FAR CPA Exam: Governmental Accounting Fundamentals (F5)

Introduction to GASB and Governmental Accounting Framework

Section F5 of the FAR CPA Exam introduces a distinct accounting framework: governmental accounting, governed by the Governmental Accounting Standards Board (GASB). This area, typically weighted at 10-20%, requires candidates to shift their perspective from the profit-driven focus of commercial accounting to the accountability and resource-management focus of state and local governments. Understanding the unique structure, fund types, measurement focus, and basis of accounting used in the public sector is critical.

The GASB, established in 1984, serves as the independent standard-setting body for governmental accounting, much like the FASB does for the private sector. The conceptual foundation for governmental accounting differs significantly from commercial accounting. While profit-oriented businesses focus on measuring net income, governments emphasize accountability, intergenerational equity, and fiscal compliance. They must demonstrate proper stewardship of public resources and compliance with budget laws and legislative requirements.

GASB Statement No. 34, “Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments,” fundamentally transformed governmental financial reporting by introducing government-wide financial statements alongside traditional fund financial statements. This dual perspective reporting model provides both short-term fiscal accountability information and longer-term operational accountability data.

Governmental financial reports must adhere to GASB Statement No. 34’s eleven financial elements:

1. Management’s Discussion and Analysis (MD&A)
2. Basic Financial Statements:
   • Government-wide financial statements
   • Fund financial statements
   • Notes to the financial statements
3. Required Supplementary Information (RSI)

CPA candidates must understand how these elements work together to tell the complete financial story of a governmental entity. The government-wide statements offer a broad economic resources perspective, while fund statements provide detailed information about specific activities and legal compliance.

Fund Accounting: The Foundation of Governmental Accounting

The foundation of governmental accounting is fund accounting. Governments use funds to segregate resources for specific activities or objectives, ensuring compliance with legal and contractual requirements. A fund operates as a separate fiscal and accounting entity with its own self-balancing set of accounts, much like a mini-entity within the larger government. This structure enhances control, improves accountability, and ensures compliance with legal restrictions on resource usage.

Fund accounting enables governments to:

• Track resources restricted for specific purposes
• Demonstrate compliance with legal and contractual requirements
• Enhance fiscal accountability to taxpayers and other resource providers
• Facilitate proper financial management across diverse government functions

Candidates must master the three broad categories of funds and their specific types:

Governmental Funds

Governmental funds account for most tax-supported activities and other non-business government functions. They operate under a current financial resources measurement focus and modified accrual basis of accounting, emphasizing short-term fiscal accountability. These funds track the acquisition, use, and balances of expendable financial resources and related current liabilities.

The five types of governmental funds include:

1. General Fund: The primary operating fund that accounts for all financial resources not accounted for in other funds. This fund records revenues from property taxes, sales taxes, income taxes, and intergovernmental grants that are not restricted for specific purposes. The General Fund typically finances core government services like general administration, public safety, and public works. Its financial statements help demonstrate compliance with the annual appropriated budget.

2. Special Revenue Funds: Account for proceeds of specific revenue sources that are legally restricted or committed to expenditure for specified purposes other than debt service or capital projects. Examples include restricted federal grants, hotel occupancy taxes dedicated to tourism promotion, or gasoline taxes earmarked for road maintenance. Each special revenue fund must have a substantial restricted or committed revenue source that composes a substantial portion of inflows.

3. Capital Projects Funds: Account for financial resources used for the acquisition or construction of major capital facilities and other capital assets (other than those financed by proprietary funds). These might include construction of schools, government buildings, or major infrastructure projects. These funds track bond proceeds, capital grants, and transfers from other funds designated for capital outlays. The financial reporting focuses on capital outlay expenditures and remaining resources available for future projects.

4. Debt Service Funds: Account for the accumulation of resources for, and the payment of, general long-term debt principal, interest, and related costs. These funds often receive transfers from the General Fund or dedicated revenue sources to make scheduled debt payments. Reporting demonstrates compliance with debt covenants and shows resources available for future debt service requirements.

5. Permanent Funds: Account for resources that are legally restricted so that only earnings, not principal, may be used for purposes that support the government’s programs. Common examples include cemetery perpetual care funds or educational endowments. The principal amount represents nonexpendable resources, while investment earnings represent expendable resources.

Governmental funds report using balance sheets (showing assets, liabilities, and fund balances) and statements of revenues, expenditures, and changes in fund balances. The fund balance classifications (nonspendable, restricted, committed, assigned, and unassigned) reveal the extent to which the government is bound by external or internal constraints on resource use.

Proprietary Funds

Proprietary funds account for government business-type activities that charge fees to external users for goods or services. These funds apply the economic resources measurement focus and accrual basis of accounting, similar to commercial businesses. This approach provides information about whether each enterprise is self-sustaining and the full cost of providing services, including capital costs and depreciation.

The two types of proprietary funds are:

1. Enterprise Funds: Account for services provided to the public on a user-charge basis. Governments must use enterprise funds when they issue debt backed solely by user fees, when laws require cost recovery through fees and charges, or when pricing policies are designed to recover costs. Common examples include:

   • Water and sewer utilities
   • Airports and transit systems
   • Solid waste disposal facilities
   • Public golf courses or swimming pools
   • Parking garages

   Enterprise funds recognize expenses (not expenditures), accrue revenues when earned, capitalize and depreciate capital assets, and establish both current and long-term liabilities directly in the funds. Their statements resemble commercial financial statements: statement of net position, statement of revenues, expenses, and changes in fund net position, and statement of cash flows.

2. Internal Service Funds: Account for goods or services provided by one department to other departments within the government (or to other governments) on a cost-reimbursement basis. These might include:

   • Central vehicle maintenance garages
   • Central purchasing and warehousing
   • Risk management and insurance pools
   • Print shops and information technology departments

   Internal service funds use full accrual accounting and aim to recover costs, typically without generating significant profits or losses. Rates charged to user departments should approximate the full cost of providing services. In government-wide financial statements, internal service fund activities are typically reported as governmental activities.

Proprietary fund operating statements distinguish between operating and non-operating revenues and expenses. Operating revenues and expenses result from providing services and producing and delivering goods. Non-operating revenues and expenses include subsidies, investment income, interest expense, and gains or losses on disposal of capital assets.

Fiduciary Funds

Fiduciary funds account for resources held by the government in a trustee or agency capacity for the benefit of parties outside the government. These resources cannot be used to support the government’s own programs. Fiduciary funds use the economic resources measurement focus and accrual basis of accounting.

The four types of fiduciary funds include:

1. Pension (and Other Employee Benefit) Trust Funds: Account for resources held in trust for pension plan members and other employee benefit plans. These funds include defined benefit and defined contribution plans for government employees. They track member contributions, employer contributions, investment returns, and benefit payments. GASB standards require extensive note disclosures and supplementary information for pension trust funds.

2. Investment Trust Funds: Account for the external portion of investment pools reported by the sponsoring government. County treasurers often manage investment pools for smaller governmental units within their jurisdiction. These funds report additions (contributions and investment income), deductions (withdrawals and administrative costs), and net position restricted for pool participants.

3. Private-Purpose Trust Funds: Account for resources held under trust agreements that benefit individuals, private organizations, or other governments. Examples include escheat property funds (abandoned property held for rightful owners) and scholarship trust funds where the government serves only as trustee. Private-purpose trusts have specific trust agreements and typically a longer time horizon than agency funds.

4. Custodial Funds: Account for assets held temporarily by the government as custodian. GASB Statement No. 84 replaced the former “Agency Funds” with Custodial Funds and requires them to report fiduciary activities that aren’t held in a trust. Examples include tax collections for other governments, student activity funds, or inmate personal funds. Unlike agency funds, custodial funds now report additions and deductions on a statement of changes in fiduciary net position.

Fiduciary funds report using two statements: a statement of fiduciary net position and a statement of changes in fiduciary net position. Importantly, fiduciary activities are excluded from the government-wide financial statements because these resources cannot be used to finance government operations.

Government-Wide Financial Statements

Beyond the fund statements, governments also prepare government-wide financial statements. These statements (Statement of Net Position and Statement of Activities) present a consolidated view of the government’s overall financial health, excluding fiduciary activities. They use the full accrual basis and economic resources measurement focus, requiring conversion adjustments from the governmental fund data (which uses modified accrual). Reconciling the fund-level statements to the government-wide statements is a key skill tested.

The government-wide statements focus on:

• The total economic condition of the government
• Operational accountability over the long term
• All costs of providing government services
• The government’s ability to finance its activities and meet obligations

Statement of Net Position

The Statement of Net Position reports all financial and capital resources using the economic resources measurement focus and accrual basis. It resembles a commercial balance sheet but organizes elements differently. Assets and liabilities are classified as either current or noncurrent, and net position replaces equity.

Net position is reported in three components:

1. Net Investment in Capital Assets: Capital assets less accumulated depreciation and outstanding debt related to acquisition, construction, or improvement of those assets
2. Restricted Net Position: Assets with constraints imposed by external parties (creditors, grantors, laws) less related liabilities
3. Unrestricted Net Position: The residual amount of net position that has no external restrictions

The Statement of Net Position includes infrastructure assets (roads, bridges, etc.), all long-term debt, and reports on full accrual (including depreciation and accrued interest). This provides a more comprehensive picture of the government’s financial position than fund statements alone.

Statement of Activities

The Statement of Activities reports the cost of providing services by function or program and shows to what extent they are self-financing through fees, grants, and other sources. The format aligns with the government’s focus on service delivery rather than profit generation.

Key aspects include:

• Direct expenses are reported by function (public safety, education, etc.)
• Program revenues are reported in categories: charges for services, operating grants, and capital grants
• General revenues (taxes, unrestricted grants) are reported separately
• The difference between expenses and program revenues shows the net cost to taxpayers
• Special and extraordinary items are separately reported

The statement follows a net (expense) revenue format that helps users identify the functions that rely most heavily on general revenues. It also distinguishes between governmental activities and business-type activities, facilitating comparisons to the private sector where appropriate.

Reconciliation between Fund and Government-Wide Statements

Converting from modified accrual (fund statements) to accrual basis (government-wide statements) requires several adjustments:

• Capital outlays, shown as expenditures in governmental funds, are capitalized and depreciated
• Principal payments on debt, shown as expenditures in governmental funds, reduce liabilities (not expenses)
• Issuance of long-term debt is recorded as other financing sources in governmental funds but as liabilities in government-wide statements
• Revenues that are “unavailable” under modified accrual are recognized under full accrual
• Long-term liabilities (compensated absences, claims, pensions) are reported in government-wide statements
• Internal service fund activities are included in governmental activities

These reconciliations are explicitly reported and help users understand the relationship between the different perspectives provided by fund and government-wide statements.

Budgetary Accounting

Budgetary accounting is another unique feature of governmental accounting, particularly for governmental funds (especially the General Fund and Special Revenue Funds). Governments formally adopt budgets, and the accounting system tracks budgeted versus actual revenues and expenditures to ensure compliance and control. Candidates need to understand how to record the budget, encumbrances (commitments for future expenditures), and related budgetary accounts, and how these are reported or disclosed.

The Budgeting Process

The budget serves several critical functions in governmental entities:

• Legal authorization to collect and expend resources
• Financial and operational plan for the fiscal year
• Expression of public policy and political priorities
• Control mechanism to ensure compliance with legal restrictions
• Guide for evaluating performance

The budgetary process typically follows these stages:

1. Preparation: Departments submit requests; executive officials prepare a proposed budget
2. Adoption: Legislative body reviews, modifies, and formally adopts the budget
3. Execution: Resources are collected and spent according to the budget
4. Reporting: Actual results are compared to the budget

Budgets may be prepared on different bases (cash, modified accrual, or accrual) and at different levels of detail. The legally adopted budget becomes the standard against which actual performance is measured.

Recording the Budget

When the budget is formally adopted, the government records budgetary entries in the accounting system. For governmental funds, this typically involves:

1. Recording estimated revenues:

   Debit: Estimated Revenues
   Credit: Budgetary Fund Balance
   

2. Recording appropriations (authorized expenditures):

   Debit: Budgetary Fund Balance
   Credit: Appropriations
   

3. Other financing sources and uses are similarly recorded

These budgetary accounts do not represent actual assets, liabilities, inflows, or outflows. They represent legal authorizations and expectations, and they control actual transactions. Government accounting systems track both budgetary accounts and actual accounts simultaneously.

Encumbrance Accounting

Encumbrance accounting is a control technique that reserves appropriations when commitments are made (typically through purchase orders), before goods or services are received and expenditures are recognized. This prevents overspending and provides information about future cash requirements.

The accounting entries for encumbrances are:

1. When a purchase order is issued:

   Debit: Encumbrances
   Credit: Budgetary Fund Balance - Reserve for Encumbrances
   

2. When goods are received and the expenditure is recognized:

   Debit: Budgetary Fund Balance - Reserve for Encumbrances
   Credit: Encumbrances
   

   And simultaneously:

   Debit: Expenditures
   Credit: Vouchers Payable
   

Outstanding encumbrances at year-end may be carried forward to the next year, depending on the government’s policies and the continuing validity of the commitments. They may also be reported as assigned or restricted fund balance, depending on their nature.

Budgetary Comparison Schedules and Statements

GASB standards require budgetary comparison information for the General Fund and each major Special Revenue Fund with a legally adopted budget. This may be presented as:

• Required Supplementary Information (RSI), which includes original and final budget amounts compared to actual results
• Basic financial statements, if the government chooses to present this information as a basic statement

These comparisons show variances between budget and actual results, alerting decision-makers to areas requiring attention. CPA candidates should understand both the form and content of these comparisons, including the treatment of encumbrances.

Measurement Focus and Basis of Accounting (MFBA)

The Measurement Focus and Basis of Accounting (MFBA) differences between fund types and the government-wide statements are central to understanding governmental accounting. The combination of measurement focus (what resources are being measured) and basis of accounting (when transactions are recognized) creates a framework for recording and reporting financial information.

Current Financial Resources Measurement Focus

The current financial resources measurement focus emphasizes current assets and current liabilities—those expected to be used or liquidated within a short time, typically one year. This focus applies to governmental funds and concentrates on:

• Current financial resources (cash, receivables, investments)
• Current claims against those resources (accounts payable, short-term liabilities)
• Net current resources available for spending (fund balance)

Under this approach, long-term assets like capital assets and long-term liabilities like bonds payable are not reported in the governmental fund statements. Instead, they appear in the government-wide statements and the notes.

Economic Resources Measurement Focus

The economic resources measurement focus includes all assets and liabilities, both current and long-term. This focus applies to proprietary funds, fiduciary funds, and government-wide statements. It provides a complete picture of the entity’s economic condition, including:

• All financial and capital resources
• Both current and long-term obligations
• The total economic net position (assets minus liabilities)

This approach closely resembles commercial accounting and includes recognition of depreciation on capital assets.

Modified Accrual Basis of Accounting

Modified accrual recognizes revenues when they are measurable and available, and expenditures when the liability is incurred (with some exceptions). The “available” criterion adds a critical short-term focus to the traditional accrual concept.

Under modified accrual:

• Revenues are recognized when they are both measurable and available to finance current-period expenditures. “Available” typically means collectible within the current period or soon enough thereafter to pay liabilities of the current period (usually 60-90 days).

  • Property taxes receivable but not available are reported as deferred inflows of resources
  • Grants received before eligibility requirements are met are reported as unearned revenue

• Expenditures are generally recognized when the related liability is incurred, except for:

  • Unmatured principal and interest on long-term debt (recognized when due)
  • Compensated absences, claims, and judgments (recognized to the extent they will be liquidated with expendable available financial resources)
  • Inventory items (recognized as expenditures when used rather than when purchased)

Modified accrual records expenditures, not expenses. The term “expenditure” emphasizes the acquisition of goods and services or the satisfaction of liabilities, regardless of when the economic benefits are received or consumed.

Full Accrual Basis of Accounting

Full accrual recognizes revenues when earned and expenses when incurred, regardless of cash flow timing. This basis applies to proprietary funds, fiduciary funds, and government-wide statements.

Under full accrual:

• Revenues are recognized when earned, regardless of when cash is received
• Expenses are recognized when incurred, regardless of when cash is paid
• Capital assets are capitalized and depreciated over their useful lives
• Long-term liabilities are reported when incurred
• Assets and liabilities are classified as current or noncurrent

Accrual accounting provides a more complete picture of the economic impact of transactions and events. It matches costs with the periods benefited rather than with the periods in which resources are acquired or consumed.

Applying the Correct MFBA

Properly applying the correct MFBA based on fund type is crucial for accurate governmental financial reporting:

The dual perspective reporting model (fund statements plus government-wide statements) provides a comprehensive view of the government’s finances, but candidates must clearly understand the different approaches to record transactions correctly in each context.

Conclusion and Exam Strategy

Section F5 requires a systematic approach to learning the different fund structures and accounting bases. While distinct from commercial GAAP, the underlying principles of accountability and stewardship drive the GASB framework, providing a logical structure for mastering this important area of accounting.

When preparing for governmental accounting questions on the FAR CPA Exam, candidates should:

• Focus on understanding the conceptual differences between governmental and commercial accounting
• Master the different fund types and their specific accounting requirements
• Practice reconciling between fund statements and government-wide statements
• Understand how budgetary accounting integrates with the financial reporting system
• Review the differences between expenditures (governmental funds) and expenses (proprietary funds)
• Study the recognition criteria for various revenue types under both modified accrual and full accrual

Governmental accounting represents a significant portion of the FAR exam, with questions often requiring application of concepts to realistic scenarios. Understanding both the “why” behind the unique governmental approach and the “how” of recording specific transactions will position candidates for success on this challenging but manageable section of the exam.