future value of an annuity for periodic investments of the same amount. Basic material on these time value of money calculation can also be seen in exercises and demonstrations under Introductory discussion. Specific material on the future value of $1 and the future value of an annuity can also be fund in exercises and demonstration under future value of $1 and future value of an annuity.
What type of investments (e.g., types of stocks and bonds) should be made to save all this money is of course a critical question? The greater the return on the investment the less money the government has to raise. This issue is covered in the last lesson (lesson 5) of this chapter -- investment strategies.
When bonds are sold to raise money for capital projects or for other reasons, the bond proceeds are included in one of the funds, often the capital projects fund . Within this fund, the bond proceeds are placed under a category called " other financing sources " in the statement of revenues, expenditures, and changes in fund balances. In essence borrowing is used to offset spending which is different from the business approach where only revenues can be used to offset or match spending. If the $5,000,000 in the above illustration for a capital project funds were proceeds from bonds and that money was used for capital expenditures (a purchase of a building, for example) then the one would offset the other and the capital project fund would have neither a deficit nor a surplus (assuming all activity took place in the fiscal year).
Unlike the bond proceeds (i.e., the inflow of money), the long term obligations arising from the bond are not included in the governmental funds until money has to be paid. Obligations, whether principal or interest , are kept in the general long term debt account group until due. Thus, in the above illustration, the $5,000,000 due in five years would not be in any of the governmental funds; rather it would be in general long term debt account group. Further, the long term obligations in the general long term debt group can and are backed by the full faith and credit of the government not necessarily by any tangible assets.
An example is given below to show the presentation of long term bonds in the financial statements, assuming use of a capital projects fund. It is based on borrowing $5,000,000 for a capital expenditure, with the assumption that the total is due five years from now and the first interest payment not due until next year. The government does have $250,000 to pay for this debt. In other words, the presentation of the financial report information is based on the same numbers and assumptions as the above example of borrowing $5,000,000.
Government Name
Statement of Revenues, Expenditures, and Changes in Fund Balances
For the Year Ended 12/31/x0
Capital
Projects
Revenues 0
Expenditures
capital outlays 5,000,000
Other financing sources
bond proceeds 5,000,000
Excess of revenues and other
financing sources over expenditures 0
Fund balance - 1/1 0
Fund balance - 12/31 0
Government Name
Balance Sheet
12/31/x0
Government Funds Account Groups
General Long
Debt fixed term
service assets debt
Assets:
investments ............ 250,000
buildings ................................. 5,000,000
amount available ......................................... 250,000
amount to be provided .................................. 4,750,000
total assets ................................. 5,000,000 5,000,000
Liabilities & Fund Equity:
Liabilities:
bonds payable ........................................... 5,000,000
Fund Equity:
investment in fixed assets .................. 5,000,000
(capital fund)
Fund Balance:
designated for debt service 250,000
total liabilities & fund .................... 5,000,000 5,000,000
equity 250,000
Several observations can be draw from these financial statements. On the one hand, no obvious distress signals are provided. That is, there is no deficit anywhere. The excess of revenues and other financing sources over expenditures is zero. Other the hand a careful reader must ask where is the money to come from to pay back the $4,750,000 for bonds payable? Now, only the full faith and credit, that is, amount to be provided , in the general long term debt group stands behind the $4,750,000 due. As a result it is important to examine the statements carefully and look in other sections of the CAFR for related information. For example, are government revenues rising? Are expenditures holding steady? If revenues are rising while expenditures remaining relatively constant, then the government many be able to garner enough revenue to pay the debt when it comes due. Chapter 3, lesson 4 provided ratios and indicators for assessing debt burden under the topic of Using the Financial Statements
Answers depend on the type of pension plan.
These next few sections provide basic background. One the foundation is established, state and local pensions and some of the controversy surrounding them are explored.
Ordinarily there are two types of pension plans:
The first, defined contributions, is relatively easy to handle. The employer promises that whatever is placed into and accumulates belongs to the employee, no more, no less. Of course, everybody who is suppose to put in money must. If this money is invested wisely and earns more money and the pension contract promises it all to the employee (which by definition should be true) then that accumulation is what the employee receives. If money is contributed but the investments turn out poorly then the employee suffers.
Two scenarios are given to show what might result from a defined contribution plan. Both are simplified for the purposes of presentation.
In the first, a given amount is invested each year at a certain rate (perhaps a safe bond or government note) and held for a period of time. For example, in the first year $2,000 is invested at 5% and held for 5 years. Similar investment practices (with different amounts invested) are the case for all years except the last. In the last year the amount was invested (perhaps in a stock) but had to be sold at a loss.
In the table, the future value of $1 shows the interest earned at the interest rate specified and the compounding effecting from holding the investment. For instance, $2,000 invested at 5% and held for five years has a compounding effect of 1.2763 as shown by the future value of $1 held for five years at 5%. The future value of $1 is used rather than the future value of an annuity because the amount is only invested once. If an amount were invested each year for several years then the future value of a annuity would be appropriate.
Amount years interest future value $1 final value gain
2000 5 5.00% 1.2763 2552.60 552.60
2500 4 6.00% 1.2625 3156.25 656.25
2750 3 0.00% 1 2750.00 0.00
3000 2 9.00% 1.1881 3564.30 564.30
3500 1 -3.00% 3395.00 -105.00
$13,750 $15,418.15 $1,668.15
To reiterate, the first four investments would be future values of $1 and the last would just be a straight loss.
Over the period of 5 years, $13,750 was invested and that yielded $15,418.15 for a total gain of 12.13% (i.e.,(15418.15-13750)/13750) and annual gain of 2.43% (12.13%/5). The employee(s) would be entitled to the $15,418.15, no more no less. Again, basic explanations on time value of money and future values can be found in exercises and demonstrations, particularly in the introductory discussion section.
In this second demonstation for a defined contribution plan, all the money (the initial investment, the next investments, and any gain) is invested for a one year period. In the first year, this is simply $2,000. The next year, the first ($2,000) and next amount ($2,500) plus any interest or gain ($100) is added together and reinvested. Notice the $4,600 cumulative in the second year. As the amount accumulates the stakes get higher. A good year can really boost the value, but a bad year can do the converse.
cumul return or
Amount ative interest future value gain
2000 2000 5.00% 1.05 100
2500 4600 6.00% 1.06 276
2750 7350 0.00% 1 0
3000 10350 9.00% 1.09 931.5
3500 14781.5 -3.00% ($443)
$13,750 $864
$14,614
As in the first case, the same total amount is invested, $13,750, but this time the total accumulation is $14,614. Three of the five years showed gains, with one of these yielding 9%. One year had neither a gain nor a loss and one year had a loss. Given that this plan is a defined contribution plan, the employees would be entitled to all that is accumulated.
Technically, for the first four amounts, the future value is the future value of $1 for one year since only one year is at stake at a time. The last years is simply a straight percentage loss.
The other plan, the defined benefit pension is more complex. With defined benefits, the employer makes a promise to pay the employee at retirement regardless of what was invested and earned. Such a promise is complicated because the promise is often in terms of a formula that will not be filled with the specifics until the employee retires. Thus, the employer must invest, with its inherent risk, for amounts that can only be estimated. For example, the promise might be to provide a retirement pension of 2% for each year worked for the highest three years' salary. If person works 25 years that means 50% of the average of the highest three years salary. If this average salary is $80,000, then the yearly pension (assuming no cost of living increases) is $40,000 (i.e., 25*.02*80000). Of course the employer must also estimate how long the person will live after (assuming no survivor's benefits) and thus how long the employee will collect the promised amount.
Understanding defined pension plans can be taxing. Nonetheless, keeping a few basic points in mind can help. First, separate the amount(s) the employer should contribute from the amount the employer actually does. Second, separate the pension trust (assuming one exits) that ought to be operated for the benefit of the employees from the employer's books. Acturaries usually do or help with the calculations of the amount(s) that should be contributed and the trust holds information on those amounts, amounts contributed, and other related information such as whether the pension trust is over or underfunded. The employer makes the contribution and records the expenditure or expense and any liability is the contribution does not measure up to the requirement. As a result of these typical separations there are two main sets of actors (the employer and the trust) and two sets of books (the employers and the pension trust).
Governments and firms usually hire actuaries to do many of the calculations involved in the estimations needed for pension planning. The actuaries must often estimate worker longevity, disability if relevant, salary projections, and life expectancy.
Here is an example (purely for illustration) to show how involved the estimate can be for a few employees who have worked for a unit. In this case, the unit promises to pay the employee 1.5% for every year worked and to pay that as a percentage of the highest year's salary. For example, 20 years at 1.5% yields 30% and if the highest salary is $100,000, then the annual pension benefit at retirement is $30,000 per year (assuming no special provisions such as early retirement or cost of living adjustments).
Assume that the company has these five positions this year and generates these estimates for future payout via actuarial analysis.
final annual
position years salary % of salary benefit live total
1 20 105,000 30.00% 31,500 25 787,500
2 not vested
3 25 95,000 37.50% 35,625 10 356,250
4 15 120,000 22.50% 27,000 30 810,000
5 10 80,000 15.00% 12,000 5 60,000
sum 106,125 2,013,750
For position #2 the unit assumes the person will not be vested, that is, not work long enough with the unit to be guaranteed a pension. The assumption is that all others will be vested.
Of course all these employees would probably retire at different times thus making the analysis more complex. That is, starting to save now for $2,013,750 is not the best approach since the unit needs to know how much will be needed when.
For purposes of simplicity take position 3 on the assumption that person will retire 25 years from now and will live 10 years after retirement. Assume the unit must have all the money saved by the first year the person retires.
The investment question can be stated as such: how much to save each year in order to have $356,250 twenty-five years from now, assuming that the money invested will earn 5%.
pension obligation= $356,250 interest rate= 5% years = 25 future value, annuity= 47.726 annual investment= $7,464
This problem is cast as a future value of an annuity calculation where the future value of annuity table shows that $1 invested each year for 25 years yields $47.726. However, the task is to determine how much to invest each year for 25 years with a yield of 5% to produce $356,250. A simple way, without going through all the rules of algebra, is to think of partitioning or dividing the $356,250 by the future value of an annuity, which in this case is 47.726 (356,250/47.726). That translates into investing $7,464 dollars each year.
In actuality, if the unit were able to accumulate $356,250 25 years from now, it would only have to give up $35,625 in the first year and could continue receiving interest on the remaining amount. As a result the unit could possibly add that interest earned to all the pension assets and have to invest less in future years. Or, the unit could recast the problem and set up an investment plan for 35 years (25 years of work and 10 years of longevity after work).
The illustration presented is simplified. Various techniques exits to determine annual pension cost and the contribution needed to meet these costs. Some contribution plans start at a low level and build as it becomes more certain that the payouts will be forthcoming. Others try to partition the cost equally over long periods and adjust if necessary. The example given for the five positions was an artifical one that only included limited elements of cost and divided contributions equally for the years between the promise and payout. Calculating costs and contributions are far more involved because of plan changes and unexpected gains or losses on investments.
One can see all the potential complexity involved. How long will a person work with the unit; what salaries will that person earn; will the plan change; will returns be better or worse than expected; and how long will the person live after retirement? Nonetheless, a prudent government would go though this analysis if pension promises were made.
Acturaries have specific methods for assessing pension cost. One is called the projected unit credit method. This method estimates the cost for the year worked. Funding it tends to be low in the early years of a person's employment but much higher as the employee continues to add years to his or her career with the employer. Entry age normal method is another approach. It attempts to smooth the funding so that the cost and amount needed are relatively equal each year rather than increasing each year as the employee puts in more years. An article by J. Smith and M.E. Cohen in the Winter, 1997 issue of the Government Accountant Journal covers several of the methods acturaries use. The article is titled "Penson Plans: Understanding the Actuarial Methods and Assumptions." It can be found on pages 24 to 29.
GASB has gone through years of controversy over the pension issue. In some respects the disagreements revolve around the fundamentals of the compliance and liquidity model versus the accrual and consolidation. Those who favor the compliance and liquidity model favor methods that satisfy or emphasize the pressures of the annual budget. That is, devise a systematic and reasonable method to estimate the pension cost and use that method to guide the actual funding from current budget resources. The systematic and reasonable method should avoid peaks and valleys from year to year. Rather, the method should produce smooth or even results so the budget is not burdened in some years. The realities of how much the budget can fund is the driving force. Moreover, with the compliance and liquidity model, if the legislative body cannot fund the calculated cost, then the unfunded portion goes in the general long term debt group, not the liability of the general fund. When revenue production is better or other demands less, then the unfunded portion will be gradually funded. Those who favor the accrual and consolidation model, focus on accounting rules to show the full pension cost irrespective of what the budget can or cannot afford in any given year. If the legislative body cannot or will not meet that cost, then the liability should go directly into the general fund or some entity-wide financial statement.
Although the approach for pension reporting has changed over the years, the methods have favor the compliance and liquidity model as might be expected. It is the dominant model in state and local accounting. Nonetheless, as greater pressure has surfaced to move to the accrual and consolidation model, the accepted approach has taken on more accrual characteristics with the accrual information placed in the notes of the financial statements.
As a result, avoiding undue pressure on any one budget calendar year is the driving force for calculating pension cost and contribution. Nonetheless, considerable information on any underfunding is placed in the notes. For instance, the budget oriented calculation may show a pension cost of $1,000,000 and a contribution that year of $700,000. Usually the cost ($1,000,000 here) will be an expenditure in the Statement of Revenues, Expenditures, and Changes in Fund Balance for the general fund. The part not funded is placed off balance sheet and not have a direct negative effect on the balance sheet. Only the notes will show the total picture of the full under or overfunding by comparing the present value of the future obligation with the assets accumulated. Several years of data will be offered to show whether the situation is improving or not. Overall, the task of obtaining a clear picture of the status of the pension plan is daunting because the information is located in different places in the CAFR -- a small amount on the annual cost and funding situation in the main financial statements but most of the large obligations in the notes.
The first approach discussed in this lesson for pension accounting and reporting follows the techniques used and approved by GASB prior to 1997. A later discussion will introduce the new adopted techniques, although each still adheres to the compliance and liquidity model where annual budget needs dominate and information on underfunding (or overfunding) is placed off balance sheet and in the notes.
Before the rule changes that go into effect in 1997-1998, GASB relied heavily on rules designed by NCGA (National Council on Governmental Accounting). Although GASB permitted choice over which rules to use, there was not much difference among the different NCGA rules available for pension accounting and reporting. NCGA was driven by the compliance and liquidity model. NCGA had rules #1 and #6. In this presentation, more is drawn from #6.
For pensions it is important to appreciate that the rules and calculations for the pension must usually deal with the employer and also the trust fund or funds set up to hold and distribute pension assets. Pension trust funds are often referred to as PERS (Public Employee Retirement Systems) In this situation, the employer may have one set of rules for reporting pension activity while the trust fund another set of rules. Historically, NCGA and GASB have tried to meld the two, making the rules for the employer and for the pension trust both senstive to annual budget pressures. Nonetheless, accounting and display rules for the employer and the trust fund or funds are somewhat different. Fortunately, the information required of the employer and of the trust fund is in the Comprenhensive Annual Financial Report (CAFR).
A good starting point in discussing specific accounting and reporting pension rules is the calculation for the pension obligation. How much might an employer be obligated to pay an employee when that employee retires, assuming retirement is the sole or main event tripping payment.
More technically stated, in the process of estimating how to save and invest to pay future benefit obligations, governments need to come up with what is called the present value of the annual pension obligations, sometimes called the pension costs or pension expense. The government could use a variety of acturial methods such as the projected unit credit method or entry age normal method already mentioned. These methods estimate the annual cost and the annual reported expenditure but, as noted, the government does not have to fully fund the cost estimated.
Essentially, governments with defined benefit plans had formulas outlining the pension promise. For instance, 1.5% for every year worked times the average salary of the best or highest three years could be the formula. Then the actuary had to estimate how long a person would work and how long they might live after retirement, with these as very simple assumptions since pension plans can have many other facets including early retirement, surviver's benefits, and cost of living adjustments. Once all these factors were included the actuary would have an idea of the total obligation. To translate that obligation into the costs for the year the actuary had to bring that value back to the present value (a variety of approaches exist). In simple terms, what is the cost for this year? The full cost for a single employee might run into the millions, but what part is assigned to the current year? That amount is the pension cost or expense. It had to be gauged for that year's workforce.
GASB GAAP for pension reporting prior to 1997 required the actuarially determined cost to be reported in the general fund Statement of Revenues, Expenditures, and Changes in Fund Balance. Any difference between contribution and pension cost were placed off balance sheet in the general long term debt account. Footnote disclosure included some of the specifics on the pension cost estimates as well as disclosure of the amounted saved and whether the fund is over funded or under funded . In other words, is the government funding more and earning more than is expected to be needed (over funded) or is the government putting in less and earning less than is expected to be needed (underfunded)? As noted, governments do not take on a liability in any of the governmental funds for unfunded pensions since any long term obligation is place off balance sheet in the general long term debt account group . This result is a function of the compliance and liquidity model where only current assets and liabilities go into the governmental funds.
. The rule making body ( GASB ) was slow to clarify how to measure pensions obligations and how to display them. There is no one place to see the revenues and expenses and the assets associated with pensions and whether these are all sufficient to cover pension obligations. Although the current discussion is based on rules that will be superceded after June 15th, 1997, the framework for present pension result is still founded on the fund logic. That is, annual activities are in the funds; summaries of long term obligations amounts are in the account groups; and explanations and detail are in the notes to the financial statements or in the statistical section.
As noted, the amount calculated as the pension cost would be presented in the Statement of Revenues, Expenditures, and Changes in Fund Balance in the general fund. More information from the notes may be summarized and placed in the trust fund column of this same statement. That is, for annual operations, such information would likely be found in a combined statement of revenues, expense, and changes in fund balances -- all proprietary fund types and similar trust funds. The information is placed here since this statement follows the accrual logic and pension trust funds are based for the most part on accrual accounting. The statement would show revenues, expenses and net profit or loss of the pension trust for the year.
In the combined balance sheet, a small amount of information would likely appear. One common figure is the amount available after current liablities are subtracted from pension trust assets. It had the title of reserved for employee retiremen system. In other words, it is money that can only be spent on legtimate pension activities. Since this figure referred only to the current year, it did not provide any idea of underfunding or overfund. Again, the compliance and liquidity nature of fund accounting place a premium on current, not long term data.
More detailed information is found in the combining statements. Here, each individual pension trust would be outlined for both an operating statement and balance sheet. However, even these are generally incomplete since information is not necessarily presented on total pension liabilities and thus on the amount of under or over funded liabilities. In the balance sheet, current liabilities are compared against all assets; again, the readers knows the net available, but not whether the pension is adequately funded for all future pension promises as of the date of the balance sheet.
In notes is the detailed information on the pension trust fund or funds. The data presented on revenues, expenses, and changes in fund balance/ retained earnings (retained earnings is in the title because at this point pension data are shown along with the proprietary funds which borrow wording from business reporting) really provides a picture of what is available to meet future obligations. For instance, a pension trust fund may have shown $200,000 in net income, beginning retained earnings of $1,000,000, and therefore ending retained earnings of $1,200,000. Knowing that a pension fund earned more than it paid in a given year is positive information. However, readers of the CAFR also want to know whether the retained earnings or net available is adequate to cover the obligations accumulated. For such information, it is necessary to delve into all assets and liabilities. If total assets exceed all liabilities then the fund is in good condition (i.e., adequately funded or perhaps over funded). If the liabilities exceed the assets then underfunding is a problem.
If there is an unfunded liability (not enough assets to cover the liabilities) that too might be difficult to find in the financial statements. It might be in the long term debt group or it might not. GAAP does not always require it. Thus, with respect to the financial statements, there is likely to be reasonably good information on current revenues and expenses associated with the pension fund as well as total assets, but not on cumulative liabilities or whether the pension trust is under or overfunde.
Nonetheless, information on adequate funding and progress toward adequate funding is presented in the CAFR. Some of the most insightful information on pensions obligations is in the notes to the financial statements. Here, in a section often called retirement plans, will be a verbal description of the plan and how the calculations are made to determine the obligations. The tables in the notes show the amount and percent unfunded (or overfunded) for the current year and for past years.
Business reporting, which rests on the accrual logic, gives a much better picture. Any pension obligation not funded is placed in the liabilities section of the balance sheet and places a clear burden on the financial conditions and health of the firm.
Government Name
Combined statement of revenues, expense, and changes in fund
Balance/retained earnings -- all (proprietary funds and) pension trust funds
For the Year Ended 12/31/x0
Pension Trust Fund
Operating revenue:
contributions 2,000,000
revenue from the use of money 20,000
gain on sale of investment 100,000
total 2,120,000
operating expenses:
administrative 10,000
benefits 1,750,000
loss on sale of investments 5,000
total 1,765,000
Net income (loss) before transfers 355,000
transfers in 0
Fund balance 1/1 50,000
Fund Balance 12/31 405,000
(Only the pension fund is shown; not any of the proprietary funds)
From this statement the pension situation looks fine -- the fund had more revenue coming in that payments or expenses going out. However, the bulk of pension demands will ordinarily take place in the future as more and more people retire. Thus, information is needed on how total pension assets compare with total pension obligations. It would be also helpful to have comparative data on the above statement, namely, is the fund balance growing or declining?
The combined balance sheet may or may not have information on pension obligations. If it does, it will likely be in some deferred compensation category in the long term debt account groups. Further, it will have no negative impact on the balance sheet since it is place in the account group and as such it will be backed by the full faith and credit of the government under the title of amount to be provided. In the combining statements (where the individual pension funds are shown), it might have a category in the fund balance called reserved for employees' retirement plan, but this amount also does not reflect any underfunding. It only shows the excess of pension assets over current pension liabilities.
Since some detailed information on total pension assets and current pension liabilities will likely be found in the combining statements, a balance sheet is shown.
Government Name
Retirement Funds
Combining Balance Sheet
12/31/xx
Assets: Retire 1 Retire 2
cash 100,000 75,000
investments 900,000 400,000
accrued interest 45,000 32,000
total 1,045,000 507,000
Liabilities:
accounts payable 150,000 90,000
accrued liabilities 300,000 125,000
total 450,000 215,000
Fund Balance
Reserved for
retirement 595,000 292,000
Total liabilities and
fund balance 1,045,000 507,000
While this information is more detailed (it gives data on each retirement fund; in this case, called retire 1 and retire 2) it does not match all pension obligations against all the asset to show whether the plans are under or over funded. Again, as in the combined statement, the reserved for retirement is total assets minus current liabilities.
The critical information on whether the pension plan or plans are fully funded is in the notes. This information is usually titled: pension benefits obligations. An illustration is provided.
Notes to the financial statements
(unaudited)
Pension Benefit Obligations
Retirees and beneficiaries
currently receiving benefits
and terminated employees not
yet receiving benefits $5,000,000
Current employees 9,000,000
Total pension benefit 14,000,000
obligation
Net assets available
at cost 8,000,000
at market 7,100,000
Unfunded pension benefit 6,000,000
obligation (at cost)
Net assets (at cost) as
a percent of pension benefit
obligations 42.86%
Finally, in the notes to the financial statements, comes the important information on how well or poorly the plan is funded. The total amount under or over funded is given along with the percentage. In terms of the example data being presented for illustrative purposes, this picture is far more bleak than that given in the operating statement for the pension trust fund just presented where there is enough revenue in that particular year to cover expenditures. In short, while the government is getting by for the current period, the government does not have half the assets to cover the obligations. The picture is worse if the market value of the assets is used.
To get a broad picture of the pension situation, the reader would need to examine the operating statement for the current situation, the combined balance sheet for a summary of all pension funds (but with no information on over or under funding), the combining statements for details on all plans and all assets, and the notes for the long term situation. Neither the combined nor the combining balance sheet generally provides clear information on total pension obligations. All the various statements and notes must be examined to get a picture of the current, long term, and changing conditions of the pension funds.
GASB has produced a new package of standards for pension funding and accounting. These will replace those several prior statements. Officially, the prior statements (and the ones used in this section of chapter 4) are NCAG 1 and 6 (National Council on Governmental Accounting), FASB 35 (Financial Accounting Standards Board) and GASB 5. The new statements are GASB 25 through 27. However, as long as state and local governments continue to rely soley on the fund model (called compliance and liquidity in this text), the accounting and reporting situation will not change dramatically. The financial statements will show the annual situation, but not the long term conditions of the pension funds. Information on long term conditions will be in the notes. The new standards are more demanding but the greater pressure on candid reporting will show in the notes (and perhaps the long term debt account group). Only in crisis years when the current intake does not cover the current outflow will a danger signal be given in the financial statements.
Details on these new statements (GASB 25-27) will appear in this volume in fall of 1998.
A capital lease is an obligation or liability because the government is obligated under contact, and often penalty, to pay for an asset (a building, for example) for a long period of time. In substance the lease is not very different from actually borrowing the money, owing the building, and paying off the loan over a period of years. Reporting can complex since different funds and account groups can be involved as well as time value of money calculations.
Sick leave and vacation can be long term obligations because government can allow employees to build up (i.e., accrue) sick leave and vacation time and get paid for time not taken when they leave or retire. As a result these two must be added the list of long term obligations.
Some reporting of these other obligations is done, but, again, since they are long term in nature, the reporting is limited in the governmental funds. The lease expenditure would be balanced by an artificial amount, just as if the government borrowed to pay the lease. Since borrowing can be added to revenues, the long term lease does not have any negative consequences until it is due and payable in a current budget. Accrued sick leave and vacation are handled similarly. They may be recorded under deferred compensation in the general long term debt account group of the balance sheet, but they are offset by the full faith and credit of the government. Thus, regardless of how large these items are they cannot have negative effects until they become due and payable as a current item. Then, it is possible to borrow to cover the current items and put the borrowing off balance sheet.
Certainly not all governments promise huge future payments without considering the consequences. Many governments have or have become prudent about matching future promises with savings and in coming revenue. Those that are not prudent face the grim prospect of defaulting and not being able to pay either all the interest or principal. Other alternatives are also unenviable. They include more borrowing or dramatically cutting back on service or maintenance to pay for these obligations.