1. Assessing Municipal Credits
William P. Kittredge, Ph.D.
Research Director
Center for the Study of Capital Markets
DOI: 10.13140/RG.2.1.3209.8168
2. “If to do were as easy as to know
what were good to do, chapels
had been churches, and poor
men's cottage princes' palaces.
-William Shakespeare
3. Today’s Agenda
Context
Definitions
Municipal Bonds and the Bond Market
Credit Ratings
Local Government Accounting
Financial Condition Analysis
4. Context
Where Does Financing Fit?
Strategic Plan
Asset
Management
Plan
Capital
Improvement
Plan
Lifecycle Cost
Analysis
Priorities
Capital
Budget
Financing
Options
Debt
Financing
Current
Revenues
Capital
Inventory
Physical
Inventory
Condition
Assessment
Capital
Maintenance
Plan
6. Context
Capital Improvement Plan
Identify capital needs for next 4-6 years
Separate one-time from recurring capital
projects (e.g. capital maintenance)
Use realistic assumptions
Reconcile to annual budget
Update annually
Fund the Plan
Example: Onondoga County, NY
7. Context
Capital Improvement Funding Options
Grants
Capital contributions
Subsidized loans
Current own source revenues (pay-as-you-go)
Joint Ventures
Privatization
Debt Issuance
8. Definitions
‘Municipal Bonds’
Functional definition
NYS legal definition
Functionally, refers to all agreements used to
acquire capital goods that commit the
borrower’s resources over time
Used generically to refer to bonds, notes, leases,
and sundry complex instruments
Municipal credits
9. NYS Definitions
Obligations
The term "obligations" shall mean bonds
or notes and only “obligations” constitute
“indebtedness”.
“Every municipality, school district and
district corporation shall pledge its faith
and credit for the payment of all
indebtedness contracted by it.”
10. NYS Definitions
Local Debt Limits
“No county, city, town, village or school
district in a city shall contract
indebtedness for any purpose or in any
manner which, including existing
indebtedness, shall exceed an amount
equal to the following percentages of the
average full valuation of such county,
city, town, village or school district”.
11. NYS Definitions
Local Debt Limits
“Any county, other than the county of Nassau, for
county purposes, seven per centum;
Any city, other than the city of New York, having
one hundred twenty-five thousand or more
inhabitants … for city purposes; nine per centum;
Any city having less than one hundred twenty-
five thousand inhabitants …, for city purposes,
excluding education purposes, seven per centum;
Any town, for town purposes, seven per centum;
Any village, for village purposes, seven per centum;
12. NYS Definitions
Local Debt Limits
The term "average full valuation" shall
mean the valuation of taxable real
estate … which is derived by dividing the
assessed valuations of taxable real
estate on the last completed and the four
preceding assessment rolls by the
equalization rates …”
A 5 year rolling average
13. NYS Definitions
Equalization Rate
An equalization rate is a ratio of the locally
determined assessed value of taxable real
property to the Office of Real Property
Office's estimate of market value.
14. NYS Definitions
Equalization Rate
Equalization rates are New York State’s
independent measure of each
municipality’s level of assessment.
For example, an equalization rate of 50
indicates that a town’s total assessed
value of all real property is 50% of the
town’s full (market) value determined for
a specified date.
15. NYS Definitions
Equalization Rate
The state’s responsibility for
“equalizing” local property
assessments to a common full
(market) value is important because
the full values are used for a variety
of purposes.
16. NYS Definitions
Equalization Rate
These include the allocation of various
state-aid programs, the fair apportionment
of county and school property taxes, and
the determination of tax and debt limits
for local governments.
One of the most important uses of the
equalization rate is to apportion the tax
burden among municipalities that are in
the same school district.
17. NYS Definitions
“Periods of Probable Usefulness”
“A municipality, school district or district
corporation may not contract
indebtedness for any object or purpose for
a period longer than the period of
probable usefulness…”
18. NYS Definitions
“Periods of Probable Usefulness”
Water and Wastewater Systems
40 years for “acquisition, construction or
reconstruction of or addition”
20 years for water meter purchase and installation
10 years for voting machines
30 years for single story school buildings
outside a city
20 years for brownfield remediation in the City
of Buffalo
19. Definitions
We will use ‘municipal bonds’ in the more
inclusive and generally accepted sense to
include all municipal credits.
Although the technical difference under
NYS law is the province of the bond
counsel, it is important to an
understanding of the issuer’s context.
20. Municipal Bonds
Security Classes
Notes
General obligation bonds
Revenue bonds
True revenue bonds
Sophisticated instruments
Capital leases
Certificates of participation
Special assessment bonds
21. Notes
Short-term (less than 1 year)
Issued in anticipation of:
Tax revenues
Grant funds
Bond proceeds
22. Notes
Managing Cash Flow
Operating cash flow notes
Tax anticipation notes (TANs)
Revenue anticipation notes (RANs)
TRANs
Capital project interim financing notes
Bond anticipation notes (BANs)
May not be issued without bond issuance authority
Grant anticipation notes
Grant anticipation notes (GANs)
May be issued for either operating or capital purposes
23. Bonds
Long-term obligations
Limited by useful life in NYS
Two broad categories
General obligation (GO)
Revenue
While still used by the industry and U.S. Census, two
categories, in my opinion, no longer comprehensively
describe the varieties of municipal bonds
Bonds are typically sold in $5000 dominations or
multiples of $5000
24. Types of Bonds
General Obligation
Pledge “full faith and credit” of the issuer
Usually require plebiscite under NYS law
Pledge may be limited by tax and expenditure
limitation legislation – such bonds are referred to as
GO limited tax (GOLT)
Not to exceed a fixed percentage of average full valuation
Lowest interest rate (Simonsen & Robbins 1996)
25. Types of Bonds
Revenue
Originally referred to bonds issued for improvements
with independent revenue streams, e.g. water
systems
Now a catchall term that includes anything not a GO
True revenue bonds, e.g. for water systems
Lease-revenue bonds, e.g. COPS
Special district and authority issues, e.g. NYSTA
26. Revenue Bonds
Debt service reserve
Provides additional security for investors
Sources of funding:
Bond proceeds
Cash on hand
System revenue reserves
Credit enhancement
Coverage covenant
Formal, legally binding assurance to investors that revenues will be
maintained at levels sufficient to generate net revenues in excess of debt
service requirements
Usually expressed as a percentage of debt service, e.g. 120%
Commonly 105-150% range
27. Revenue Bonds
Additional bond test
Legally binding assurance to investors that
revenue and coverage pledges will not be
diluted by future issues
Feasibility study
Done by specialized consultants at issuer’s
expense
‘Criticality’
Reasonability
28. Special Assessment Bonds
General characteristics
Secured by specified tax revenues
Collection limited
Project specific
Not general fund revenue
May reduce demands on general fund revenues
Types:
Property tax based
Sales tax based
29. Special Assessment Bonds
Property tax based
General characteristics
Property owners in area receiving benefits pay costs
Often formed as limited duration districts
Security may be tied to expected increases in
property value and/or decrease in other costs
associated with improvements
Formation of a fire district lowers fire insurance rates
Paving roads increases property values
Limitations:
Not usually attractive is tax base is small
Skewed incentives if used speculatively e.g. bare land
30. Special Assessment Bonds
Sales tax based
General characteristics
Secured by incremental sales tax revenues
Collection limited to maturity period or
retirement of debt
Limitations:
Requires voter approval
Security more volatile than property tax based
31. Leases
‘True lease’
AKA ‘tax lease’ or ‘operating lease’
Lowest payments
Usually used for computers, copiers, etc.
End of lease options
Replace equipment with newer technology
Return to lessor
Renew lease
Purchase at fair market value
32. Leases
Capital lease
AKA ‘financing lease’ or ‘lease-purchase’
‘Constructive sale’
Usually used for buildings, machinery and other long-
lived assets
End of lease options
Purchase at pre-agreed price
33. Leases
All local government leases always contain a
fiscal funding or appropriation clause
Technically makes the lease ‘breakable’ if
appropriation is not forthcoming
Sometimes called ‘subject to appropriation
clause’
Usually counteracted by ‘non-substitution clause’
34. Certificate of Participation (COP)
A form of lease revenue bond that permits
multiple investors (participants) to share a
stream of lease payments
Tied to the acquisition or construction of
specific equipment, land or facilities
35. Certificate of Participation (COP)
Re-payment by annual appropriation
COPs provide weaker security and carry
ratings that are below an issuer's general
obligation rating.
Risk premium
36. Selecting the Method of Sale
Sale methods
Competitive sale
Negotiated sale
Private placement
Selection factors
Debt policy
Statutory considerations
Market factors
37. Competitive Sale
Issuer chooses size and structure of issue
Solicits bids from underwriters
Awarded on the basis of lowest True
Interest Cost (TIC) in Georgia
38. Competitive Sale
Increased competition should put downward
pressure on interest costs
Cost advantage will increase with the number
of bidders
Bonds are well understood, nearly
commodities, with well functioning market
39. Negotiated Sale
Underwriter selected prior to bond structuring
Awarded directly to the underwriter or
underwriting syndicate without bidding
Local officials “match wits” with underwriters
40. Negotiated Sale
Conditions Favoring
Some issues are too large or complex to sell
through competition
Revenue pledges may not be well understood
Issues may not attract bidders under certain
conditions
Volatile markets
Periods with rapidly rising interest rates
Poor issuer credit history, e.g. history of default
41. Negotiated Sale
Underwriter Compensation - Spread
Discount from issue purchase price
Net bond proceeds less than par value
Underwriter’s gross margin
Expressed as:
Percentage per bond or of issue amount
Dollars per thousand dollars of par value
42. Negotiated Sale
Underwriter Compensation - Spread
Take down
Sales staff commissions
Should vary with maturities and issue characteristics
Management fee
Investment bankers
Structure and market issue
Should vary with need for investment banker’s involvement
43. Negotiated Sale
Underwriter Compensation - Spread
Expenses
Travel, lodging, meals, etc
Should be itemized and reasonable
Underwriting fee
Underwriter’s risk
Should vary with pre-sale success
44. Private Placement
Special Form of Negotiated Sale
Small, infrequent issuers
Placed with local or regional bank – bank-
qualified securities
Extremely complex and/or risky ventures
Direct negotiation with “qualified investors”
Central City (CO) Business Improvement
District sale 2003
45.
46. Structuring the Issue
Match with purpose
Short-term – receipt of revenues or funds
BANs, TANs and GANs
Long-term – useful life of asset
Match with fiscal capacity
Overall financing goals
Receipts pledged to debt retirement
47. Bond Structures
Issue Structure
Serial
Term
Zero coupon
Debt Service Structure
Fixed
Variable rate bonds
Usually short-term
Rate adjusted periodically according to a prescribed formula
48. Issue Structure
Serial Bonds
The typical serial bond issue contains as many maturities
as the years of the issue’s term
15 year serial issue retires (redeems) part of the principle (issue
par value) each year (that year’s ‘maturity’)
Longer term increases interest rates on each maturity
A serial issue pays lower interest rates than a term issue of the
same duration
See maturity schedule example in packet
49. Issue Structure
Term Bonds
All bonds have one maturity
Sinking fund requirement
Similar to traditional corporate debt
Zero Coupon Bonds
Pay no periodic interest or principal payment
to investor
Sold at deep discount
50. Debt Service Structure
Fixed Rate
Equal principal
Level debt service
Graduated principal
Deferred principal
51. Debt Service Structure
Fixed Rate
Equal principal
Lowest total interest cost (nominal dollars)
Annual debt service declines each year
Level debt service
Total interest cost slightly higher (nominal dollars)
Annual debt service payments approximately
equal
52. Debt Service Structure
Fixed Rate
Graduated principal
May complicate marketing and require feasibility
study
Increased total interest cost (nominal dollars)
Allows redemption schedule to match expected
revenue increases attributable to asset
53. Debt Service Structure
Fixed Rate
Deferred principal
Interest only payments for some period of time
Total interest costs increase as a function of deferral
period
Capitalized interest feature common
Provides flexibility to match redemption schedule to
expected revenue increases attributable to asset
54.
55. Municipal Market Overview
Participants
Citizens
Government Issuer
Elected officials
Professional staff
Financial advisor
Underwriter
Specialized attorneys
Rating agencies
Bond insurers
Trustees
Investors
61. Financial Advisor
Independence
Independence
FA activities sole source of income
Does not underwrite, buy or sell securities
Objectivity
Opinions not compromised by conflicting incentives
Accountability
Responsible to issuer alone
Appearance of impropriety and openness of the public
process
62. Independent Financial Advisor
“Unlike an underwriter, however, an independent
financial advisor represents the interests of its
issuer clients, acting as a business agent in the
analysis, negotiation and structuring of financial
transactions and in long-term capital planning
and budgeting. Independent financial advisors
function best as extensions of their issuer-
clients’ staffs.”
Source: http://www.agfs.com/whyfinancialadvisor.shtml
Accessed: September 30, 2002, 11:20 am EST
63. Independent Financial Advisor
“All else equal, having a debt policy
provision that requires the use of an
independent financial advisor results in
lower TIC.” (Kittredge, 2002)
“When the financial advisor is also the
underwriter, interest costs are increased.”
(Clarke, 1998)
64. Financial Advisor
Selection Process
Identify qualified firms
NAIFA website http://www.naipfa.com/
Commercial and investment banks
Competitive process – RFP
Name and qualifications of advisors, including availability
commitment
Firm resources and relevant experience
Discussion of firm’s understanding of issuer, including
proposed issue structure
Discussion of relevant funding sources and innovative
financing approaches
References
65. Financial Advisor
Compensation Fixed fee
Can be experience based
Capped hourly
Hourly basis
Issue basis
$/$1000 issued or percent of issue
Creates conflict of interest
Not recommended
67. Bond Counsel
Opinion
Assures investors as to issuer’s legal authority
Interest exempt from federal and state income tax
Participates drafting offering statement and
other issuance documents
Represents investor’s interests
68. Bond Counsel
Method of selection
Similar to FA process (Tab 4)
Legal specialty requires specialized firms
Compensation
Flat fee (bid)
Customary in GO and true revenue sales
Hourly basis
More common in complex issues
69. Underwriter
Firm or group of firms (syndicate)
Purchases issuer’s securities for
remarketing to investors
Investment banks
Goldman, Sachs & Co. and Salomon Smith
Barney (national)
Commercial banks
Insurance company subsidiaries
72. Disclosure
What is disclosure?
Disclosure, simply put, means that the issuer
must provide investors with the information
they need to make decisions about the bond
issue. (Tab 9)
Who is responsible?
It is the legal responsibility of the issuer to
ensure that disclosure is adequate, and
reliance on outside experts is not a legal
defense if the rules are violated.
73. Disclosure
When must disclosure take place?
Pre-sale – initial disclosure
Post sale – continuing disclosure (more in the After the Sale
section)
Required under SEC Rule 15(c)(2)-12
False or misleading disclosure subject to
penalties under SEC Rule 10(b)(5) including
fraud enforcement and private damages
74. Initial Disclosure
Offering documents are required for the
underwriting of municipal securities
Market offering documents
notice of sale,
preliminary official statement (POS)
official statement (OS)
bond resolution
bond counsel’s opinion letter
75. Initial Disclosure
Intended to ensure that investors are
clearly aware of all material facts and
significant information relevant to the
bonds or obligations
POS used by underwriters to market bonds to
perspective investors
OS
Amend POS to reflect changes
Contains interest rates of the bonds issued
76. Continuing Disclosure
Required under SEC Rule 15(c)(2)-12
Annual financial condition update for the investor community
Promptly advise investor community of ‘material events’
False or misleading disclosure subject to penalties
under SEC Rule 10(b)(5) including fraud enforcement
and private damages
Any failure to comply could result in contractual
liability to bondholders
77. Continuing Disclosure
Issuer is responsibility to the investor
community
Provide information needed to make decisions about the
bond issue
Reliance on outside experts is not a legal
defense if the rules are violated
Applies to agency staff and governing boards
78. Continuing Disclosure
Investor community
Rating agencies
Bond holders
Nationally Recognized Municipal Securities Information
Repository (NRMSIR) (Tab 10)
Required to file information with all NRMSIR
Annual filing requirements
Consolidated Annual Financial Report (CAFR)
Most common way to meet “continuing disclosure” requirements
Annual audited financial statement
Other annual financial and operating data
79. Continuing Disclosure
Promptly provide notification of failures to
meet these annual filing requirements
Promptly provide notification of certain
designated material events as they occur
Major employer leaves town
Tax limitation passed
Bond defeasment
IRS review of tax status?
80.
81. Arbitrage
Arbitrage is the profit earned from the
investment of tax-exempt bond proceeds
in higher yielding taxable securities
All net earnings must be remitted to the
federal government
82. Arbitrage
Due to the tax-exempt status of most municipal
bonds (which results in a lower cost-of-funds
than prevailing taxable rates)
Freedom from taxation by the federal
government enjoyed by municipal entities
Municipal issuers can usually earn arbitrage by
investing proceeds in US Treasury or Agency
securities.
83. Arbitrage
May occur when an issuer raises money through
the sale of a bond issue and invests the
proceeds in instruments with a yield above the
bond issue's cost-of-funds
Debt reserve sinking fund
Investment pending disbursement
84. Arbitrage
The 1986 Tax Reform Act was passed, in part,
to address arbitrage earnings by municipal
authorities
It places restrictions on the interest income
earned on the investment of bond proceeds
85. Arbitrage
In simple terms, income earned in excess of a tax-
exempt cost-of-funds must be returned to the federal
government
This process is known as ‘arbitrage rebate’,
Bond attorneys often refer to the cost of funds as the ‘rebate
yield limit’
The federal government has the power to revoke the
tax-exempt status of municipal bond issues that
improperly earn arbitrage profits
86. Arbitrage
The computation of arbitrage and the
appropriate application of investment techniques
to maximize non-rebatable income are fields of
specialization within municipal finance
Usually beyond the scope of both bond
attorneys and underwriters
87. Arbitrage
Arbitrage can be earned and legally retained in
certain circumstances
Most common exception is for small issuers
Government entities that issue less than $5 M per
year are usually exempt from arbitrage rules
26CFR1.148-8
88.
89. Credit Ratings
Credit rating is an evaluation of credit
quality – an assessment of the probability
of timely repayment
People are willing to pay more for certainty
Two assets with equal average returns but
with one greater variation have different prices
Investors are risk averse, so the more variable
asset is more costly to the government
90. Credit Ratings
3 private companies
Moody’s Investors’ Service
Standard & Poor’s
Fitch
91. Credit Ratings
Ratings are paid for by the issuer
Ratings are not required or necessary,
currently approximately 30% the issues
coming to market do not have a rating.
92. Credit Ratings
Unrated bonds generally get interest rates
marginally better than speculative grade
bonds
Some governments go unrated when they feel
they would not be well rated
Unrated bonds don’t carry the premium you
might expect!
93. Credit Ratings
Hierarchy of Risk
Hierarchy of Risk
Risk Categorization Moody's
Fitch
S&P
Interest
Rate
Least Prime Aaa AAA Lowest
Excellent Aa AA
Upper Middle A, A1 A
Lower Middle Baa, Baa1 BBB
Most Speculative Ba BB Highest
Difference between Aaa and Ba typically exceeds 100 basis points or
a 1% increase interest cost!
94. Credit Ratings
During the last 20 years, cumulative
default rates for municipal bonds has been
less than 1.5%
95. Credit Ratings
However, this figure is the product of
averaging bonds that are arguably not
equivalent and have very different default
profiles:
GO 0.01-0.04%
Health care, utility, and multi-family housing 1-4%
Industrial development bonds ~15%
Source: FitchIBCA Public Finance Special Report “Municipal Default Risk” 9/15/99 at
www.fitchibca.com
96. Credit Ratings
Ratings are a signal to the market
Economic conditions
Amount of debt – all else equal most important factor in
rating
Financial condition
Management ability
97. Mechanisms to Raise Bond Ratings
Managing well
No statistically significant measures of ‘good
management’ exist, so highly subjective
Managing poorly
e.g. ‘budget crisis’ in Nassau County, NY
98. Mechanisms to Raise Bond Ratings
Selection of bond type
Multiple ratings are perceived as a credit
enhancement
Many governments purchase three ratings!
Credit and Liquidity Enhancements
100. Bank Enhancements
Letters of Credit
Irrevocable pledge
Strength and value tied to bank’s rating
Critical liquidity enhancement for Variable Rate issues
due to redemption rights (put features) tied to
interest rate changes
Line of Credit
Less secure than Letter of Credit
101. Debt Service Reserve Fund
Source of payment for principal and interest in
the event that revenues are unable to cover
these obligations when due
The DSRF is to equal
10 percent of the value of the bond issue
one year of debt service
125 percent of the average annual debt service
102. Debt Service Reserve Fund
Three cash funding alternatives
Proceeds of the bond issue
Issuer equity contribution (GF monies)
Project revenues generated from the project that the
bonds were issued to finance
Should the DSRF fall below its mandated level,
the issuer is required to bring the fund to the
required balance
103. Debt Service Reserve Fund
Three fund management alternatives
Purchase a Surety Bond/Letter of Credit in lieu of
investments
Use special investment products: Guaranteed
Investment Contracts, Forward Purchase Agreements,
and Repurchase Agreements
Actively manage marketable securities (e.g., US
Treasury Notes, US Government Agency Securities)
104. Surety Bond
Replaces or reduces debt service reserve
fund cash requirement
Offered by bond insurance companies
May be used in avoid arbitrage problems
associated with debt service reserve fund
105. Bond Insurance
Purchased through a one time payment of a
premium at the time of the bond closing
May be capitalized
Not all issues qualify for insurance
Governments with severe financial problems may not
be able to purchase bond insurance
Methods
Direct purchase
Elective bidding
106. Bond Insurance
Guarantees the payment of principal
and interest if the issuer defaults
Assuming that the insurance company
doesn’t get overwhelmed by claims
Never been really tested by a serious crisis
Re-insurance spreads risk
107. Bond Insurance
Resulting bond ratings are based on the
credit of the insurer rather than solely
on the underlying credit of the issuer
May result in significant interest cost
savings
issuer's underlying credit
market conditions at sale time
108. Bond Insurance
Moody's S&P Fitch Insurer
Aaa AAA AAA AMBAC Assurance Corporation
Aaa AAA AAA Financial Guaranty Insurance Co.
Aaa AAA AAA Financial Security Assurance Inc.
Aaa AAA AAA MBIA Insurance Corporation
Aaa AAA AAA XL Capital Insurance
na AA AA Radian Asset Assurance Inc.
na A A ACA Financial Guaranty Corp.
109. Bond Insurance
The ratings noted reflect the claims paying
ability of the bond insurer
Insured bonds do not automatically receive
these ratings
The issuer is also responsible for paying the
rating fee to each rating agency that assigns
ratings to the bond issue
110. Bond Insurance
Interest cost savings
Higher bond rating
Enhanced liquidity
Emerged in 1971
1980 3% insured compared
40% in 2002
113. A Third Basis of Accounting:
Modified Accrual
Cash Accounting recognizes revenues when cash is received and
expenses when bills are paid (focus on cash movement).
Accrual Accounting recognizes revenue when goods or services have
been provided and recognizes expenses when resources have been
used (focus on when revenues are earned or resources are consumed).
Governmental funds use Modified Accrual Accounting. Expenditures
are recognized when resources are received. Revenues are
recognized when they are measurable and available within the
accounting period or shortly afterwards (focus on financial resources).
– Financial resources are cash or assets that can be translated
to cash, less current liabilities.
114. Inflow (Revenue) Recognition
CollectedMeasurable
and Available
Modified
Accrual Basis
Earned
Accrual
Basis
Cash
Basis
Note: Governmental resource inflows are available if they are deemed to be
collectable during or shortly after the end of the accounting period. This may
happen before cash is received.
Payment has been
received or will be
received soon.
Service has
been provided.
Payment has
been
received.
115. Outflow (Expense or Expenditure)
Recognition
Appropriation
Encumbrance
Delivery Payment
Use
Modified
Accrual
Basis -
Expenditure
now.
Cash
Basis
Expense
now.
Accrual
Basis
Expense
now.
Authorization
to spend money.
Order has
been placed.
Order has
been received.
Payment is
made.
Item is
consumed.
No expense
at this time -
any basis.
No expense
at this time -
any basis.
116. Implications of Modified Accrual
Accounting
No long-term assets.
- Long-term acquisitions such as buildings and equipment
are recognized as expenditures when acquired.
- There is no recognition of depreciation.
No long-term liabilities.
- Principal (repayment of debt) and interest are recognized
as expenditures when paid.
Proceeds from borrowing are treated as a non-revenue source
of fund balance rather than as a liability.
117. Differences Between
Bases of Accounting
Accrual Modified Accrual
Outflows
(Expenses or Expenditures)
When resource
is used
When resource is acquired,
legal obligation to pay exists
and payment will come from
available resources
Inflows
(Revenues)
When resource
is earned
When resource is legally
owed, measurable and
available
Assets Current and
long term
Current
Liabilities Current and
long term
Current
118. Governments and Fund Accounting
Governments use funds to account for separate sub-entities.
Governments have three major classes of funds:
- Governmental funds account for the operating activities
of governments (Modified Accrual Accounting).
- Proprietary funds account for activities that are run on
a business-like basis (Accrual Accounting).
- Fiduciary funds account for the government's activities
as trustee and agent (Accrual Accounting).
119. The Governmental Funds
Governmental funds include:
- General Fund used for the bulk of the day-to-day revenues
and expenditures of the government.
- Special Revenue Funds for the revenues and expenditures
of specific activities that are subject to legal or management-
imposed restrictions.
- Capital Project Funds to account for major acquisitions of
plant or equipment.
- Debt Service Funds to account for the accumulation of
resources to pay for principal and interest on long-term debt.
- Permanent Funds, which are similar to endowment funds.
120. Proprietary Funds
Proprietary Funds are used for activities that are run on a
business-like basis. Revenues come from fees, tolls, and
other charges:
- Internal Service Funds are established to account for
elements of the government that provide services to other
governmental units.
- Enterprise Funds are established to track the activities of
governmental units which provide goods and services to
individuals and organizations outside of the government.
What are some examples of each type of fund?
121. Fiduciary Funds
Fiduciary funds are held for another. They are not the
resources of the government.
- Trust Funds are established whenever money is given to
a government under the terms of a trust agreement such as
for an employee pension plan or an unemployment
compensation fund.
- Agency Funds are used to account for money that a
government is holding for some other operating entity like a
volunteer fire department or another level of government.
122. Modified Accrual Transactions
The Town of Millbridge buys and receives some fireworks on
January 15th that it intends to use on July 4th. It receives a bill
from the manufacturer for $50,000. How would the transaction be
recorded by the Town under modified accrual accounting?
Modified accrual accounting (purchase approach)
Assets = Liabilities + Fund Balance
No Change = A/P + $50,000 - Expenditure $50,000
Governments generally record transactions using modified accrual,
but have the option of using modified accrual or accrual for
prepayments, materials, and supplies.
123. Property Tax Transactions
Millbridge issues $611,000 in property tax bills this year. Total collections for
the year are $600,000 made up of $575,000 of this year's taxes and $25,000 from
last year's tax bills. The remaining $36,000 from this year is expected to be
collected within 60 days of year-end. It is "available." How would these financial
events be recorded?
Assets = Liabilities + Fund Balance
Recording the property taxes billed this year
Taxes Tax
Receivable + $611,000 = No Change + Revenue $611,000
Recording the receipt of $600,000 in collected taxes
Cash + $600,000
Taxes Receivable - $600,000 = No Change + No Change
Where are the $25,000 in last year’s collected taxes and the $36,000 in
uncollected taxes from this year in these transactions?
124. Long-Term Liabilities
Modified Accrual Accounting
When a government borrows money on a long-term basis:
- no liability is created on the balance sheet.
- cash is increased and the fund balance is increased.
This is how a $1,000,000 loan would be recorded:
Assets = Liabilities + Fund Balance
Other Financing
Cash + $1,000,000 = No Change + Sources $1,000,000
Note that the increase in the fund balance is not referred
to as revenue.
125. An Interfund Transaction
During the fiscal year the general fund was legally required to transfer
$100,000 to the debt service fund. Only $97,000 was transferred.
How would this transaction be recorded?
Assets = Liabilities + Fund Balance
General Fund
Due to Other Financing Use
Cash - $97,000 = DSF + $3,000 - Transfer to DSF
$100,000
Debt Service Fund
Cash + $97,000 No Other Financing Source
Due from GF + $3,000 = Change + Transfer from GF $100,000
126. Debt Repayment Transaction
The interest and principal due on Millbridge's debt during the year
were $15,000 and $50,000, respectively. Payments were made
from the debt service fund. How were the payments recorded?
Assets = Liabilities + Fund Balance
Interest Principal
Cash = No - expenditure - expenditure
- $65,000 Change $15,000 $50,000
Both the interest and the principal were recorded as expenditures.
Would the transaction have been recorded in the same way under
accrual accounting?
Why was there no change in any liability account?
127. Acquiring a Building
Assume that a building is purchased for $270,000, with full
payment in cash.
The acquisition of the building resulted in an asset decrease and
an expenditure of $270,000. How would the acquisition of the
building have been treated under accrual accounting?
What if the Town issued a bond for $270,000 to pay for the
building? The proceeds of the bond issue were recorded as an
increase in cash and an increase in the fund balance of the
Town. How would the proceeds have been treated under accrual
accounting?
128. Transactions for
Acquiring a Building
Capital Projects Fund
Assets = Liabilities + Fund Balance
Acquisition Using Available Cash
Building acquisition
Cash - $270,000 = No Change - expenditure $270,000
Purchase of the Building by Issuing Bond
Other sources of
Cash + $270,000 = No Change + financing $270,000
Building acquisition
Cash - $270,000 = No Change - expenditure $270,000
129. An Overview of
Government Reporting
Management Discussion and Analysis
(Analysis of the Statements)
Government-Wide Financial
Statements (Accrual Basis)
Governmental Funds
(Modified Accrual Basis)
Reconciliation
Fiduciary Funds
(Accrual Basis)
Other Required Supplemental Information
Budget Comparison (Budget Basis) and
Other Information
Proprietary Funds
(Accrual Basis)
130. Focus of Government Reporting
Keep government accountable.
Compare actual results to budgets.
Make sure of compliance with laws.
Monitor inter-period equity.
Provide information for decision making.
Allow analysis of the financial condition of the government.
131. Management Discussion
and Analysis
Presented before the financial statement.
Provides an objective and easily understandable analysis.
Compares this year to last year and explains changes.
Provides an analysis of the overall condition of the government.
Discusses material events and their potential impact on financial
condition.
132. Government-Wide
Financial Statements
Prepared using Accrual Accounting
The Financial Statements
- Statement of Net Assets
- Statement of Activities
Both statements include a breakdown of:
- Primary-Government units with columns for:
– Governmental Activities
– Business-type Activities
– Total
- Component units (legally separate entities)
133. Statement of Net Assets
Shows Columns for:
- Primary Government (Governmental and Business Units)
- Component Units
Assets and Liabilities are in order of Relative Liquidity
- Encouraged, but not required
Capital Assets
- Normally presented net of depreciation
- Network Infrastructure may be presented at cost if it is
maintained at some predetermined level
Net Assets
- Invested in capital assets, net of related debt
- Restricted by creditors, grantors, donors, law, or regulation
- Unrestricted
134. Statement of Net Assets
Primary Gov’t Primary Gov’t Primary
Governmental Business-Type Government Component
Activities Activities Total Units
Assets:
Cash and Cash Equivalents $ 375,050 $ 149,344 $ 524,394 $ 450,000
Receivables 743,343 25,118 768,461 199,456
Inventories 120,872 83,280 204,152 23,958
Capital Assets Net of Accumulated Depreciation 8,750,000 4,326,876 13,076,876 34,345,769
Total Assets $9,989,265 $ 4,584,618 $14,573,883 $35,019,183
Liabilities
Accounts Payable $ 825,443 $ 75,431 $ 900,874 $ 387,158
Deferred Revenue 380,000 18,500 398,500 34,946
Noncurrent Liabilities
Due Within One Year 650,000 70,000 720,000 2,945,639
Due in More Than One Year 7,300,000 3,600,000 10,900,000 25,145,348
Total Liabilities $9,155,443 $ 3,763,931 $12,919,374 $28,513,091
Net Assets
Invested in Capital Assets – Net of Debt $ 800,000 $ 656,876 $ 1,456,876 $ 6,148,390
Restricted For:
Capital Projects 15,000 15,000
Debt Service 18,000 18,000
Unrestricted 822 163,811 164,633 357,702
Total Net Assets $ 833,822 $ 820,687 $ 1,654,509 $ 6,506,092
135. Statement of Activities
Includes Line Items and Summary Columns for:
- Primary Government including
– Each Governmental Activity
– Each Business-type Activity
- Each Component Unit
Shows details of:
- Expenses (Area B),
- Dedicated Revenues [excluding taxes] (Area C), and
- Net Expenses or Revenues (Area D).
– Provides an indication of self-sufficiency or required
subsidy.
136. Statement of Activities
A
Line Item
Functions
B
Expenses
by
Function
C
Program
Revenues
by Function
D
Net
(Expenses)/
Revenues
by Program
E
General Revenues,
Unrestricted Contributions,
Transfers &
Changes in NA
F
Changes in Net Assets
137. Revenues Not Related to Activities
Includes (E):
- Taxes by type (property, sales, income, school, etc.)
- Unrestricted Contributions
- Special (one shot) Items
- Transfers
Columns Summarizing Changes in Net Assets (F) for:
- Total Government Activities -
Total Business-type Activities -
Total Primary Government Activities, and -
Total Component Units
138. Statement of Activities
A
Line Item
Functions
B
Expenses
by
Function
C
Program
Revenues
by Function
D
Net
(Expenses)/
Revenues
by Program
E
General Revenues,
Unrestricted Contributions,
Transfers &
Changes in NA
F
Changes in Net Assets
139. Governmental Fund Statements
Required Statements
- Balance Sheet
- Statement of Revenues, Expenditures, and Changes
in Fund Balances
Statements Show
- The general fund
- Other major funds (separate column for each)
- Smaller funds may be aggregated in an other-funds column
- Total of all Governmental Funds
140. Governmental Funds Balance Sheet
Under Modified Accrual Accounting there are no long-term
assets or long-term liabilities.
Fund Balances are divided into reserved and unreserved
amounts.
Reasons for reserves are shown.
Unreserved funds are specified by type of governmental fund.
141. Governmental Funds Balance
Sheet
General New Town
Hall Project
Other Govern-
mental Fund Funds
Total Governmental
Funds
Assets:
Cash $ 43,978 $ 5,000 $ 23,965 $ 72,943
Investments 832,190 128,345 67,000 1,027,535
Receivables, net 746,330 32,548 778,878
Due from other funds 186,000 25,000 211,000
Receivables from other governments 458,400 50,000 72,000 580,400
Total Assets $2,266,898 $183,345 $220,513 $2,670,756
Liabilities and Fund Balances
Liabilities:
Accounts payable $ 28,988 $ 42,385 $ 71,373
Due to other funds 75,000 75,000
Payable to other governments 12,000 35,089 47,089
Total Liabilities $ 115,988 $ 77,474 $ 193,462
Fund Balances
Reserved for:
Encumbrances $ 45,000 $ 45,000
Debt service 1,500,000 1,500,000
Unreserved, reported in
General fund 605,910 605,910
Special revenue fund $ 78,344 78,344
Capital Projects fund $183,345 64,695 248,040
142. Statement of Revenues, Expenditures,
and Changes in Fund Balances
Interest, principal, and capital outlays are all shown
as expenditures.
Proceeds from long-term debt are shown as a source
of funds.
No depreciation.
143. Statement of Revenues, Expenditures, and Changes in Fund Balance General Town Hall Other Funds Total Funds
Revenues: Property taxes $ 8,435,674 --- $ 1,232,476 $ 9,668,150
Fees 1,234,746 --- 343,321 1,578,067
Permits 894,035 --- 43,984 938,019
Intergovernmental 2,089,994 --- 434,598 2,524,592
Charges for Services 1,542,959 --- 2,324,659 3,867,618
Investment Earnings 354,222 --- 390,712 744,934
Total Revenues $ 14,551,630 --- $ 4,769,750 $ 19,321,380
Expenditures
Current:
General Government $ 7,535,980 --- $ 340,576 $ 7,876,556
Public Safety 3,999,745 --- 1,239,435 5,239,180
Sanitation 2,453,909 --- 784,445 3,238,354
Debt Service
Principal 250,000 --- 2,000,000 2,250,000
Interest and Other Charges 15,000 --- 120,000 135,000
Capital Outlay: 2,150,000 --- 270,395 2,420,395
Total Expenditures $ 16,404,634 --- $ 4,754,851 $ 21,159,485
Excess of Revenues Over Expenditures $ (1,853,004) --- $ 14,899 $ (1,838,105)
Other Financing Sources (Uses)
Proceeds from Long-term Capital Related Debt $ 2,000,000 $ 2,000,000
Transfers In 200,000 $ 45,000 $ 10,000 255,000
Transfers Out (85,000) (25,000) (110,000)
Total Other Financing Sources & Uses $ 2,115,000 $ 45,000 $ (15,000) $ 2,145,000
Net Change in Fund Balance $ 261,996 $ 45,000 $ (101) $ 306,895
Fund Balances – Beginning 2,004,902 138,345 220,614 2,363,861
Fund Balances – Ending $ 2,266,898 $183,345 $ 220,513 $ 2,670,756
144. Proprietary Fund Statements
Accrual Basis Accounting
Statements (activities in columns)
- Statement of Net Assets
- Statement of Revenues, Expenses, and Changes in Fund
Net Assets
- Statement of Cash Flows
– Uses Direct Method
– Statement structure includes cash flows from:
Operating activities
Non-capital financing activities
Capital and related financing activities
Investing activities
145. Financial Statements
of Fiduciary Funds
Financial Statements
- Statement of Fiduciary Net Assets
- Statement of Changes in Fiduciary
Net Assets
Prepared on an accrual basis.
146. Other Required Supplemental
Information
Budgetary Comparison
- Line Items show:
– resource inflows by source of funds and
– resource outflows by activity.
- Columns show:
– original budget,
– final budget - including legal changes authorized
over the year,
– actual amounts expended on a budgetary basis, and
– variance from final budget (optional).
- Prepared on the same basis as the budget which varies
by governmental unit.
149. Best Practices
Fund balance reserve policy/working capital
reserves – very significant
Multiyear financial forecasting - significant
Monthly or quarterly financial reporting and
monitoring - significant
Contingency planning policies - influential
150. Best Practices
Policies regarding nonrecurring revenue -
influential
Debt affordability reviews and policies – very
significant
Superior debt disclosure practices – very
significant
Pay-as-you-go capital funding policies –
significant
151. Best Practices
Rapid debt retirement policies (greater than
65% in 10 years) – significant
Five-year capital improvement plan integrating
operating costs of new facilities – influential
Financial reporting awards – influential
Budgeting awards – influential
152. Best Practices
Audits
Professional auditors
Recognized CPA auditors
Legislative audit not adequate
Annual
GAAP compliant
GASB S34 compliant
153. GASB S34
Inventory of capital assets
Current condition of capital assets
Depreciation
Capital Maintenance
Capital Improvement Plan (CIP)
154. After the Sale
Investment of bond proceeds
Arbitrage
26CFR1.148
Rating agency and investor relations
Continuing disclosure
Market monitoring
155. Investing Bond Proceeds
Security
Robert Citron’s mistake
Liquidity
Match investment maturities with project cash
flow needs
Return
Maximize returns subject to arbitrage rules
156. Investor Relations
Timely and complete continuing disclosure
Maintain periodic contact with rating agency
analysts
Direct transmission of continuing disclosure
documents may be appropriate
Contact with large holders of you bonds
157. Debt Policy
“A debt policy is a set of principles and practices, which guides
and informs the debt issuance process.
Your debt policy may take the form of a charter provision or ordinance
enacted by the legislative authority (e.g., council or commission).
It may be an administrative rule or set of rules formally promulgated by
your government’s administration.
A debt policy may also be unwritten. It could take the form of strongly
held principles of good government.” (Simonsen & Kittredge 1997;
Kittredge 2000)
158. Debt Policy
Purposes
Debt limits (legal and policy limits)
Use of moral obligation pledges
Types of debt permitted
Issuance criteria
Structural criteria
Credit objectives
159. Debt Policy
Sale method selection criteria
Criteria and method for selection of
outside professionals
Refunding policy
Disclosure
Legal compliance (e.g. arbitrage)
Debt policy – CIP linkage
Investment of bond proceeds
160. Debt Policy – Practical Benefits
Lowers interest cost and improves credit rating,
especially when strongly linked to CIP (Kittredge
2000)
Provisions included in debt policy have greater
impact on decision-makers’ actions (Simonsen,
Robbins & Kittredge 2001)
Strong selection criteria for outside professionals
lowers interest cost (Kittredge 2003)
164. Warning Signs
Delaying or reducing payments to pension
funds
Putting off preventive maintenance for another
year
Using so-called "innovative" financing methods
that let you to pay for this year’s operating
expenses in a later year
Reducing the amount of capital asset purchases
formerly financed by current taxes
Seeking out "one-shot" revenue enhancements
165. Financial Condition Analysis
Major Influences
Economic Conditions
Demographics
population and its growth rate
age, skills, wealth, employment levels, and
earning capacity of the population.
Management
only factor under local control
Measure of ability to cope with changes in first
two factors
166. Financial Condition Analysis
‘Balanced Budget’
Many different possible meanings
Legally ‘balanced’ doesn’t necessarily
indicate strong fiscal condition
Use of one time revenues
Inappropriate use of borrowing
Fiscal gimmicks such as delaying payments
until ‘next year’
167. Financial Condition Analysis
‘Balanced Budget’
‘Structurally balanced’
long-term view of the local economy’s ability to pay
recognizes revenues rise and fall with economic
swings
identify a basic level of services that is sustainable
even during economic downturns
uses surpluses built up during favorable economic
swings, personnel attrition and other expenditure
reductions during unfavorable economic swings to
support the basic level of services without causing
fiscal stress.
168. Cash Solvency
CS 1 — Cash Liquidity
CS 1A — Cash and Cash Equivalents as a Percentage of Current
Liabilities
CS 1B — Cash and Cash Equivalents as a Percentage of Average Monthly
Total Expenditures and Other Financing Uses
CS 2 — Current Liabilities
CS 2 — Current Liabilities as a Percentage of Total Revenues and Other
Financing Sources
CS 3 — Real Property Tax Collections
CS 3A — Real Property Taxes Receivable as a Percentage of Real
Property Tax Revenues
CS 3B — Uncollected Current Year Real Property Taxes as a Percentage
of Total Current Real Property Tax Levy
169. Structural Budgetary Solvency
BS 1 — Operating Surplus or Deficit
• BS 1 — Total Revenues and Other Financing Sources less Total
Expenditures and Other Financing Uses (Operating Surplus or
Deficit) as a Percentage of Total Revenues and Other Financing
Sources
BS 2 — Fund Balance
• BS 2A — Total Unreserved Fund Balance as a Percentage of
Total Revenues and Other Financing Sources
• BS 2B — Appropriated Fund Balance as a Percentage of Total
Revenues and Other Financing Sources
BS 3 — One-Time Revenues and Other Financing Sources
• BS 3 — One-Time Revenues and Other Financing Sources as a
Percentage of Total Revenues and Other Financing Sources
170. Long-Term Solvency
LT 1 — Capital Expenditures
LT 2 — Long-Term Debt
LT 3 — Pension Status
LT 4 — Other Long-Term Liabilities
LT 5 — Debt Service
171. Long-Term Solvency
LT 1 — Capital Expenditures
LT 1 — Tax-Financed Capital Expenditures as a
Percent of Total Expenditures and Other Financing
Uses
Often when a local government is starting to
experience financial difficulties, one way it deals
with the difficulties is to reduce or eliminate current
tax-financed funding for capital investment.
172. Long-Term Solvency
LT 2 — Long-Term Debt
LT 2A — Total Direct Long-Term Debt per Capita
LT 2B — Total Direct Long-Term Debt as a Percent of
Taxable Full Value of Real Property Assessments
LT 2C — Total Direct Long-Term Debt as a Percent of
Personal Income
LT 2D — Total Debt Subject to Constitutional or Charter
Debt Limit as a Percent of Total Debt Allowed by
Constitutional or Charter Debt Limit
173. Long-Term Solvency
LT 3 — Pension Status
LT 3A — Pension Fund Assets Available for Benefits as a
Percent of Pension Benefit Obligation (funded ratio)
LT 3B — Pension Fund Assets Available for Benefits as a
Percent of Benefits Paid Last Year
LT 4 — Other Long-Term Liabilities
LT 4 — Other Long-Term Liabilities per Capita
• LT 5 — Debt Service
LT 5 — Debt Service as a Percent of Total Revenues and
Other Financing Sources
174. Economic & Demographics
ED 1 — Population and Age Composition
Total Population and Proportion of Population
Aged 65 and Over
ED 2 — Real Property Value
Full Value of Taxable Real Property
ED 3 — Personal Income
Per Capita Income (and/or Median Household
Income, Total Personal Income)
ED 4 — Poverty
Percentage of Persons Living in Poverty
175. Economic & Demographics
ED 5 — Unemployment
Percentage of Persons Unemployed
ED 6 — Revenue Behavior
ED 6A — Change in Real Property Tax Revenue
Relative to Real Property Tax Base and other
Bases
ED 6B — Change in Sales Tax Revenue Relative to
Personal Income Base
176. Economic & Demographics
ED 7 — Expenditure Behavior
Change in Governmental Expenditures Relative to
Personal Income Base
ED 8 — Revenue Base Risk
Portion of Real Property Tax Revenue Provided by
Largest Taxpayers
177. Management Factors
Budgetary Management
MA 1 — Regressive trends over a period of
time
MA 2 — Maintaining year-to-year
structural budget balance
MA 3 — Accuracy of original budget
estimates
178. Management Factors
Internal Environmental Indicators
MA 4 — Managing for results, including strategic
planning and/or performance measurement
MA 5 — Long-term budgeting and capital
planning
MA 6 — Timeliness, accuracy, and usefulness of
the internal recordkeeping and reporting
MA 7 — Managerial environment
179. Management Factors
Miscellaneous Factors
MA 8 — Flexibility of local control over revenues
and expenditures
MA 9 — "Political" environment, including terms
of office and cumbersome or difficult
organizational structures
MA 10 — Ability and willingness to influence
economic and land use development
180. Analysis Methods
Comparisons over time
Comparisons to industry benchmarks
Peer group comparisons
Comparison to statewide data
181. Comparisons Over Time
trend may be more significant than the
actual current value
six-year comparison used
any period between five and ten years is
usually good.
longer periods will often be needed for
analyzing the economic/demographic
indicators
182. City of Harlan
Tax Financed Capital Investment
City of Harlan has been reducing the level of its
tax-financed capital expenditures over the last
four years.
This demonstrates a pattern that management is
either deliberately or inadvertently reducing the
City’s tax-financed capital investment
expenditures.
Which and why?
Year 1993 1994 1995 1996 1997 1998
Indicator LT 1 0.3% 0.6% 0.6% 0.5% 0.3% 0.2%
183. City of Harlan
Tax Financed Capital Investment
City is getting smaller
This is a long-term trend
Raises concerns about sustainable levels of
taxation
1960 Census 1970 Census 1980 Census 1990 Census 1998
Estimate
20,129 18,653 18,144 16,825 16,333
1960 to 1970 1970 to 1980 1980 to 1990 1990 to 1998 1960 to 1998
-7.3% -2.7% -7.3% -2.9% -18.9%
185. Type of
Gov.
Proximity
to City of
Harlan
Size
(Pop.)
Service Mix
Harlan City Same 16,825 Police, Fire, Highway, Water,
Sewer, Parks and Rec.,
Planning and Zoning
Monty City 38 mi. 19,714 Police, Fire, Highway, Water,
Sewer, Parks and Rec.,
Planning and Zoning
Dutch City 102 mi. 13,243 Police, Fire, Highway, Water,
Sewer, Parks and Rec.,
Planning and Zoning
Chateau City 332 mi. 13,989 Police, Fire, Highway, Water,
Sewer, Parks and Rec.,
Planning and Zoning
Fullerton City 55 mi. 15,656 Police, Fire, Highway, Water,
Sewer, Parks and Rec.,
Planning and Zoning
Saratoga City 10 mi. 7,249 Police, Fire, Highway, Water,
Sewer, Parks and Rec.,
Planning and Zoning
Alberta City 3 mi. 11,061 Police, Fire, Highway, Water,
Sewer, Parks and Rec.,
Planning and Zoning
186. Tax-Financed Capital Expenditures
% Total Expenditures
tax-financed capital investment is extremely low
and has been dropping over the last four years
is, and has been over the last six years, well
below the peer group.
This is a potential indication of long-term fiscal
stress
Year 1993 1994 1995 1996 1997 1998
City of
Harlan
0.3% 0.6% 0.6% 0.5% 0.3% 0.2%
Peer
Average
4.1% 6.7% 4.2% 3.9% 2.9% 2.3%
187. Questions About Trends
Was there an awareness of the trend?
If so, is there general agreement on what
is causing the trend?
What plans have already been made to
address the trend?
189. Municipal Leases
Overview
A typical lease financing involves the issuance of lease
revenue bonds or certificates of participation (COPs).
The payment of debt service is derived from lease
payments by a municipal entity for a particular asset or
group of assets, such as a prison or government office
buildings.
The lessor, usually a municipal or not-for-profit financing
shell, assigns the lease payments to the bond or
certificate trustee.
190. Municipal Leases
Overview
Lease payments usually constitute lease purchase payments toward
the ultimate ownership of the asset by the lessee.
Generally, the municipality’s obligation to make payments under the
lease is subject to annual legislative appropriation.
The municipality, therefore, is not legally obligated to make rental
payments in future years should it choose not to budget and
appropriate the payments.
However, pursuant to the remedies under the lease and other
documents, the municipality would lose use and possession of and
ultimate ownership interest in the asset, thereby providing an
incentive to continue making rental payments until the underlying
debt is paid.
191. Key Credit Factors
Lessee’s credit quality
Lessee’s recognition of lease as debt and its intent to
pay same
Essentiality of the leased property and other project
considerations
Structural provisions of the lease financing
The factors are interrelated and their weighting of
importance may vary by individual situations.
192. Lessee Credit Quality/Financial
Flexibility
A lease analysis begins with a general credit assessment of the lessee,
considering the four major categories financial condition, and the issuer’s
willingness to pay.
An analysis of a lease cannot simply categorize the obligation based on
project essentiality or legal structure.
In addition to strong fundamentals and flexibility, a strong credit should
have a demonstrated willingness to take the measures necessary to
maintain financial health and meet its obligations.
Stronger credits may be more likely to be in a position to honor less viable
or essential lease obligations than weaker entities, particularly if the
magnitude of the exposure is not of great significance.
Accordingly, the context of the obligor’s overall credit standing and financial
flexibility, and the extent to which it asserts its commitment to support the
financing (intent to pay), should also be considered.
193. Recognition as Debt/Intent to Pay
The intent to pay can be demonstrated in how the obligor recognizes the
financing in its authorization and administrative processes.
These processes should be reviewed for consistency with the lessee’s
regular legislative and administrative approval processes for issuing tax-
backed long-term debt.
Optimally, specific executive and legislative participation in the approval of
the lease financing is desirable.
Strong legislative voting outcomes are viewed favorably, particularly in
instances where there has been extensive public discourse about the
project being financed.
The administrative office that is normally responsible for debt issuance
should be directly involved in the lease financing process. Central oversight
of lease programs is important in the budgeting and payment process,
particularly in those jurisdictions where lease payments are appropriated
and paid through multiple departments and agencies.
194. Recognition as Debt/Intent to Pay
High-level oversight indicates recognition of an obligation to pay and
administratively protects against inadvertent omissions of payment from
the budgetary process.
Recognition of capital leases as long-term debt in the entity’s financial
statements, inclusion of such leases in its capital improvement plan and
other debt planning documents (such as debt affordability studies), and
other disclosure of capital leases as financial obligations
Intent to pay can be further demonstrated through upfront equity
contributions to the leased project or program.
Entities with a history of issuing and paying for lease debt are considered
favorably. Certain states and localities severely restrict GO debt issuance
through very low debt limits or difficult, super-majority voter approval
requirements.
In such situations, use of lease debt as the principal means of finance is
viewed more positively than, for instance, the first-time use of lease
financing to avoid seeking voter approval for a particularly unpopular
project.
Entities that have lease-backed debt as a major portion of their debt
structure, such as the states of New York and Virginia, are, among other
reasons, less likely to jeopardize access to this financing vehicle and
existing credit standing by failing to appropriate lease rental payments.
195. Recognition as Debt/Intent to Pay
There are also situations where lease financing presents the best
debt alternative. Certainly for equipment financings, a well-
structured master lease program can be more flexible and
economical than a bond issuance.
With a time-sensitive project, such as meeting court or regulatory
orders before financial penalties begin to accumulate, leasing may
be used to avoid the time consuming bond election process.
Similarly, there are certain projects, such as prisons, that, while very
critical to a government’s operations or court mandated, may not be
popular with voters.
Leases also offer governments a way to avoid the sometimes more
costly government procurement processes on construction projects,
because the government lessee will not be the owner/builder of the
project and the builder/lessor may not be subject to the same
procurement codes.
196. Essentiality/Project Factors
The function a particular asset will serve is
an important part of any lease analysis.
The more integral the asset is to the core
functions of a government, the less likely
it is that the government will consider
discontinuing the lease. For instance, a
police headquarters would be considered
much more essential to a municipality’s
operations than would a neighborhood
health clinic.
197. Financial Performance Risk
Risks increase more significantly for leased projects that carry
financial performance risk, such as parking garages tied to economic
development projects or entertainment projects, since failure to
meet financial or other expectations may cause political pressure to
discontinue rental payments, particularly if the lessee believed that
the project would be self-supporting.
Accordingly, the reasonableness of the expectations concerning the
project’s self-support and related economic benefits is important.
This risk may be mitigated through the use of an asset transfer,
whereby assets more essential to governmental functions than the
asset being financed become the leased assets. For example, a city
could sell and lease back a court building to finance the construction
of a parking garage.
198. Technological Risk
This risk can be a factor, particularly in
equipment leases. Operational problems in
sophisticated equipment can render them
unusable, and technological obsolescence is an
inherent risk, particularly in the rapidly evolving
computer and communications fields. Therefore,
it is preferable that, where high-technology
equipment is involved, amortization be
appropriately short to offset this risk as it relates
to non-appropriation.
199. Construction Risk
Delays in construction and cost overruns are an inherent
risk in any building project and can increase
appropriation and payment risks in lease financings.
Certain municipalities, such as in California and Indiana,
are not required to or are prohibited from making lease
payments until the building is completed and occupied.
This risk factor can be mitigated by: sizing the lease
financing to include capitalized interest for a sufficient
period beyond the project’s expected completion; the
contractor’s experience, coupled with a guaranteed
maximum fixed price contract; penalties for late
construction; performance bonds; and sufficient
contingency built into cost estimates and in certain
situations, a guaranteed contract from a third party.
200. Structural Provisions
Structural/legal provisions of the financing are closely analyzed and can affect the
rating outcome. As discussed earlier, strong lease structures, such as covenant to
budget and appropriate leases, can compensate for project weaknesses, resulting in
a higher rating than otherwise possible under a structure with a weaker requirement
to make rental payments. Conversely, weak legal provisions can cause a lower rating.
The following is a review of certain key provisions.
Length of Lease: The lease term should not extend beyond the useful life of the
property but should equal or exceed the term of the debt. In many instances, long-
term leases are not permissible, but must be renewed annually or biennially. If so,
automatic renewal or the need for positive action to cancel is preferable.
Lease Purchase: Lease financings generally entail lease purchases, as opposed to
true leases where the lessee does not build up equity ownership in the assets. Real
property financing structures usually involve a sale/leaseback or lease/leaseback. The
lessor, through purchase or long-term leasing for a nominal sum, gains long-term
title to the fee or leasehold interest, usually from the lessee of the asset (land and
improvements). It then leases or subleases the asset back to the lessee. Such lease
payments, in substance, generally constitute payments toward the ultimate purchase
and ownership of the asset by the lessee, as opposed to a true lease where lease
payments are the equivalent of simple rent. This buildup of equity ownership over the
lease term increases the likelihood of continuing appropriations. A variation to the
basic lease/purchase arrangement is an asset transfer, whereby what is being leased
is unrelated to the project being financed.
201. Master Lease
Where equipment is involved, a master lease is the
preferable structure because the cross-collateralization
avoids selective appropriation risk. Under this structure,
there is a singular rent payment for all assets,
preventing the lessee from choosing payments for
specific items of equipment. Therefore, if the lessee
decides that a particular item is not essential and
consequently elects to not pay rent, it would stand to
lose all of the equipment pursuant to the trustee’s
security interest. A master lease can be used for real
property as well, and the inclusion of real property can
strengthen an equipment lease transaction.
202. Security Interest
The debt holder, through the trustee, should
have a security interest in the assets — both
equipment and real property. The trustee should
have the right, in the event of non-appropriation
or default, to repossess the property, evict the
lessee, and sell or re-let the assets. While the
rating is not based on the ability to raise
sufficient moneys in the sale or re-lease of the
property, the loss of use of the asset by the
lessee is considered a significant incentive to
continue to make lease payments.
203. Equity Contribution
Upfront investment in a project (either as
cash or real property) is a positive factor,
because the lessee has an early and
ongoing incentive to continue making
lease payment appropriations. Such
investment also demonstrates willingness
to pay.
204. Triple Net
The lease should clearly state that, not
withstanding anything to the contrary, payments
are “triple net” and are not subject to
counterclaim or offset. This means that
regardless of what has been said to the contrary
elsewhere in the lease, if there is any dispute or
litigation between the parties, the lessee must
continue paying rentals and assume other cost,
including taxes, insurance, and maintenance.
205. Seek Appropriation
Where legally permissible, the lessee
should state its intent to use its best
efforts to seek an appropriation from the
legislative body on an annual basis. Also,
declarations of essentiality and intentions
to make appropriations for the full lease
term are viewed favorably.
206. Risk of Loss
Damage and destruction pose a risk to lease
transactions. If not repaired or replaced, loss of
use of a leased asset increases the possibility of
non-appropriation and can result in proportional
reductions in rental payments where the lease
has an abatement provision. Such risks can be
offset through maintenance and insurance
requirements. The lease should state that the
lessee will maintain the property in good repair
and insure it against loss.
207. Risk of Loss
Property/casualty insurance coverage requirements should
cover replacement cost of the asset or the redemption value of
the outstanding debt. Proceeds should be used for property
repair or debt redemption; partial redemption is acceptable if
the remaining property will support the remaining debt. Where
leases contain abatement provisions, rental interruption
insurance should be provided, generally one year for equipment
and one-to-three years for real property. Self-insurance may be
acceptable, provided that a qualified individual annually certifies
to the trustee the adequacy of such coverage.
Title insurance, on a real property project, is desirable in that it
provides protection against title defect or challenges to title
that could jeopardize the true value or use of the property.
Also, the due diligence undertaken by a title insurance
company provides additional assurances that outstanding title
issues have been identified.
208. Debt Service Reserve
Where there is abatement or late budget adoption
risk, a debt service reserve should be funded at least
at the level of the maximum semiannual debt service
requirement.
Except for abatement leases, proper structuring can
obviate the need for a reserve.
Late budget risks can be addressed by setting the first
semiannual debt service payment date several months
after the beginning of the fiscal year.
Even for entities with a strong record of timely budget
adoption, it is preferable to avoid setting debt service
payments earlier than two months into the fiscal year.
209. Other Considerations
Lease financing debt structures usually take the form
of a lease revenue bond or a COP.
Regardless of the debt instrument, financing
structures usually entail the lessee government to
make payments directly to a trustee, pursuant to an
assignment by a lessor or issuer.
The lessor is usually a financing shell, such as a
municipal authority or corporation or not-for-profit
corporation, created by the government lessee to
carry out the lease arrangement. Such entities may
file for bankruptcy only voluntarily and, in the case of
municipal entities, only if authorized by state law.
210. Other Considerations
If such entities can only issue non-recourse debt, then
their bankruptcy is generally viewed as remote.
Where the lessor is an ongoing operating entity, legal
counsel should provide an opinion that the assignment
of rental to the trustee is absolute, for example, a sale
as opposed to a pledge, and that bankruptcy of the
lessor would not result in disruption or recapture of
the lease payments to the bondholder.
Otherwise, a bankruptcy-proof lessor should be
established. Such a lessor should be a not-for-profit,
single-purpose corporation established solely to
undertake the project at hand and restricted to issue
debt only for that project.
211.
212. Cash Solvency
Our Cash Solvency analysis shows that, while
the City of Harlan has improved slightly from its
virtual cash crisis situation in 1995, the cash
liquidity indicators still point to a high level of
stress at the end of 1998. The current liabilities
indicator also points to a high level of stress at
the end of 1998. The only bright spot in the
cash solvency analysis is that, since the county
where the City is located started buying the
current-year uncollected real property taxes in
1996, this indicator shows no risk of stress.
213. Budgetary Solvency
Our Budgetary Solvency analysis shows that, while the
operating surplus or deficit indicator trend and the related
improvement in fund balances are positive, the City has
experienced continuing fund deficits in its general fund and all
its major special revenue funds.
In addition, much of the improvement in both operating
surplus and fund balance has been financed with one-time
revenues and other financing sources.
The City is growing and is a relatively heavy user of one-time
revenues and other financing sources in the general and water
funds.
214. Budgetary Solvency
The City is growing and is a relatively heavy user of one-time
revenues and other financing sources in the general and water
funds.
Lastly, the City has significantly added to its tax bite in the last
few years, without making significant improvements to its
short-term, budgetary solvency financial condition (see the
Chapter 7 discussion of ED 6A Change in Real Property Tax
Revenue Relative to Property Tax and Other Bases).
All these factors point indicate a high risk of budgetary
insolvency and fiscal stress in the City of Harlan.
Therefore, both the Cash Solvency and Budgetary Solvency
indicators point to a high risk of short-term fiscal stress in the
City of Harlan at the end of the 1998 fiscal year.
215. Long-Term Solvency
The City of Harlan’s long-term debt (LT 2), other long-term
debt (LT 4), and debt service (LT 5) indicators have been
decreasing over the last three years.
In addition, the long-term debt (LT 2) and debt service (LT 5)
indicators have been improving in comparison to the peer
group average.
However, all these indicators are above the peer group
average and in the high range in the statewide comparison at
the end of 1998. The pension indicator (LT 3) has no current
effect on the long-term financial condition analysis. However,
the tax-financed capital expenditure indicator (LT 1) is
troublesome.
216. Long-Term Solvency
The drop in that indicator shows that the City
has been decreasing its tax-financed capital
expenditures even though they were already at
very low levels compared to the peer group
cities and the statewide comparison.
The combination of the low and declining tax-
financed capital expenditure indicators and the
declining debt and debt service indicators is a
bad one. It shows that the City is deferring
needed infrastructure improvements. This could
have significant long-term negative financial
condition implications.
217. Long-Term Solvency
First, it will probably cost the City more in the future
to catch up with its infrastructure and capital asset
needs than if it had kept up with its needs.
Second, as the infrastructure deteriorates, the City
probably will have a harder time attracting and
keeping both necessary business and affluent
population in the future.
Further analysis of the City’s capital needs and plans is
required to reach a conclusion here. In the meantime,
based on all the above, we assess the overall risk of
long-term fiscal stress for the City of Harlan as high.
218. Economics & Demographics
The economic and demographic indicators for
the City of Harlan are generally negative,
indicating continued pressure on the City’s
finances.
The City’s per capita income is relatively low
compared with other jurisdictions in its county
and state.
219. Economics & Demographics
Population losses, increasing poverty rates, and
declining property values all have the
continuing potential for straining the City of
Harlan’s budget.
Therefore, the economic/demographic
indicators for the City of Harlan have and will
continue to show the pressure on the City of
Harlan’s finances that could keep the City in
fiscal stress.
220. Internal/External Factors
In this step we look at the Internal/External
Factors Affecting Management’s Adaptability for
the City of Harlan.
To summarize our analysis of the
internal/external factors affecting
management’s adaptability for the City of
Harlan, indicators MA 1, MA 2, MA 4, MA 5, MA
6, MA7, MA 9, and MA 10 show a high level of
risk of fiscal stress.
221. Internal/External Factors
In addition, indicators MA 3 and MA 8 show a
medium level of risk of fiscal stress. Of course
we aren’t just counting the number of high-risk
indicators, but the high risk indicators seem to
be pervasive.
Therefore, based on the above analysis of all
the management adaptability indicators, we
assess the overall risk of fiscal stress for the
City of Harlan as high.