Although long term asset are a vital part of government operations and can have a significant impact on financial success , conditions , and compliance , reporting on these assets in the governmental funds is one of the weakest areas in governmental financial reporting. Negative audit reports ( qualified opinions or adverse opinions ) are frequently based on poor reporting for fixed assets, even though the GAAP requirements are not demanding.
In discussing fixed assets, it is important to understand that governmental accounting and financial report draws a distinction between
long term fixed assets and
infrastructure.
Infrastructure consists of the major physical
assets, such as streets, sewers, and bridges.
Reporting on these is optional on the grounds that
finding the cost might be more trouble than benefit
and it is unlikely that the government will sell
these. However, with privatization, the notion of never
selling infrastructure may need to be revisited. In
short, a government may sell a bridge!
With DCF, a business would try to determine whether the discounted flow of revenues (cash, usually) were greater than the discounted cost of the investment. Some discounting factor is taken based on how much the company expects to earn from its investments. The higher the discount rate, the more the firm expects to earn and the tougher it is for an investment to show a positive or competitive return. An example is given. More background on selecting projects is presented in exercises and demonstrations under Practical applications, selecting projects.
Here is a partial analysis a business might do to determine whether to purchase a machine. The initial investment is $500,000 and the firm expects a cash flow (revenue) for four years as presented below. Since dollars earned later as worth less than dollars earn earlier it is necessary to discount the value back to the present. The rate chosen here is 10% on the assumption that other investments the company could make could earn 10%.
Illustration of discounted cash flow (DCF):
Present
value
of $1
Expected Discounted Discounted
year Investment Revenue Factor 10% Value
1 500,000
2 200,000 0.82645 165,290
3 150,000 0.75131 112,697
4 300,000 0.68301 204,903
total $500,000 $650,000 $482,890
Although the total revenue expected over four years ($650,000) is higher than the initial investment ($500,000) , the discounted cash flow does not measure up adequately. The discounted cash value is less than the investment ($482,890 compared to $500,000). Thus, the company would likely look for other investments with higher expected revenues, assuming they feel they can continue to earn or want to earn 10% on their money.
Notice in the analysis that with each succeeding year the present value of $1 as listed under the discounted factor falls, showing that dollars earned later are worth less than dollars earned later.
As noted, governmental use of DCF is more complex since the results of a project cannot always be translated into dollars. In the following problem, in order to represent a government investment decision, the government is faced with an increased number of elderly who live in a particular section of a community. These people have asked the policy makers to provide more facilities for seniors.
Two options have been suggested:
The estimated cost and benefit stream for these options are given below:
Center: The analysis runs for five years, with cost being: 1/4 of a million (250,000) to construct, then 1/8 of a million (125,000) in the first year and 150,000 each year after to operate the center. Benefits, which could have a 20% error on the downside and 20% on the upside, start in the second year running from 200,000 for the second, third and fourth year to 300,000 in the fifth year. Benefits are social and health benefits plus some income from fees and commissions on item made and sold. The ratio of benefits is 50/25/25, social/health/income benefits.
Bus Service: It costs 1/8 of million (125,000) to get started in the first year and 150,000 to run. Its benefits start in the first year with 90,000 and go to 170,000, but there is no data on how quickly it will go from 90 to 170,000. It could immediately jump or not move until the last year. Benefits are mainly fares plus salaries that the seniors will earn in other parts of the community. Ratio of benefits is 25/75, fares/salary. Tables for the DCF analysis are given below:
Senior Center
(000)
net pv at
benefits benefit 0.06 discount-
yr cost average low high ave. discount ed value
1 250 -250 -250 -250
2 125 200 160 240 75 0.89 66.75
3 150 200 160 240 50 0.8396 41.98
4 150 200 160 240 50 0.7921 39.605
5 150 300 240 360 150 0.7473 112.095
tota 825 900 720 1080 75 $10.43
discount rate 0.06
The analysis of the senior center was done only for the average benefit. The analysis yields a positive value, 10.43 (or $10,430), although the benefits are quite subjective given that most have to be translated from general health or social benefits to dollars.
Bus Service
(000) pv at
net 0.06 discount-
benefits benefit discount ed value
yr cost average low high ave.
1 125 90 90 90 -35 0.943 -33.005
2 150 110 90 170 -40 0.89 -35.6
3 150 130 90 170 -20 0.8396 -16.792
4 150 150 90 170 0 0.7921 0
5 150 170 170 170 20 0.7473 14.946
tota 725 650 530 770
Net present value -70.47 -70.45
discount rate 0.06
The analysis of the bus service does not show a positive return. However, the assumption is that these estimates are less subjective than those for the senior citizen center. The return in this case is from bus fares and salaries the seniors might earn by going to other parts of the community. With the center, most of the benefits are in better self esteem (social) and better health (e.g., fewer visits to the physician).
Such subjective comparisons are typical of government decisions. As a result the DCF is a tool often of limited use.
The technique is nonetheless used for some guidance and should be understood.
In each case all the dollars values are taken back to the present value via the present value of $1 for a discount of 6% and the number of years involved. Taking everything back to a present value makes the projects more comparable. For example, in the bus service, the net gain of 20 (20,000) in the fifth year is taken back to its present value discounted at 6% with the factor or .7473 or $14,946 in present value dollars. Both fundamentals and illustrations of present value and other time value of money consideration can be found in exercises and illustration. For the above example, the present value of $1 under Introductory discussion would be particularly relevant.
When the long term activity starts in the capital projects fund that usually means money is borrowed for the acquisition (purchase or construction and possibly lease) of a major asset, such as a building. Then the long term debt is placed in the general long term debt account group and money may be transferred from the general fund to the debt service fund to pay off the principal and interest when due. Records of actual assets are kept in the long term fixed asset account group. Below is a simple sketch to show the flow when money is borrowed for a major capital project.