Interpreting local government financial statements.

• Author: Gauthier, Stephen J.
• Position: Financial report

The published financial report of a local government provides a wealth of information to anyone with an interest in the government's economic condition. Taking advantage of this information, however, poses a real challenge to many users of these reports. This chapter aims at helping potential users of local government financial statements to meet this challenge.

PUBLIC SECTOR V. PRIVATE SECTOR

The primary goal of a private-sector business is economic--to make a profit. While local governments also have economic goals, their principal objective is social rather than economic--to provide services to citizens. Stated differently, economic goals in the public sector are a means to an end, rather than an end in themselves. Therefore, the approach taken to interpreting financial statements in the public sector must necessarily differ in important respects from the approach taken in the private sector.

Ratio analysis provides a good illustration of this point. It is common in the private sector to combine various financial statement elements into ratios to serve as a point of reference for analysis. Yet few of the most commonly used private-sector ratios can be applied meaningfully to local governments. A number of them, in fact, cannot even be calculated for a typical local government because they presume the ownership of stock and operations focused on the sales of goods and services to customers.

Consequently, even when local government financial statements most closely resemble those of a private-sector business (e.g., the accrual-based government-wide financial statements), it is not possible simply to apply private-sector analytical techniques. A fundamentally different approach is needed, consistent with the unique objectives and circumstances of local governments.

FOCAL POINTS FOR ANALYSIS

It is common in the private sector to speak of a "bottom line" for evaluating financial performance (i.e., net income). Local government financial statements offer no single measure suitable for this purpose. Instead, users of local government financial statements must assess a local government's financial health from three different perspectives.

* Near-term financing. One particularly pressing concern is a local government's near-term financing situation. Is the government able to meet its short-term financial obligations in a timely manner? Are its operating inflows adequate to cover its operating outflows? Is the government financially prepared for contingencies (e.g., budgetary shortfalls and natural catastrophes)?

* Financial position. It would be shortsighted, of course, to focus exclusively on the near term. An equally important concern is a government's overall financial position as represented by the totality of its assets and liabilities, as well as the difference between them (i.e., net assets). Financial position is an essential point of reference for determining whether a government's overall financial situation is improving or deteriorating.

* Economic condition. Needless to say, a local government's finances do not exist in a vacuum. Inevitably, a government's financial position will be affected by its circumstances (e.g., the vitality and diversification of the local economy, the breadth and depth of the government's tax base). Likewise, a government does not exist in a time warp. Past experience often is vital to predicting future developments (e.g., Have intergovernmental revenues been increasing or decreasing over time? Has the government's population been growing or shrinking?).

Consideration of such factors provides the necessary context for interpreting current-year financial data. When financial statement users consider a local government's financial position in the light of such factors, they are said to be concerned with its economic condition. Viewed another way, economic condition focuses on the likelihood that today's financial position will improve or deteriorate in the future. These three perspectives are summarized in Exhibit 1.

ASSESSING A GOVERNMENT'S NEAR-TERM FINANCING SITUATION

Local governments present both fund financial statements and government-wide financial statements. Fund accounting reflects the fact that local governments segregate their financial resources for specific purposes based on special regulations, restrictions, or limitations. Such restrictions naturally have an important effect on near-term financing. Consequently, assessments of a local government's near-term financing situation tend to focus almost exclusively on the fund financial statements rather than on the government-wide financial statements.

Governmental...