Chapter Two

PRINCIPLES OF ACCOUNTING AND FINANCIAL

REPORTING FOR STATE AND LOCAL
GOVERNMENTS
Activities of Government
There are three major activity categories
of a state and local governments:
• Governmental Activities,
• Business-Type Activities, and
• Fiduciary Activities.

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 Governmental Activities

As per GASB Concepts Statement No.1, government provides certain

core services called General Activities. General Activities provided by
most general purpose governments are related to:
 Protection of life and property, police and fire protection,
 Public works (streets and highways, bridges, and public buildings),
 Parks and recreation facilities and programs,
 Cultural and social services.
Governments also incur costs for general administrative support such as
data processing, finance, and personnel. Core governmental services,
together with general administrative support, comprise the major part of
governmental type activities or simply Governmental Activities

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Business-type Activities

Governments also engage in business type activities. These include:

 Public utilities (electric, water, gas and sewer utilities)
 Transportation systems;
 Toll roads and toll bridges;
 Airports;
 Hospitals;
 Parking garages and lots;
 Liquor stores;
 Swimming pools;
 Stadiums and arenas
Many of these activities are intended to be self supporting by charging users for
the services they receive. Operating subsidies from general revenues are not
uncommon, particularly for transportation systems.

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Fiduciary Activities

Governments often act in a fiduciary capacity, either as an

agent or trustee, for parties outside the government. A
government may serve as agent for other governments in the
administering and collecting of taxes. Governments serve
also as trustees for amounts placed in trust from private
citizens for parks and other purposes, for escheat properties
that revert to the government when there are no legal
claimants or heirs to a deceased individual’s estate, and for
assets being held for employee pension plans

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 Principle № 1: Accounting and Reporting Capabilities
A governmental accounting system must make it possible:
a. to present fairly and with full disclosure the financial
position and results of financial operations of the funds
and account groups of the governmental units in
conformity with GAAPs; and

b. to determine and demonstrate compliance with finance-

related legal and contractual provisions.

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Governmental units may prepare two sets of financial
statements: one set in compliance with legal requirements,
and another set in conformity with GAAP provided that
there is a difference between them. For example the
government regulation may state that revenue should be
recognized on cash basis. Where as GAAPs of
governmental unit states that revenue should be either on
accrual or modified accrual basis. But, if there is no
difference between legal requirements and GAAP, one set
of financial statement satisfies both requirements. This
option is generally true in business organizations.

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 GAAP and Legal Compliance
Governments must comply with the many varied legal and
contractual requirements, regulations, restrictions and
agreement that affect their financial management and
accounting. And such compliance must be demonstrable and
reported upon regularly. Compliance is necessary even though
legal requirements may be archaic, useless, or even
detrimental to sound financial management. Governments
should also prepare financial statements in conformity with
generally accepted accounting principles. Because they
provide uniform minimum national standards and guidelines
to financial reporting.

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 . Where as business accounting systems must provide data both for
GAAP reporting and for income tax reporting, the first GASB
principles recognizes that governmental accounting systems must
provide data both for reporting in conformity with GAAP and for
controlling and reporting on finance-related legal compliance
matters.
 Principle № 2: Fund Accounting System

Governmental accounting system should be organized and

operated on a fund basis.
A fund is defined as a fiscal and accounting entity with a self
balancing set of accounts recording cash and other financial
resources together with all related liabilities and residual equities of
balances, and charges therein which are segregated for the purpose
of carrying on specific activities or attaining certain objectives in
accordance with special regulations, restrictions or limitations

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The diverse nature of government operation and the necessity
of assuring legal compliance preclude recording and
summarizing all governmental financial transactions and
balances in a single accounting entity. Unlike a private
business, which is accounted for a single entity ( A=L+OE), a
governmental unit is accounted for through several separate
fund and account group entities, each accounting for certain
assets, liabilities and equity or other balances( F1;A=L+FB,
F2;A=L+FB….). Thus, from an accounting and financial
management viewpoint, a governmental unit is a combination
of several distinctly different fiscal and accounting entities
having their own balances.

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 Principle № 3: Types of Funds
To accomplish different purposes of the governmental unit, the
unit establishes a variety of funds. The government bodies or other
internal parties may assess the financial performance of each fund
in the fulfillment of the specific purpose for which it was
established. Governmental entities use eight types of funds, which
are generally classified into three major categories based on the
similarity of accounting and reporting methods used.
A. Governmental Funds: General government functions typically are
financed through one or more fund types in this expendable fund
category. The sources uses and balances of the government’s
expendable financial resources and the related current liabilities
(except those accounted for in proprietary funds) are accounted for
through governmental funds (General, Special Revenue, Capital
Project, and Debt Service Funds).
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 1. General Fund: all financial resources except those required to be
accounted for in another fund are accounted for in the general fund.
This fund includes transactions for general government services
provided by the executive, legislative and judicial operations of the
government unit. In addition, public services such as fire and police
protection and public cultural and recreation activities are included
here. There can be only one general fund and it accounts for most of
the ongoing activities of the government.
2. Special Revenue Funds: to account for the proceeds of specific
revenue service (other than expendable trusts or for major capital
projects) that is legally restricted to expenditures for specific
purposes. This fund includes resources and expenditures for
operations of such terms as public libraries, parks, schools, and
highways.

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 3. Capital Project Funds: to account for financial resources to
be used for the acquisition or construction of major capital
facilities other than those financed by proprietary funds and
trust funds. Capital projects, such as public park, civic centers
and municipal buildings that provide benefits to everyone are
accounted for by this fund.
4. Debt Service Funds: to account for the accumulation of
resources for, and the payment of general long-term debt
principal and interest. As its name implies, this fund is
responsible for servicing the long-term debt of the
government.

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B. Proprietary Funds: are non-expendable fund organizations and
activities that are similar to private business enterprises (enterprise
and internal service funds).All assets, liabilities, equities, revenues,
expense and transfers pertaining to these business (quasi-business)
organizations and activities are accounted through proprietary funds.
Proprietary fund accounting measures net income, financial
positions and change in financial position.
5). Enterprise Funds: to account for operations:
a. That are financed and operated in similar manner to private business
enterprises where the intent of the governing body is that the costs
or expenses, including depreciation of providing goods or services
to the general public on a continuing basis be financed or recovered
primarily through user charges; or

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b. Where the governing body has decided that periodic determination
of revenues earned, expenses incurred, and/or net income is
appropriate for capital maintenance, public policy, management
control, accountability or other purposes.

6) Internal Service Funds: the financing of goods or services provided

by one department or agency to another department or agencies of
the government unit, or to other government units, is accounted for
in internal service funds. The services are usually provided on a
cost-reimbursement basis. Examples are motor vehicles pools, city
print shops and central purchasing operations. The services of these
operations are offered only to government agencies and are not
available to the general public.

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C. Fiduciary Funds: These funds are used to account for assets held
by the government in a “trustee” or "agency capacity" whether for
individuals, private organizations, other governmental units or other
funds of the government.
Trust and Agency Funds: to account for assets held by the
government unit for others.
7) Trust Funds: assets held by a government unit in a trustee capacity
for individuals, private organizations, other government units or
other funds are accounted for in trust funds. Trust funds may be
classified as: expendable (e.g. income from a non-expendable trust
fund, resources received for a trust that can be spent), non-
expendable (e.g. the principal amount of a trust fund) and pension
trust funds (e.g. municipality employees’ retirement funds).

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8) Agency Funds: assets held by a government unit in an agency
capacity for employees or other individuals, or for other government
units are accounted for in agency funds. The city employees’ payroll
withholding tax for health insurance
● Principle № 4: Numbers of Funds
Governmental units should establish and maintain those funds
required by law, sound financial administration, and GAAPs. A
governmental entity may use at least one and at most seven types of
funds. Only the minimum number of funds consistent with legal and
operating requirements should be established, however, since
unnecessary funds result in inflexibility, undue complexity and
inefficient financial administration. GASB recognizes the need both to
maintain those funds necessary to appropriately manage and
demonstrate accountability for government resources and to avoid
excessive fragmentation of the financial report by establishing
unnecessary funds.
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 Principle № 5: Accounting for Fixed Assets and Long Term
Liabilities
A clear distinction should be made between:
a. Fund fixed assets that are related to specific proprietary funds or
non-expendable and pension funds which should be accounted for
in those funds. General fixed assets, such as land, buildings,
equipment, etc used by governmental fund which should be
recorded in General Fixed Asset Account Group ( GFAAG) ; and
b. Fund long-term liabilities that are related to specific proprietary
funds or non expendable and pension trust funds which should be
accounted for through those funds. General long-term debts that
are unmatured general long-term liabilities of governmental funds
should be recorded in General Long Term Debt Account Group
(GLTDAG).

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 General Fixed Asset Account Group (GFAAG) and General
Long Term Debt Account Group (GLTDAG) are accounting
entities, but not fiscal entities. Because they do not receive
resources or make expenditures. Thus, they are not funds, they
are simply accounting records used to maintain a record of the
government unit’s general fixed asset and long term debt,
respectively.
 Principle № 6: Valuation of Fixed Assets
Cost is the basic valuation method for both fund fixed assets
and general fixed assets. Fixed assets should be accounted for
at cost or if the cost is not practicably determinable, at
estimated cost. Donated fixed assets should be recorded at
their estimated fair value at the time received. Estimated cost
at the time of acquisition is allowed because some
governments have not maintained a adequate fixed asset
records before beginning to report in conformity
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 This principle allows a government to estimate the original cost of
both general fixed assets of a specific fund assets for which costs
cannot reasonably be determined but requires that its other fixed
assets and all fixed assets acquired subsequently be recorded at cost
or estimated values, if donated.
 Principle № 7: Depreciation of Fixed Assets
Depreciation of general fixed assets should not be recorded in
governmental funds and GFAAG. But, depreciation of fixed assets
accounted for in proprietary funds and non-expendable and pension
trust funds should be recognized. The GASB rationale of this
principle is that depreciation accounting is an important element of
the income determination process. Accordingly, it is recognized in
the proprietary funds and in those funds where expenses, net
income, and/or capital maintenance are measured. Expenditures,
not expenses, are measured in governmental fund accounting.
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 To record depreciation expense in governmental funds it would
be inappropriately mix fundamentally different measurements,
expenses and expenditures. General fixed asset acquisitions
require the use of governmental fund financial resources and are
recorded as expenditures. General fixed asset sale proceeds
provide governmental fund financial resources. Depreciation
expense is neither a source nor use of governmental fund financial
resources, thus is not properly recorded in the account of such
funds.
Principle № 8: Basis of Accounting
Basis of accounting refers to when revenues, expenditures or
expenses, transfers and related assets and liabilities are recognized
in the accounts and reported in the financial statements.

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 Both the accrual and modified accrual basis of accounting are
used in governmental accounting system, as appropriate. Accrual
basis of accounting is appropriate for proprietary and similar
fiduciary funds. And, modified accrual basis of accounting is
appropriate for governmental funds and similar fiduciary funds.
Under the modified accrual basis of accounting revenue is
recorded or recognized when it both objectively measurable and
available to finance the expenditures of the current period.
Measurable means that the accountant can place a monetary value
on the amount of revenues. And, available means that the
revenues can be collected in time to pay the debts for the current
period. When the measurable and available requirements are
applied, some revenues are recognized on cash basis and others on
accrual basis.
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 For instance, at the time property is tax levied, revenue is
recorded on accrual basis rather that waiting until the tax is
received. Whereas other items of revenue, such as fines,
forfeits, sales taxes fees and income tax generally are
recognized on the cash basis because they are not both
objectively measurable and available until cash is received.
 Expenditures are generally recognized in the period in which
the related liabilities arise or incurred if measurable, except
for unmatured interest on general long-term debt, which
should be recognized when due or paid.
 Some examples are given below:-

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 Costs for personal services, such as wages and salaries are generally
recorded in the period paid because they are normal, recurring
expenditures of a governmental unit.
 Goods and services obtained from outside the government entity are
recorded as expenditures in the period in which the goods or
services are received.
 Capital outlays for equipment, buildings, and other long-term
facilities are recorded as expenditures in the period of acquisition.
 Interest on long-term debt is recorded in the period in which it is
legally payable.
Under the accrual basis of accounting revenues are recognized in
the accounting period in which they are earned and become
measurable; and expenses should be recognized in the period
incurred, if measurable. Transfers should be recognized in the
accounting period in which the inter-fund receivable and payable
arise.
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 Principle № 9: Budgeting, Budgetary Control and
Budgetary Reporting
The GASB express the needs of budget in the following
principles:
a. Every governmental unit should adopt an annual budget(s);
b. The accounting system should provide the basis for
appropriate budgetary control;
c. Budgetary comparisons should be included in the
appropriate financial statements and schedules for
governmental funds for which an annual budget has been
adopted.

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Principle № 10: Transfers, Revenue, Expenditure and
Expense Account Classification
The tenth GASB principle states that:
a. Inter-fund transfers and proceeds of general long-term debt
issues should be classified separately from fund revenues and
expenditures or expenses.
b. Governmental fund revenues should be classified by fund and
source. Expenditures should be classified by fund, function
(program), organization unit, activity, character, and principal
classes of objects.
c. Proprietary fund revenues and expenses should be classified
in essentially the same manner as those of similar business
organizations, functions, or activities.

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 Principle № 11: Common Terminology
A common terminology and classification should be used
consistently throughout the budget, the accounts and the financial
reports of each fund. Agreement on a common terminology and
classification scheme is needed to make sure that the accounting
procedures provide the information needed for budget
preparation and for financial statement and report preparation.

 Principle № 12: Interim and Annual Financial Repots

Financial report of governmental unit could be classified as interim
financial reports, comprehensive annual financial report (CAFR),
and general purpose financial statement (GPFS).

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 Appropriate interim financial statements of financial position,
operating results and other pertinent information should be
prepared to facilitate management control of financial
operations, and where necessary or desired, for external
reporting purposes.
 A comprehensive annual financial report covering all funds
and the account groups of the governmental unit-including
appropriate combined, combining and individual fund
statements should be prepared and published. CAFR should
contain introductory, financial and statistical sections.
 General purpose financial statements of the reporting entity
may be issued separately from the CAFR.

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 Components of Basic Financial Statements (BFS)
Basic Purpose Financial Statements have three components:
Government wide financial statements, fund financial statements
and Notes to the financial statements.
1. Government Wide Financial Statements
A. Statement of Net Assets
The Statement of Net Assets presents the financial position of
the reporting entity on the last day of the fiscal year so,
Ethiopian governmental entities statements should be dated Sene
30, of each year. The Statement of Net Assets includes the
governmental activities and business type activities of the
governmental units in separate columns. A total column
representing the total entity wide activity of the unit is then
presented. Component unit activities are also shown on this
Statement but these are not included in the total for the entity
wide activities.
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 The Statement of Net Assets uses the economic resources
measurement focus and the accrual basis of accounting.
B. Statement of Activities

The Statement of Activities uses the economic resources

measurement focus and accrual basis of accounting. The
statement provides an accounting of revenues, expenses and
other activities that impact on the entity’s net assets. Fund
Financial Statements
Governmental Funds
Each fund is evaluated to determine if it meets the criteria to be
a major fund or aggregated with other funds and presented in
the non- major fund category.

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a. Balance Sheet
The balance sheet reports only current assets and current liabilities.
Each major fund is presented in a separate column with a separate
column for non-major funds. The difference between the assets and
liabilities is the fund balance. Fund balance is comprised of two
components: reservations and designations. Reservations represent
legal obligations of the governmental unit. Designations represent
management’s decision to dedicate a portion of the fund balance for
future use. A designation is only an intent to spend; this money may
be used for another purpose if necessary.
b. Statement of Revenues, Expenditures and Changes in Fund
Balance
This is the operating statement of the governmental unit. Each
major fund is presented in a column with a separate column for
aggregated non-major funds. Any fund designated as major on the
balance sheet must also be displayed as major on this statement.
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 Revenues are listed first followed by expenditures. A total line for
Excess (deficiency) of revenues over expenditures must be included.
Other financing sources (uses) and special and extraordinary items are
shown after this line. The Net change in Fund balances is the
difference between the Excess (deficiency) of Revenues over
Expenditures and the Total Other Financing sources (uses) plus the
Special and Extraordinary items. This total is added to the beginning
fund balance to arrive at an end of the year fund balance. This total
must equal the total ending fund balance on the balance sheet.
c. Reconciliation Statements
 There are two required reconciliation statements. These statements

reconcile the information on the fund financial statements that are

presented on a modified accrual basis to the entity wide statements
presented on full accrual. Some reconciling items include the impact
of acquiring capital assets, long-term liability treatment and revenue
recognition.
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2. Proprietary funds
a. Statement of Net Assets
This statement is prepared using the economic resources
measurement and the accrual basis of accounting. Funds should be
presented based on the major fund criteria with a separate column
for non-major funds. Internal Service funds are presented on this
statement, however, they are not included in the major fund criteria
and the information is not included in the total column for
Proprietary funds.
Assets and liabilities must be displayed as current and non-
current. The difference between total assets and total liabilities is
the net assets of the fund.
b. Statement of Revenues, Expenses and Changes in Fund Net
Assets
This statement is the basic statement of activities for the proprietary
funds and must utilize the same major fund categories as the
statement of net assets. The revenues and expenses must be
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c. Combined Statement of Cash Flows
The combined statement of cash flows provides the user
with information relevant to the cash receipts and cash
disbursements of an entity during an accounting period.
The statement reports cash receipts, cash disbursements,
and net change in cash resulting from operating, investing
and financing activities of a governmental entity’s
proprietary funds. This statement is generally quite useful
to the user who has limited knowledge regarding financial
matters. Most people, having experience with at least
their own checkbook, can relate to issues concerning cash.

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