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FINANCIAL
MANAGEMENT
IN THE
PUBLIC SECTOR
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FINANCIAL
MANAGEMENT
IN THE
PUBLIC SECTOR
Tools, Applications, and Cases
Third Edition
XiaoHu Wang
First published 2014 by M.E. Sharpe
Published 2015 by Routledge

2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
711 Third Avenue, New York, NY 10017, USA
Routledge is an imprint of the Taylor & Francis Group, an informa business
Copyright © 2014 Taylor & Francis. All rights reserved.
No part of this book may be reprinted or reproduced or utilised in any form or by any electronic,
mechanical, or other means, now known or hereafter invented, including photocopying and recording,
or in any information storage or retrieval system, without permission in writing from the publishers.
Notices
No responsibility is assumed by the publisher for any injury and/or damage to persons or property
as a matter of products liability, negligence or otherwise, or from any use of operation of any methods,
products, instructions or ideas contained in the material herein.
Practitioners and researchers must always rely on their own experience and knowledge in evaluating and
using any information, methods, compounds, or experiments described herein. In using such information
or methods they should be mindful of their own safety and the safety of others, including parties for
whom they have a professional responsibility.
Product or corporate names may be trademarks or registered trademarks, and are used only for
identification and explanation without intent to infringe.
Library of Congress Cataloging-in-Publication Data
Wang, XiaoHu, 1962–

Financial management in the public sector : tools, applications, and cases / by XiaoHu Wang. — Third Edition.
pages cm
Includes index.
ISBN 978-0-7656-3688-1 (cloth : alk. paper) — ISBN 978-0-7656-3689-8 (pbk.: alk. paper)
1. Finance, Public. 2. Finance, Public—Accounting. 3. Budget. I. Title.
HJ141.W36 2014
352.4—dc23 2013025355
ISBN 13: 9780765636898 (pbk)
ISBN 13: 9780765636881 (hbk)
Contents
List of Illustrations xi
Preface and Acknowledgments xv
Part I. Tools for Financial Planning 1
1. Revenue Forecasting 3
Learning Objectives 3
Concepts and the Tool 4
Simple Moving Average (SMA) 4
Exponential Smoothing (EXS) 6
Transformation Moving Average (TMA) 8
Regression Against Time (Regression) 8
A Quasi-Causal Forecasting Model 10
Determining Forecast Accuracy 11
A Case Study 13
Step 1: Cleaning the Data 13
Step 2: Choosing the Forecasting Technique 14
Step 3: Forecasting 15
Step 4: Monitoring Forecasting Performance 15
Exercises 16
2. Resource Development Analysis 22

Defining the Issue: The Revenue Shortage 23
Estimating the Revenue Shortage 24
Developing Revenue Options 27
Assessing Revenue Options 30
Making Decisions 31
v
vi CONTENTS
A Case Study 32
Step 1: Defining the Issue 33
Step 2: Estimating the Revenue Shortage 33
Step 3: Developing Revenue Options 36
Step 4: Assessing Revenue Options 37
Step 5: Making Decisions 37
Exercises 38
3. Cost Estimation 41
Cost Classification 42
Total Cost Estimation 44
Average Cost Estimation 46
A Case Study 46
Step 1: Determining Personnel Costs 47
Step 2: Determining Operating Costs 47
Step 3: Determining Capital Costs 48
Step 4: Determining Total Program Costs 49
Step 5: Determining Average Costs 49
Exercises 50
4. Cost Comparison 54
A Case Study 58
Step 1: Estimating Project Costs 58
Step 2: Determining the Present Value of Cost 59
Exercises 60
5. Incremental Cost Analysis 63

A Case Study 65
Step 1: Examining Each Cost Item 66
Step 2: Determining the Incremental Cost
(or the Marginal Cost, If Necessary) 67
Exercises 67
6. Cost-Benefit Analysis 70
Introduction to Cost-Benefit Analysis 70
Issues in Cost-Benefit Analysis 72
CONTENTS vii
A Case Study 74
Step 1: Formulating the Question in Cost-Benefit Analysis 76
Step 2: Determining the Benefit 76
Step 3: Determining the Cost 77
Step 4: Determining the Discount Rate 78
Step 5: Calculating the Net Present Value 78
Exercises 78
Part II. Tools for Financial Implementation 83
7. Financial Performance Monitoring 85

Determining Monitoring Indicators 86
Detecting Unacceptable Performance 90
Understanding the Causes and Taking Action 91
A Case Study 93
Step 1: Determining and Assessing Individual Financial Indicators 93
Step 2: Detecting Unacceptable Performance 93
Step 3: Understanding Causes of Underperformance 94
Step 4: Developing a Monitoring Report 94
Exercises 95
8. Cash Management: Determining the Optimal Cash Balance 99

Creating a Cash Budget 100
Determining the Optimal Cash Balance 102
A Case Study 106
Step 1: Data Collection and a Review of the Data 106
Step 2: Use of the Miller-Orr Model 107
Step 3: Conducting the Analysis 107
Exercises 108
Part III. Tools for Financial Reporting and Analysis 113
9. Financial Reporting and Analysis: The Statement of Net Assets

and the Statement of Net Position 115
What Information Is in the Statement of Net Assets? 116
What Information Is in the Statement of Net Position? 117
The Accounting Process 118
Principles That Govern Accounting Practices 122
viii CONTENTS
A Case Study 122

Step 1: Reviewing and Analyzing This Year’s Statement of Net Assets 125
Step 2: Comparing with Last Year’s Statement 125
Step 3: Searching for Solutions and Taking Actions 125
Exercises 126
10. Financial Reporting and Analysis: Statement of Activities 128

What Information Is in the Statement of Activities? 129
Accounting Bases 132
A Case Study 133
Step 1: Examining the Statement of Activities 134
Step 2: Comparing with Last Year’s Statement 135
Step 3: Searching for Solutions and Taking Action 135
Exercises 135
11. Financial Reporting and Analysis: Fund-Level Statements 137

Governmental Funds 138
Proprietary Funds 140
Fiduciary Funds 141
A Case Study 141
Step 1: Reviewing the Fund Statements 142
Step 2: Comparing with Last Year’s Statements 143
Step 3: Analyzing the Issues 144
Step 4: Searching for Solutions 144
Exercises 145
12. Financial Condition Analysis 148

What Is Financial Condition Analysis? 148
Determining Measures in FCA 149
Identifying Any Warning Trend of a Deteriorating Financial Condition 153
Specifying the Relationship 154
Explaining the Relationship 156
FCA Report Writing 157
A Case Study 157
Step 1: Defining the Scope of the Analysis 158
Step 2: Determining Measures and Collecting Data 158
Step 3: Identifying Warning Trends 160
Step 4: Specifying the Relationships 161
Step 5: Explaining the Relationships 163
CONTENTS ix
Step 6: Taking Action to Improve Financial Condition 165

Exercises 166
13. Debt Capacity Analysis 169

Types of Debt 170
Debt Capacity Analysis: A Simple Example 171
Assessing the Current Debt Level 172
Determining the Debt Capacity 173
Determining the Additional Debt Capacity 174
Determining the Future Debt Capacity 175
A Case Study 175
Step 1: Calculating the Current Debt Level 175
Step 2: Determining the Debt Capacity 176
Step 3: Determining the Additional Debt Capacity 177
Step 4: Determining the Future Debt Capacity 178
Step 5: Preparing a Debt Capacity Report 180
Exercises 180
14. Financial Risk Assessment: Analyzing the Risk of Revenue Loss 183
What Is Financial Risk? 183
How to Measure the Risk of Revenue Loss 184
How to Reduce the Risk of Revenue Loss 188
A Case Study 190
Step 1: Developing the Purpose of the Analysis 192
Step 2: Identifying Major Revenue Sources and Estimating
Revenue Risks 192
Step 3: Analyzing the Risks 193
Step 4: Making Recommendations to Reduce the Risk 195
Exercises 196
Appendix A: Introduction to Microsoft Office Excel 199

Appendix B: Exercise Answers 201
Glossary 223
Index 239
About the Author 255
List of Illustrations
TABLES
1.1 Forecasting Example One 4
1.2 Forecasting Example Two 8
1.3 Incremental Changes in TMA 9
1.4 Franchise Taxes in City of Sunburn 12
1.5 Incremental Changes of Franchise Taxes in City of Sunburn 12
1.6 Utility Taxes in Sunnytown, Florida 13
1.7 Comparison of MAPEs 15
1.8 Revenues of the Past Five Years 17
1.9 Licenses, Permits, and Fees in Sun Lake 18
1.10 Franchise Taxes in Sunbelt 18
1.11 Franchise Taxes from BellSouth in Sunbelt 18
1.12 Miscellaneous Revenues 19
2.1 Example of Estimating Expenditure Growth 26
2.2 Two Possible Spending Scenarios 27
2.3 Applicability of Revenue Options According to Activity Type 31
2.4 Applicability of Revenue Options According to Time Frame 31
2.5 The Decision-Making Matrix for Revenue Options 32
2.6 Estimated Expenditure Next Year in Woodbury 34
2.7 Expenditure Saving Estimate If Woodbury Leaves 35
2.8 Revenue Shortage Estimate If Woodbury Leaves 36
2.9 A Sales Tax Example 39
2.10 A User Charge Example 39
2.11 An Example of Expenditure Estimation 40
3.1 Cost Estimation for the Northenville COP Program 48
4.1 Estimated Cost of the Maintenance Option 58
4.2 Estimated Cost of a New Swimming Pool 59
4.3 Cost Estimates for EOP and PMS 61
5.1 Incremental Cost Analysis 65
xi
xii LIST OF ILLUSTRATIONS
5.2 Incremental Cost Analysis (Continued) 66

5.3 Cost Comparison in Incremental Cost Analysis 67
5.4 Incremental Costing Exercise 68
6.1 CBA for Garbage Pickup Options 72
6.2 Present Value of Benefits for QTS 77
6.3 Present Value of Costs for QTS 77
6.4 Cost-Benefit Analysis for Two Public Infrastructure Projects 79
7.1 Operating Surplus (or Deficit) of the Past Three Years 91
7.2 Revenues, Expenditures, and Surplus (Deficit) in the Current Year 92
7.3 Expenditure by Function 92
8.1 Expected Cash Receipts by Source in January 100
8.2 Expected Cash Disbursements by Function in January 101
8.3 Cash Budget 101
8.4 An Example of Computing Variance of Daily Net Cash Flow 103
8.5 Cash Flows and Balances of Riverside 107
8.6 Cash Flows of Selected Days 109
8.7 Monthly Cash Flows: Bridgetown Foundation 110
9.1 Statement of Net Position: City of Evergreen, Florida, for the
Year Ending December 31, 20x4 119
9.2 Asset and Liability Allocations: City of Evergreen, Florida,
as of December 31, 20x4 123
9.3 Statement of Net Assets Comparison: City of Evergreen 124
10.1 Expenses in the Statement of Activities: City of Evergreen,
Florida, for the Year Ending December 31, 20x4 130
10.2 Expenses, Program Revenues, and Net (Expenses) Revenues in the
Statement of Activities: City of Evergreen, Florida, for the
Year Ending December 31, 20x4 131
10.3 Expenses, Program Revenues, Net (Expenses) Revenues, and
General Revenues in the Statement of Activities: City
of Evergreen, Florida, for the Year Ending December 31, 20x4 132
10.4 Comparison of Net (Expenses) Revenues and General Revenues:
City of Evergreen, Florida, for the Year Ending December 31, 20x4 134
11.1 Balance Sheet of the General Fund, December 31, 20x4:
City of Evergreen 139
11.2 Statement of Revenues, Expenditures, and Changes in
Fund Balance, the General Fund, December 31, 20x4:
11.3 General Fund Revenues and Expenditures in 20x4:
11.4 Revenue and Expenditure Comparison: General Fund
in the City of Evergreen 143
11.5 Millage of Local Real Property Taxes for Citywide Services:
12.1 Socioeconomic/Organizational Factors in FCA 153
12.2 Population and Revenues 154
12.3 Interpretation of the Correlation Coefficient 155
LIST OF ILLUSTRATIONS xiii
12.4 Population, Revenues, and Revenue Per Capita 156

12.5 CAFR Data for the City of Lucille 159
12.6 Operating Ratio and Own-Source Revenue Ratio 161
12.7 What May Affect the Operating Ratio? 161
12.8 What May Affect Revenues? 161
12.9 What May Affect the Own-Source Ratio? 162
12.10 Expenditure Data 167
12.11 City of Lucille’s Additional Financial Data for the Past Five Years 168
13.1 General Obligation Bonds in Lakeview 176
13.2 Debt Capacity in Lakeview 177
13.3 Future Debt Capacity in Lakeview 179
13.4 Debt Capacity Analysis in a Capital Planning Process 182
14.1 Revenues from Two Sources 185
14.2 Growth Rates of Two Revenues 186
14.3 A Revenue in Stable Decline 189
14.4 Major Revenues in Solivita 191
14.5 Risks of Major Revenue Sources in Solivita 192
14.6 Historical Risks of Revenues in Solivita 194
14.7 Data from Two Revenue Sources 196
14.8 General Fund Revenues of a Suburban City 197
FIGURES
6.1 VTM Diagnostic Process 75
6.2 QTS Diagnosis 76
8.1 The Miller-Orr Model 102
9.1 Example of an Accounting Journal 120
9.2 Example of an Accounting Ledger 121
9.3 The Accounting Equation with a Transaction 121
12.1 Impact of Taxable Property Values on Budget Solvency 163
12.2 Impact of Population on Budget Solvency 164
12.3 Impact of the Millage on Budget Solvency 165
EXCEL SCREENS
1.1 Simple Moving Average 5
1.2 Exponential Smoothing 7
1.3 Regression Against Time 10
4.1 Calculating Present Value 56
4.2 Calculating Annualized Cost 57
8.1 Calculating Variance of Net Cash Flow 104
8.2 Calculating Variance from a Datasheet 105
12.1 Calculating Correlation Coefficients 155
13.1 Calculating Debt with Excel 172
13.2 Calculating Lakeview’s Debt with Excel 178
14.1 Calculating Standard Deviation with Excel 187
Preface and Acknowledgments
I always ask a few questions before buying a book. What is the book about? Why did
the author write it? How are important topics covered? I use this preface to answer
some questions that may be in the mind of a possible reader.
WHAT IS THIS BOOK ABOUT?

This book is a step-by-step guide on how to use budgeting and financial management
tools. It teaches how to use the budgetary and financial information to make effective
decisions and to solve real-world problems.
WHY DID I WRITE THIS BOOK?

I wrote this book because I want the reader to use it, not just read it. This is a book
about application. It is about using what is learned. During my longtime teaching
experience on financial management and budgeting, I have learned that two things
really stimulate student learning. One is an instructor’s interest in student learning.
Another, more important, factor is application of the materials. If students know they
will use what they learn, they are more interested in learning it. This book emphasizes
the application of budgeting and financial management tools in the real world. Its
goal is to familiarize students and readers with the application of analytical tools to
resolve financial management and budgeting issues.
HOW ARE APPLICATIONS EMPHASIZED IN THIS BOOK?

The book uses a case study approach to illustrate the application of financial man-
agement and budgeting concepts and tools. Each chapter starts with a discussion of
a tool (or tools) and related concepts, with examples. It then presents a factual case
study to demonstrate the use of the tool(s). The chapter ends with a list of exercise
questions. This presentation method is the result of my experience teaching analytical
techniques, which often require repetitive examples, cases, and exercises for student
xv
xvi PREFACE AND ACKNOWLEDGMENTS
learning and application. This method stresses the importance of the case study. The
case study allows students to understand the conditions under which a tool can be
properly used. It also stimulates student interest and learning by relating the tools to
a real-world scenario. Each case study here presents a step-by-step guide to applica-
tion. A case starts with a presentation of a decision-making scenario in which a tool
can be applied, and then demonstrates its application in solving the problem, step by
step. The exercises reinforce student understanding of the tools. Exercises also allow
students to experience possible variations of a tool.
Microsoft® Excel™ spreadsheet software is used to assist students in financial
calculation. Financial calculation is a critical part of budgeting and financial manage-
ment, but is often ignored in textbooks. Since the processes of many calculations are
complex, the use of computer software or financial calculators is necessary. Excel is
a popular and powerful software program for financial calculation. This book pro-
vides step-by-step examples of Excel programming for many tools. The use of Excel
can save students time in calculating and enables the instructor to teach calculation-
sophisticated tools that they could not teach otherwise.
WHAT IS COVERED IN THIS BOOK?

The material is covered in three sections: financial planning, financial implementa-
tion, and financial reporting and analysis. In the financial planning section, the focus
is on how to project and develop financial resources (Chapter 1: Revenue Forecast-
ing; Chapter 2: Resource Development Analysis), and on how to plan and improve
resource use (Chapter 3: Cost Estimation; Chapter 4: Cost Comparison; Chapter 5:
Incremental Cost Analysis; Chapter 6: Cost-Benefit Analysis).
The focus in the financial implementation section is on tools to detect and correct
undesirable financial operations, and on tools to ensure continuation of normal finan-
cial activities (Chapter 7: Financial Performance Monitoring). Tools to monitor cash
flows are also covered in this section (Chapter 8: Cash Management: Determining
the Optimal Cash Balance).
In the financial reporting and analysis section, the material stresses how to use
financial information to analyze and improve the financial condition of an organiza-
tion. This section includes several most important financial reports in state and local
governments: The Statement of Net Assets and the Statement of Net Position (Chapter
9) and The Statement of Activities (Chapter 10). It also presents financial reporting
at the fund level (Chapter 11). Chapter 12 discusses the tool to evaluate the overall
financial condition of a government. Chapters 13 and 14 present tools to analyze two
specific aspects of financial condition: debt capacity and financial risk.
WHAT WERE THE CRITERIA FOR SELECTING TOPICS TO COVER?

First, a topic must be important in public financial management and budgeting. Finan-
cial managers are frequently asked to forecast revenues, evaluate revenue potentials,
compare and evaluate costs, monitor financial performance, manage cash flows, and
conduct financial analysis. These topics are included in the book. Second, a topic must
PREFACE AND ACKNOWLEDGMENTS xvii
be analytical in nature, which means that a technical solution is needed and financial
calculation is involved. Therefore, simple subjects such as drafting a budget request,
determining budget line-item classifications, or preparing a spreadsheet of revenue
(or expense) summary are not included.
Although the book does not provide comprehensive coverage of all of the tools in
public budgeting and finance, the analytical processes covered in the book should be
generic enough that the reader can relate and develop a good knowledge of analytical
tools used in public budgeting and financial management.
WHO SHOULD USE THIS BOOK?

The book can be used as a supplementary textbook in a public budgeting or a public
financial management course. It can supplement a textbook that mainly covers theories.
It can also be used as a main textbook for a public financial management course that
focuses on application of budgeting and financial management tools. Teachers of
analytical techniques courses can also consider it as recommended reading. Finally,
it can be used by financial and budget personnel in governments, or anyone who is
interested in governmental finance.
WHAT IS THE MATH REQUIREMENT FOR THE READER?

As the calculations can be performed using Excel, the math requirement for the reader
is minimal. A reader can readily understand the materials and exercises with a basic
knowledge of high school algebra.
WHAT IS NEW IN THE THIRD EDITION?

Several major changes were made in addition to normal updates of the materials.
First, Chapter 9 was rewritten to reflect the latest changes recommended by the
Governmental Accounting Standards Board (GASB) Statements No. 63 and No.
65 on reporting deferred resources in the statement of net position in US state and
local governments. Subsequent changes were also made in Chapters 7, 10, and 11,
and the glossary has been updated. Second, more exercise questions were added at
the request of students and instructors. A new discussion section has been added to
the Exercises in each chapter. The development of these new questions was partly
based on the Government Finance Officers Association (GFOA) recommendations
on best practices in budgeting and finance in government. The introduction to Excel
(Appendix A) was extended to cover Excel 2010 and Excel for Mac.
ACKNOWLEDGMENTS
I am very grateful to many people for their support, encouragement, and suggestions.
Many people have provided valuable feedback on the previous edition of this book:
John Bartle at the University of Nebraska Omaha, Hal Steinberg of the Association of
Government Accountants, Bartley Hildreth at Georgia State University, John Mikesell
xviii PREFACE AND ACKNOWLEDGMENTS
at Indiana University, Zhirong (Jerry) Zhao at the University of Minnesota, Alfred

Tat-Kei Ho at University of Kansas, Thomas Lauth at the University of Georgia,
Howard Frank at Florida International University, Gerasimos (Jerry) Gianakis at
Suffolk University, Aimee Franklin at the University of Oklahoma, and many others.
I thank my previous and current colleagues at the University of Central Florida
(UCF) and City University of Hong Kong for their support and encouragement.
Many students in my financial management and budgeting courses also offered their
feedback. I want to thank the people I worked with at M.E. Sharpe for their support:
Harry Briggs, Elizabeth Parker, and many others.
Finally, special thanks are reserved for my wife, Yan, whose love and support are
an everlasting source of inspiration for me.
PART I
TOOLS FOR FINANCIAL PLANNING

1 Revenue Forecasting
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
s 5SE FORECASTING TOOLS PRESENTED IN THIS CHAPTER

s $ETERMINE THE FORECAST ACCURACY
s !PPLY THE MOST ACCURATE TOOL FOR FORECASTING
Why forecast revenue? Revenue forecasting helps financial planning. Because

revenue determines service capacity, accurate revenue forecasting allows for a good
understanding of an organization’s ability to provide services. Forecasting is also a
process through which managers learn about their communities and organizations.
For example, how much of a community’s resources can be used to provide services
in demand? How capable is the organization of collecting these resources? A poor
forecast—a large gap between the forecast and actual revenues—warrants a close look
at a community’s resource potentials and an organization’s revenue collection efforts.
Who does forecasting? It is often the responsibility of budget offices or central
management offices. Sometimes, individual agencies that have their own resources,
such as businesslike enterprise functions in many governments, also forecast their
revenues.
What forecasting tools are available? A variety of qualitative and quantitative
tools are used in revenue forecasting. The Delphi technique is perhaps the most
popular qualitative tool. It is a process in which a group of experts are individually
questioned about their perceptions of future events that will affect the revenue flows.
Each expert gives a forecasting figure and presents a rationale, and then an outside
party summarizes these forecasts and rationales and comes back to the experts with
more questions. The process continues until a collective forecast is reached.
Quantitative forecast tools vary from simple smoothing techniques to sophisticated
causal modeling. It should be noted that mathematical sophistication is not a guarantee
of forecast accuracy. In this chapter we introduce quantitative tools that are simple to
3
4 TOOLS FOR FINANCIAL PLANNING
understand and easy and inexpensive to use. They are also the proper techniques for
most revenue sources in governments.
CONCEPTS AND THE TOOL

Before forecasting, several things need to be determined. First, the forecast sub-
ject—what is being forecast—must be decided. Is a tax, a fee, or a user charge being
forecast? Is the forecast for the whole organization/jurisdiction, or just a part of it?
Second, a forecast horizon—the length of the forecast—must be established. Should
the revenue be projected for the next month, the next year, or the next five years?
Third, the forecaster must become familiar with forecasting techniques in order to
select one that is proper for the forecasting need. This selection involves a comparison
of the forecast accuracies of different techniques in order to choose the most accurate
one. In this chapter, we study several forecasting techniques that have proven effec-
tive, simple to understand, and inexpensive to apply. They are simple moving aver-
age (SMA), exponential smoothing (EXS), transformation moving average (TMA),
regression against time, and a quasi-causal technique. We can use Microsoft® Excel™
spreadsheet software to help us in these calculations. Excel is a spreadsheet program
that can be used to perform quantitative and financial calculations. It is very popular
and easy to use. Appendix A of this book provides an introduction to the program.
If you are still not comfortable with it, take a look at an introductory manual of the
software. You should be ready in no time. First, let us look at an example. The his-
torical revenue information for a hypothetical organization over the last seven years
is shown in Table 1.1. Using this information, forecast the revenue of the eighth year.
Table 1.1
Forecasting Example One
Year 1 2 3 4 5 6 7 8
Revenues ($) 12.00 14.00 17.00 13.00 17.00 14.00 16.00 ?
SIMPLE MOVING AVERAGE (SMA)

Using the simple moving average (SMA) technique, we calculate the arithmetic
average of revenues in previous forecast periods (“years” in this case) and use it as
the forecast. To do so, we need first to determine the number of forecast periods in
calculation. Let us say that we want an average of the previous five years, then the
forecast for the eighth year is (17.00 + 13.00 + 17.00 + 14.00 + 16.00)/5 = 15.40.
Similarly, a six-year average is (14.00 + 17.00 + 13.00 + 17.00 + 14.00 + 16.00)/6
= 15.17.
SMA is very simple to understand and easy to use. But it has a major drawback—it
weighs all previous revenues equally in averaging. In other words, it treats the revenue
from ten years ago as if it is as important as last year’s revenue. Common sense says
REVENUE FORECASTING 5
Excel Screen 1.1 Simple Moving Average
that we should place more weight on the more recent revenue. It is like predicting
the outcome of a ball game. A team’s more recent performance should carry more
weight in prediction. A team that won recently is the favorite to win again. But that
is not the case for SMA. SMA assigns the same weight to all data in averaging. In
the above example, each figure in the five-year average is assigned a weight factor of
one-fifth. We will come back to this point later in this chapter.
We can use Excel to calculate SMA. The following is the Excel programming to
calculate SMA.
Step 1: Open up a new Excel file. Notice that a sheet is designed for data input in
columns and rows. Columns are named by letter; rows are named by number.
A particular cell can be located by using a letter and a number such as A1,
B2, and so forth. Now, input the revenue data in Column A as shown in Excel
Screen 1.1.
Step 2: Load the Data Analysis ToolPak if you have not done so (see Appendix A for
loading the ToolPak).
Step 3: Click the “Data Analysis” command in the “Analysis Group” on the “Data”
tab if you use Excel 2007 or Excel 2010. If you use Excel 2003, click “Data
Analysis” in the “Tools” menu.
Step 4: Select “Moving Average” in the “Data Analysis” window.
Step 5: In the “Input Range,” input $A$1:$A$7 (i.e., selecting Cell 1 through Cell 7
in Column A), as shown in Excel Screen 1.1.
Step 6: Enter 5 in “Interval,” as we used five periods in the above example.
Step 7: In the “Output Range,” input $B$1:$B$7 (i.e., selecting Cell 1 through Cell
7 in Column B), as shown in Excel Screen 1.1.
Step 8: Do not click the “Labels” box. If you do so, it will treat the first cells of your
inputs as labels.
Step 9: Click “OK.” You should see the forecast SMA figures in Column B.
Excel will provide you with three forecasting figures based on the selection of
five different periods. The average of the first five figures is 14.60. The average of
the second five figures is 15.00. The forecast of the most recent five figures is 15.40.
EXPONENTIAL SMOOTHING (EXS)

The exponential smoothing (EXS) technique assigns different weights to data of
different periods. It allows us to assign larger weights to the more recent data. In
the above example, we can give a large weight, say 40 percent (or 0.40), to the most
recent revenue, 16.00; we can assign the other 60 percent to the average of the previ-
ous six years, which is (12.00 + 14.00 + 17.00 + 13.00 + 17.00 + 14.00)/6 = 14.50.
Therefore, the forecast is (0.40)(16.00) + (0.60)(14.50) = 15.10.
Realize that the sum of the weights needs to be 1.0 (0.4 + 0.6 = 1.0), or 100 percent.
In this example, we use a six-period average. You can choose a three-period average
with the same assignment of weights. The average is (13.00 + 17.00 + 14.00)/3 =
14.67. So, the forecast is (0.40)(16.00) + (0.60)(14.67) = 15.20. Forecasters call the
weight 0.40 a smoothing constant, or (alpha is Greek letter a), and they use the
following equation in forecasting:
Ft+1 = At + (1 – )Ft
In the equation, t is the current period and t + 1 is the next period. Ft+1 is the forecast
for the next period. At is the actual revenue of the current period. Ft is the average
(or smoothed) revenue of previous periods. The Excel data analysis package has a
function for EXS. The programming is similar to that of SMA.
Step 1: Input the revenue data in a column of an Excel spreadsheet as shown in Col-
umn A of Excel Screen 1.2.
Step 3: Select “Exponential Smoothing” in the “Data Analysis” window.
Step 4: Make sure you select eight cells (one more than the original seven years of
revenue) in Column A as your “Input Range.” In other words, input $A$1:$A$8
Excel Screen 1.2 Exponential Smoothing
in the “Input Range.” This is important because you are forecasting the reve-
nue of Year 8.
Step 5: The “Damping Factor” in Excel is 1 – . In the above example, we type in
0.60 (i.e., 1 – 0.40).
Step 6: Select eight cells of the column adjacent to your data as the “Output Range.”
Step 7: Click “OK.”
Excel provides a series of smoothed revenue forecasts: 12.00, 12.80, 14.48, 13.89,
15.13, 14.68, and 15.21. Notice that Excel defines Ft as “smoothed” revenue, not
“average” as in our previous calculation, so the forecasts are a little different. In fact,
the Excel forecast for Year 8 is (0.40)(16.00) + (0.60)(14.68) = 15.21. This forecast
is a little different from our previous forecast of 15.20, but both are correct. We just
need to be aware of different Ft values used.
How to determine ? The values of go from 0 to 1. The value of 1 indicates
that the most recent revenue is used as the forecast; the value of 0 suggests that the
most recent revenue is not considered in forecasting. We also know that a larger
indicates a larger weight assigned to the most recent revenue data. However, there is
Table 1.2
Forecasting Example Two
Year 1 2 3 4 5 6
Revenues ($) 10.00 13.00 14.00 17.00 19.00 ?
no rule on what is best. A good method of selecting is by trial and error, in which
you try different s (from 0 to 1) for a revenue and select the that gives the most
accurate forecast. Later in this chapter, we will learn about a tool to determine the
most accurate forecast method. The tool can be used to determine the . Like SMA,
EXS is also simple to understand. However, it has a major drawback. Let us look at
the example in Table 1.2.
What is the forecast for Year 6? A cursory review tells us it has a very good chance
of being larger than 19.00. Why? Because the data show an upward trend—the reve-
nues have been increasing each year. So history has been repeated again and again,
and there is no reason to believe that it will not repeat this time. Now, let us use EXS
with = 0.80 (a very large weight on the latest figure 19.00) and a three-period aver-
age. The forecast is (0.80)(19.00) + (0.20)[(13.00 + 14.00 + 17.00)/3] = 18.13.
We have a forecast figure smaller than 19.00. Very likely, we have underforecast—
the forecast is smaller than the actual. This happens because EXS averages past data
in their smoothing. For the same token, if we have a downward trend—the revenues
have been getting smaller over time—EXS will overforecast. The forecast is larger
than the actual (if you do not believe me, try EXS on downward data). An important
point is that, when revenues show trends of increase or decrease over time, EXS may
not provide the most accurate forecast. We will have to look at other techniques for
accurate forecasts of revenue trends.
TRANSFORMATION MOVING AVERAGE (TMA)

A trend occurs when the revenue shows a distinctive direction over time. A positive
trend is upward: the revenue gets larger over time. On the other hand, a negative trend
shows a downward direction over time.
In TMA, we take the trend into consideration by computing incremental changes
over time. Let us use the data in Table 1.2 to illustrate this technique. The incremental
changes are shown in Table 1.3.
We then need to average the increments to get an average increment. In this case, it is
(3.00 + 1.00 + 3.00 + 2.00)/4 = 2.25. The forecast revenue in Year 6 is the most recent
actual, 19.00 in Year 5, plus this increment, which is 19.00 + 2.25 = 21.25. TMA is a
very simple technique. In general, it is more accurate than SMA and EXS for trend data.
REGRESSION AGAINST TIME (REGRESSION)

Like TMA, regression is a trend technique. In regression, a relationship is established
between revenue and forecast periods (years, months, and so forth) in the following
fashion:
Table 1.3
Incremental Changes in TMA
Year to year Increment ($)

1 to 2 13.00 – 10.00 = 3.00
2 to 3 14.00 – 13.00 = 1.00
3 to 4 17.00 – 14.00 = 3.00
4 to 5 19.00 – 17.00 = 2.00
Forecast revenue = a + b (forecast period)
In the equation, a is a baseline revenue. It means the revenue without any forecast
period (i.e., the forecast period is equal to 0); b is the revenue increment in response
to the change in the forecast period. It indicates the revenue change from one period
to another. Also, in regression language, the forecast revenue is designated by Y and
the forecast period is designated by X. Hand calculation of a and b is difficult, so we
will use Excel. Let us use the data in Table 1.2 to work through an example.
Step 1: Input the data of “Year” and “Revenues” in Columns A and B, respectively,
as shown in Excel Screen 1.3.
Step 3: Select “Regression” in the “Data Analysis” window.
Step 4: In “Input Y Range,” select Column B for the revenue (i.e., selecting
$B$1:$B$5). In “Input X Range,” select Column A for the data of year (i.e.,
selecting $A$1:$A$5).
Step 5: Select an output range below the original data (below Cell A10 or $A$10 in
this case).
Step 6: Click “OK.” The Excel output is shown in Screen 1.3.
The Excel output presents three tables of results—regression statistics, ANOVA

(analysis of variance), and coefficients and their related statistics. All we need is the
last table, which gives coefficients of intercept and X variable. The coefficient of in-
tercept is a; the coefficient of X variable is b. In our example, a is 8.00 and b is 2.20,
so the regression model is: Forecast Revenue = 8.00 + 2.20 (Year).
The equation basically means that the revenue has a baseline of 8.00 and an annual
increase of 2.20. So the forecast is 8.00 + 2.20 (1) = 10.2 for the first year, 8.00 + 2.20
(2) = 12.4 for the second year, 8.00 + 2.20 (3) = 14.6 for the third year, and so forth.
Therefore, the forecast for the sixth year is 8.00 + 2.20 (6) = 21.20.
Regression forecasting may be more accurate for trend data than SMA and EXS,
but it is more expensive to use. It often requires computer support. It can be techni-
cally and conceptually challenging for forecasters. Also, no evidence shows that it is
more accurate than TMA for trend data.
Excel Screen 1.3 Regression Against Time
A QUASI-CAUSAL FORECASTING MODEL

So far we have studied SMA, EXS, TMA, and regression. All of these techniques use
historical revenue information in forecasting. For instance, in the example in Table
1.2, we used historical data of the past five years to predict the revenue of Year 6.
The techniques that use historical data of revenue in forecasting are called time-series
forecasting techniques, and the historical data are called time-series data.
In some cases, however, time-series revenue data simply do not exist, or the data exist
but have limitations that significantly affect their utility. For example, data may be missing
for certain years in the past. Two revenue sources may be merged in the past to create a
new revenue category. The tax rate or the tax base may have changed significantly in the
past to reflect a new revenue need. Under these circumstances, the use of time-series data
in forecasting is either impossible or improper. We need to consider other tools.
If we can identify several predictors that are highly associated with the revenue,
we can use these predictors in forecasting. For example, if we know the tax base and
the tax rate of a specific tax, then the tax revenue is the product of the base and the
rate. The base and the rate are predictors of the tax revenue. If we use T for the tax
revenue, B for the tax base, and R for the tax rate, then
T=B=R
In a local property tax example, suppose that total assessed taxable property value
(i.e., the tax base) in a city is $10,000,000 this year, and that the city’s property tax
rate is $5 for every $1,000 assessed taxable value (i.e., the millage = 5). The forecast
property tax revenue for this year is $10,000,000 × 5/1,000 = $50,000.
This tool may be accurate for short-term forecasting (one to three years). It is proba-
bly more accurate for revenues whose predicators can be controlled to some degree.
For example, in the above example, if local property tax rates are determined by a
local government, forecasters in the government will know the rates for the forecast
period, and the forecast could be more accurate because of reduced uncertainty in
forecasting.
DETERMINING FORECAST ACCURACY

How accurate is our forecast? To answer this question, we can use two measures: the
absolute percentage error (APE) and the mean absolute percentage error (MAPE).
These measures estimate the difference of the forecast from the actual revenue. A
smaller actual-versus-forecast difference indicates more accurate forecasting.
/F − A /
APE =
A
F is the forecast revenue; A is the actual revenue. / / is the absolute sign, and any
number coming out of it is positive. APE is the forecast-actual difference in percent-
age. A smaller APE indicates a more accurate forecast. APE is simple to understand
and easy to use, but it does not tell the direction of the forecast error: whether it is an
underestimate or overestimate. Let us look at an example. The actual revenue receipts
for franchise taxes in the city of Sunburn are shown in Table 1.4.
Let us say that we want to forecast the revenue at Year 7 (next year). But before
forecasting, we want to know the accuracy of different forecasting techniques so we
can use the most accurate one. We first scan the data and find an upward trend. So we
limit our selection to trend forecasting techniques: TMA or regression. Now, if our
goal is to choose a more accurate technique, which is better—TMA or the regression?
First, let us compute APE for TMA. We know that, to get APE, we need both the
actual revenue and the forecast revenue. We know the actual revenue at Year 6 was
$18,625, and we also know the increments before that year, shown in Table 1.5.
The TMA forecast of Year 6 revenue, with the two most recent increments, is
$17,554 + ($806 + $1,492)/2 = $18,703. So APE for TMA is: APETMA = | $18,703 –
$18,625 | /$18,625 = 0.0042, or 0.42 percent.
Table 1.4
Franchise Taxes in City of Sunburn (in thousands)
Year 1 2 3 4 5 6 7
Revenues ($) 14,305 15,088 15,256 16,748 17,554 18,625 ?
Table 1.5
Incremental Changes of Franchise Taxes in City of Sunburn (in thousands)
Year 1 2 3 4 5
Revenue ($) 14,305 15,088 15,256 16,748 17,554
Increments ($) 783 168 1,492 806
Now, let us get the APE for the regression forecast. The regression equation with
the revenues for the first five years is (use Excel for calculation): Revenue = $13,343
+ $816 (Year). So the forecast at Year 6 is $13,343 + $816 (6) = $18,239, and then
APERegression = | $18,239 – $18,625 | /$18,625 = 0.0207, or 2.07 percent.
APETMA is smaller than APERegression. We can say that TMA is more accurate for
this revenue. But, should we choose TMA to forecast? Not quite yet. To increase the
reliability of our results, we need to get MAPE. MAPE is the average (or mean) of
multiple APEs.
First, let us look at the MAPE for TMA. In the above example, we used the reve-
nues from the first five years to forecast the revenue at Year 6 and then to compute the
APE. We can call that figure APETMA1. Similarly, we can also use the revenues from
the first four years to forecast the revenue at Year 5, which was $16,748 + ($1,492 +
$168)/2 = $17,578, and then compute another APE—let us call it APE TMA2. APE TMA2
= | $17,578 – $17,554 | /$17,554 = 0.0014, or 0.14 percent. Therefore, MAPE(TMA1 +
TMA2)
= (0.0042 + 0.0014)/2 = 0.0028, or 0.28 percent.
We can use the same reasoning to compute MAPE(TMA1 + TMA2 + TMA3) and more
MAPEs, depending on data availability. Similarly, we can calculate MAPE for the
regression. Using the first four revenue data to forecast the revenue at Year 5, we have
the following regression forecast: revenue = $13,475 + $750 (Year). So, the forecast
is $13,475 + $750 (5) = $17,225. APERegression 2 = | $17,225 – $17,554 | /$17,554 =
0.0187, or 1.87 percent. Since APERegression 1 is 0.0207 (see the APE calculation above),
the MAPE for the regression is MAPE(Regression 1 + Regression 2) = (0.0207 + 0.0187)/2 =
0.0197, or 1.97 percent.
Because MAPE(TMA1 + TMA2) is smaller than MAPE(Regression 1 + Regression 2), we can say
that TMA is a more accurate tool and should be used in forecasting the franchise tax
in the city.
A CASE STUDY
Sunnytown (population 50,259), Florida, has experienced rapid growth over the past
decade. The general fund revenue has grown for the last decade from $6.7 million to
$24.7 million. However, annual revenue growth has slowed recently from 20 percent
a decade ago to an average of under 5 percent for the past several years. During this
time, the intergovernmental revenue from the state and the federal government has
grown but become increasingly unstable. Moreover, the town’s fiscally conservative
leadership has been unwilling to raise property taxation significantly.
The service demand increase and revenue growth decrease have given impetus to
the need for enhanced forecast accuracy, particularly in the utility taxes, which have
ranged between 15 percent and 18.5 percent of general revenue over the past ten years.
Local officials have found utility taxes difficult to predict in absolute and relative
terms, particularly when compared with local property taxation. To forecast utility
taxes, the finance director has relied on his own judgment, using data from the past
five years, in consultation with other financial officials. The MAPE for utility taxes
for the ten-year period was 9.1 percent. To the finance director, forecast errors within
plus or minus 5 percent are acceptable. This makes the city’s forecast performance in
utility taxes significantly below par by its own benchmark. The annual actual utility
tax receipts for the past ten years are shown in Table 1.6. What are the forecast utility
taxes for the next year (Year 11)?
Table 1.6
Utility Taxes in Sunnytown, Florida
Year Revenues ($)

1 842,387
2 1,665,430
3 1,863,296
4 2,063,103
5 2,905,717
6 2,994,785
7 3,281,836
8 3,766,661
9 3,907,110
10 4,063,555
11 ?
STEP 1: CLEANING THE DATA

Certain events can significantly impact revenues. A new assessment of taxable proper-
ties changes the property tax base and property tax revenues. A water rate change does
the same to water fee receipts. The annexation of a neighborhood can also increase a
city’s revenue base. These events may change revenues at certain times significantly,
creating a so-called data outlier—an obvious deviation from the mainstream revenue
trend. In forecasting, these outliers often lead to inaccurate forecasts; therefore they
need to be “cleaned” before forecasting.
Quite often, through reviewing the data, we can easily spot an outlier (otherwise,
why call it an outlier?). A drastic change (increase or decrease) in revenue deserves
an investigation. If a change is temporary, such as adoption of a special rate in a par-
ticular year, then the revenue needs to be justified on a regular rate basis. If a change
is permanent or long-term, then we should consider exclusion of data prior to the
change in forecasting.
Our utility data show a dramatic increase from $842,387 in Year 1 to $1,665,430 in
Year 2 (a 97.7 percent increase!). A review of the record shows a utility rate increase
during that year from 6 percent to 10 percent. The utility tax has remained 10 percent
since then. To clean the impact of the outlier, we can either exclude $842,387 from
our forecast or justify the revenue on a 10 percent rate basis by multiplying a modifier.
In this case, the modifier justifies the revenue on a 6 percent rate basis to a 10 percent
in the following way: modified revenue = actual revenue = modifier. Using our data,
this comes to $842,387 = (10 percent/6 percent) = $1,403,978.
STEP 2: CHOOSING THE FORECASTING TECHNIQUE

Two factors should be considered in selecting forecast tools: forecast accuracy and
cost. The former is more important. First, an acceptable accuracy range should be
established (e.g., a MAPE of 5 percent). Notice that it is more difficult to accurately
forecast some revenues than others. In general, economy-sensitive revenues, such as
sales taxes, fees, and user charges, are more difficult to forecast than property taxes.
There should be a consideration to adopt different acceptable accuracy ranges for
different revenues.
Cost should also be considered in selecting a technique. In general, a mathematically
sophisticated technique is costly because it requires computer support and training. An
ideal forecast technique provides acceptable accuracy with technical simplicity.
All techniques in this chapter are relatively simple and inexpensive. So, forecast accuracy
is the only factor in our selection of forecast techniques. Let us use MAPE to determine
the forecast accuracy of the techniques. To compute MAPE for SMA, let us consider
three-year averages against actuals. The latest three-year average, to forecast revenue in
Year 10, is ($3,907,110 + $3,766,661 + $3,281,836)/3 = $3,651,869. Then, APE(Term 7,8,9)
is | $3,651,869 – $4,063,555 | /$4,063,555 = 10.13 percent. Similarly, APE(Term 6,7,8) is |
$3,347,761 – $3,907,110 | /$3,907,110 = 14.32 percent, and APE(Term 5,6,7) is | $3,060,779 –
$3,766,661 | /$3,766,661 = 18.74 percent. Therefore, the MAPE for SMA is (10.13 percent
+ 14.32 percent + 18.74 percent)/3 = 14.40 percent. Notice that the utility revenues show
an upward trend and SMA consistently underestimates them by a relatively large scale.
This proves again that SMA is not an accurate tool for trend data.
We can use Excel in EXS forecasting. When alpha (_) = 0.8, the APE for Year 10 is
APE10 = | $3,856,903 – $4,063,555 | /$4,063,555 = 5.09 percent. APE9 is | $3,656,073
– $3,907,110 | /$3,907,110 = 6.43 percent. APE8 is | $3,213,722 – $3,766,661 |
/$3,766,661 = 14.68 percent. So MAPEEXS is (5.09 percent + 6.43 percent + 14.68
percent)/3 = 8.73 percent.
Table 1.7
Comparison of MAPEs
Technique MAPE (in %)

SMA 14.40
EXS (_ = 0.8) 8.73
TMA 3.15
Regression 4.34
Suppose that we consider three increments in TMA forecasting. To forecast the

revenue in Year 10, we have three increments: $3,907,110 – $3,766,661 = $140,449;
$3,766,661 – $3,281,836 = $484,825; and $3,281,836 – $2,994,785 = $287,051.
Therefore, the forecast is $4,211,218. APE10 is | $4,211,218 – $4,063,555 | /$4,063,555
= 3.63 percent. Similarly, APE9 is 3.75 percent and APE8 is 2.08 percent. MAPE is
3.15 percent.
In regression forecasting, we can use the data of the first nine years to forecast the
revenue in Year 10 and then compare it with the actual revenue in that year to get
APE. Using Excel, we know that the regression equation with the data from the first
nine years is revenue = $976,464 + $334,750 (year). The forecast revenue in Year 10
is $976,464 + $334,750(10) = $4,323,964. The APE10 is | $4,323,964 – $4,063,555 |
/$4,063,555 = 6.41 percent. APE9 is 3.38 percent, and APE8 is 3.24 percent. MAPE
is 4.34 percent.
The MAPE comparison in Table 1.7 reveals that TMA is the most accurate forecast-
ing tool for the utility taxes. Either TMA or the regression satisfies the benchmark of
the 5 percent forecast margin.
STEP 3: FORECASTING
In this step, we use the selected technique, TMA, to forecast the revenue of the next
year (Year 11). With three increments, the utility taxes forecast for the next year are
$4,063,555 + ($156,445 + $140,449 + $484,825)/3 = $4,324,128. We can use this figure
to forecast the utility taxes in Year 12, which are $4,324,128 + ($260,573 + $156,445
+ $140,449)/3 = $4,509,950, and also forecast the revenue further into the future.
STEP 4: MONITORING FORECASTING PERFORMANCE

The performance of a selected forecasting technique should be monitored over time.
The forecast accuracy can be significantly compromised if a revenue pattern changes.
In general, revenue is affected by two factors. First, socioeconomic and demographic
changes can affect the size and the trend of a revenue. Second, policies or decisions
regarding public service delivery and management inevitably affect revenue bases
and collection capacity. A decision to increase the service capacity requires enhanced
revenue sources. To monitor forecast performance, we need to repeat the above three
steps every year after a fiscal year ends and when the actual revenue figures become
available.
EXERCISES
1. KEY TERMS
Delphi technique
Forecast subject
Forecast horizon
Forecasting techniques
Simple moving average (SMA)
Exponential smoothing (EXS)
Smoothing constant or
Underforecast
Overforecast
Transformation moving average (TMA)
Revenue trend
Upward trend
Downward trend
Incremental changes
Regression against time
Time-series forecasting
Quasi-causal forecasting model
Revenue predictors
Absolute percentage error (APE)
Mean absolute percentage error (MAPE)
Data outlier
Steps in revenue forecasting
2. DISCUSSION
1. Give examples to discuss the conditions required for revenue forecasting.
2. What are some of your considerations in determining the smoothing constant
in EXS? Why?
3. There are multiple ways to determine the incremental changes in TMA. Our
book uses the absolute value changes. Identify other possible ways to deter-
mine the incremental changes.
4. Discuss the conditions to adopt the quasi-causal model in revenue forecasting.
5. Comment on the statement “forecasting is as much art as science.”
6. Comment on the statement “the best strategy to defend your forecast from
political attacks is to be thorough in your forecasting process”
3. PRACTICING FORECAST TOOLS

Table 1.8 shows the time-series data of certain revenues.
1. Use SMA, with an average of three years, to forecast the revenue in Year 6.
Use your calculator to forecast, and then use Excel to confirm the result.
Table 1.8
Revenues of the Past Five Years
Year 1 2 3 4 5
Revenues ($) 10 12 15 13 16
2. Use EXS, with = 0.8, to forecast the revenue in Year 6. Use your calcula-
tor to forecast, and then use Excel to confirm the result. (Note that the Excel
result is a little different from your hand calculation for the reason specified
in the text, but they should be very close.)
3. Use TMA, with the consideration of three increments, to forecast the revenue
in Year 6. Use your calculator to forecast first, and then use Excel to confirm
the result.
4. FORECASTING A WATER/SEWER CHARGE
1. The revenue from a water/sewer charge can be expressed as T = C × R, where

T is total annual revenue from the water/sewer charge, C is the total annual
water/sewer consumption (in thousands of gallons), and R is the rate of service
charge. Assuming that the total annual water/sewer consumption is 568,790
(in thousands of gallons) and the rate of the service charge is $10.50 per
thousand gallons, what is total annual revenue?
2. If a revenue can be expressed as total annual forecast revenue = 10.40 + 5.50
(the year in forecast). What is the forecast revenue in Year 10? What is the
forecast in Year 11? What is the difference in revenue between Year 10 and
Year 11?
3. If a forecast is 35.00 and the actual figure turns out to be 40.00, what is the
APE of this forecast? Suppose that another forecast of the same revenue with
the same forecasting technique but different forecast periods is 46.00, and the
actual figure is 42.00, what is the APE for this second forecast? What is the
MAPE for the above two forecasts?
5. FORECASTING LICENSES, PERMITS, AND FEES IN THE

CITY OF SUN LAKE, CALIFORNIA
Table 1.9 presents the historical information of licenses, permits, and fees in the city
of Sun Lake, California.
1. Use SMA (from the revenues of the last three years), EXS, and TMA (consider
three incremental changes) to forecast the revenue in Year 8.
2. If we know that the revenue of licenses, permits, and fees in Year 8 was
$23,210,218, which of the above forecasting techniques is most accurate?
Table 1.9
Licenses, Permits, and Fees in Sun Lake
Year Revenues ($)

1 13,717,979
2 14,369,907
3 16,232,768
4 15,693,711
5 17,684,099
6 18,276,037
7 20,289,136
8 ?
Table 1.10
Franchise Taxes in Sunbelt
Year Revenues ($)

1 12,442,000
2 12,427,000
3 13,091,000
4 13,743,000
5 14,306,000
6 15,089,000
7 15,257,000
8 16,749,000
9 17,655,000
Table 1.11
Franchise Taxes from BellSouth in Sunbelt
Year Revenues ($)

1 3,727,000
2 4,100,000
3 3,927,000
4 4,435,000
5 5,722,000
6 6,036,000
7 5,950,000
8 6,700,000
9 7,062,000
3. Use the most accurate method to forecast the revenues of licenses, permits,
and fees in Years 9, 10, and 11. Use the Year 8 actual figure instead of the
forecast figure. Also consider three incremental changes in forecasting.
4. Use Excel to build a regression model. Use this model to forecast the revenue
of licenses, permits, and fees in Year 8. Is this a more accurate method than
SMA, TMA, or EXS?
6. FORECASTING FRANCHISE TAX IN SUNBELT

Franchise taxes are levied on businesses that gain a franchise right of doing business
in a jurisdiction’s territory. The data in Table 1.10 are franchise tax revenues in the
city of Sunbelt, Florida, from Year 1 to Year 9.
During forecasting, you are informed that BellSouth’s (the local telephone service
provider) current franchise contract with the city ends in Year 11. The city will seek
a 10 percent franchise tax increase from the previous year basis from BellSouth in
Year 12. The franchise tax revenues from BellSouth during the last nine years are
shown in Table 1.11. Forecast the franchise tax revenues of Years 10 to 12. Write a
report on your forecast.
7. FORECASTING MISCELLANEOUS REVENUE

Table 1.12 shows a city’s miscellaneous revenues for the last ten years. An investiga-
tion reveals that the drastic increase from Year 5 to Year 6 was due to a new reclas-
sification of the city’s revenues from fines and forfeitures. About 20 percent of the
miscellaneous revenue was not included before Year 6. Before forecast, the finance
director told you that he would rather underestimate than overestimate this revenue,
as overestimation leaves the city no room for spending flexibility. The director even
suggested that he would take 95 percent of your forecast. What is your strategy to deal
with this forecasting conservatism? What is your forecast of the city’s miscellaneous
revenues for the next year?
Table 1.12
Miscellaneous Revenues
Year Revenues ($)

1 4,250,656
2 5,138,322
3 5,188,121
4 4,555,235
5 5,151,239
6 8,968,142
7 10,742,718
8 8,249,782
9 10,783,255
10 7,556,219
8. PROBABILITY FORECASTING AND SCENARIO FORECASTING

We introduce a quasi-causal forecasting tool in this chapter. In the example about the
tool, we use the tax rate as one of two predicators to forecast property tax revenues.
In that example, the tax rate is 5 per $1,000 (i.e., 5 mills). Let us say that, in forecast-
ing the revenue for the next year, there is a chance that elected officials may vote to
increase the rate to 6 mills. Realize that I say “a chance,” which means that the rate
hike may or may not happen. Let us say that you, the forecaster, estimate that there
is 60 percent of chance that will happen, which is equivalent to saying there is 40
percent of chance that the rate is still 5 mills. Then an estimated rate for the next year
is (0.6 × 6 + 0.4 × 5) = 5.6 mills. This is a simple example of probability forecasting.
In this example, the tax rate is known as an outcome. The 60 percent and 40 percent
are the probabilities of the outcome. Assume that the tax base, $10 million, remains
unchanged next year. The forecast revenue is $10 million × 5.6/1,000 = $56,000.
In scenario forecasting, you can choose to create two forecast scenarios in this ex-
ample: rate hike or no rate hike. The forecasts are $10 million × 6/1,000 = $60,000
with a rate hike and $10 million × 5/1,000 = $50,000 without it. One advantage of
using scenario forecasting is to provide a relatively complete picture of forecast reve-
nue under uncertainty.
How to determine the probabilities? Many financial officials have some ideas
about underlying factors that influence a revenue source. Maybe more than half of
the elected officials are inclined to vote for a rate increase. Maybe the city has not
increased the rate for a long time and an increase is overdue. Maybe the neighbor-
ing cities all plan an increase. Understanding these underlying reasons is the key to
figuring out the probabilities.
Because uncertainty often exists in revenue forecasting, it is always a good idea
to practice probability forecasting in your forecast exercises. Nevertheless, it can be
difficult to determine probabilities in reality.
Though the use of probability forecasting and scenario forecasting may be limited,
they do produce a different way of thinking in forecasting that may enrich the fore-
casting effort and eventually improve forecast accuracy. Identify two to three forecast
situations in a government where a probability forecasting or scenario forecasting
applies. Explain how you may decide on the probabilities.
9. STAGE FORECASTING
This chapter focuses on the use of time-series data in forecasting. Many governments
have cumulated revenue data for a long time. Should they only use the recent data in
forecast? How far back should they go for the data? According to Government Finance
Officers Association’s (GFOA) Best Practices, a minimum of five years of data is
needed for an effective trend analysis. Data older than ten years are considered less
relevant in the analysis. However, before taking this advice, you may want to study
the trend of data to identify the stage of the revenue.
What is the stage? In the United States, many governments enjoyed a financial
boom between 2000 and 2008 because of healthy economic growth. Most of their
revenues grew rapidly during this period. But these revenues started to decline after
2008 due to economic slowdown. So, there are two clear stages before and after
2008. As a forecaster, you are better off if you know the concept of revenue stage and
understand the reasons behind it. Microsoft Excel has an excellent graphing function
that can help you plot your revenue data by time.
So one of first things you may want to do in forecasting is to find out your current
revenue stage (i.e., growth, decline, or flat). For example, if you forecast the revenue
of 2014 and you know that you are still in a stage of revenue decline that started in
2008, it makes sense that you use data after 2008 in your forecasting.
Identify three major revenue sources of a government of your choice. Use the
Excel “Graphing” function (or any computer graphing program) to identify possible
revenue stages. Then use the information to decide how many years of data you want
to use in your forecast.
10. FORECASTING REVENUES OF YOUR CHOICE

Forecast the three largest revenues from a government of your choice.
2 Resource Development Analysis
LEARNING OBJECTIVES
s $ElNE A RESOURCE DEVELOPMENT ISSUE

s %STIMATE REVENUE SHORTAGES
s $EVELOP REVENUE OPTIONS
s !SSESS REVENUE OPTIONS
s $ETERMINE OPTIMAL REVENUE OPTIONS
Imagine that your city needs a new police or fire station, a new city hall, a signifi-
cant increase in police patrol personnel, or a large increase in payoffs for employee
pension or sick leave. Imagine that the city loses revenues as a result of economic
decline, or that a major business has decided to relocate and the city will lose a large
revenue base because of the relocation. All these events cause revenue shortages and
require the city to explore its financial resources to deal with the shortages. In this
chapter, we study a tool to deal with revenue shortages.
Resource development analysis includes an estimate of the revenue shortage—how
much it will be, when it will happen, and how long it will last. It also requires an
analysis of potential revenue sources to cover the shortage. As opposed to revenue
forecasting, which emphasizes how much of the revenue is available, resource devel-
opment analysis concerns not only how much revenue, but also where it comes from.

Resource development analysis (RDA) applies to a fiscal condition where a significant
revenue increase or expenditure cut is needed for a large revenue shortage foreseeable
in the near future. Revenue shortages result from one of three conditions—a signifi-
cant expenditure increase, a significant revenue loss, or both.
It is important to note that RDA is necessary for large and persistent revenue
22
RESOURCE DEVELOPMENT ANALYSIS 23
shortages that could severely hinder an organization’s service quality and affect its
financial viability. Small, temporary, or incremental revenue shortages may be dealt
with by using financial reserves or other established financial practices, and RDA
may not be necessary. For example, the shortage caused by annual employee salary
raises to offset inflation can be covered by allocating a certain percentage of the bud-
get for the increase, and no specific justification or analysis is needed. RDA consists
of several steps:
s 5NDERSTANDING THE ISSUE )N THIS STEP A REVENUE SHORTAGE AND POSSIBLE CAUSES OF
it are specified.
s %STIMATING THE AMOUNT OF THE REVENUE SHORTAGE
s $EVELOPING REVENUE OPTIONS 0OSSIBLE REVENUE OPTIONS TO DEAL WITH THE SHORTAGE
are developed.
s !SSESSING REVENUE OPTIONS 0ROS AND CONS OF EACH REVENUE OPTION ARE ANALYZED
s -AKING DECISIONS &INALLY A DECISION ON WHICH REVENUE OPTIONS IS MOST FEASIBLE
is made.
It is important to note that RDA is a feasibility analysis on revenue options. RDA

is a first step in budget creation, but is not a budget in itself, which requires further
clarification of revenue bases, structures, administration, and collections.
DEFINING THE ISSUE: THE REVENUE SHORTAGE

Many policy and management actions have financial consequences. Efforts to im-
prove police response may force more spending on police vehicles or transportation.
Policies to increase students’ academic performance may lead to more expenditures
to hire better teachers or improve instructional facilities. Actions to appease resident
complaints about high water rates may result in a lower rate structure that leads to less
revenue from that source. Some financial consequences take the form of expenditure
increases (e.g., purchases of buildings, land, or equipment), while others are reflected
as revenue loss (e.g., water rate cut). Regardless of the form of consequences, they
eventually lead to a common fiscal phenomenon—the revenue shortage, which can
be broadly defined as: The Amount of Expenditure (or Expense) – The Amount of
Revenue.
The amount of shortage (Expenditure – Revenue) can be measured by its relative
size to the total revenue (or expenditure). For example, if the shortage is $1 million of
$100 million revenue, the shortage is 1 percent (i.e., 1/100). Another measure of the
shortage is the percentage of the shortage in financial reserves. A large and continual
revenue shortage is a financial warning sign and necessitates an RDA.
Revenue shortages are the result of revenue loss, expenditure growth, or both.
Causes of shortages are many. First, changes in socioeconomic environments may
cause the shortage. Population growth, especially if it is rapid, could create strong
demand for services and therefore rapid expenditure growth. Population decline
could erode the revenue base and result in revenue loss. Economic depression or
recession could cause a loss of revenues that rely on economic growth and property
valuation. Second, policy changes could also lead to a significant decline in reve-
nues or an increase in expenditures. A decision to put more police officers on the
street will surely increase police expenditures. Building a new fire station increases
expenditures significantly. Infrastructure improvement and maintenance are other
reasons for significant expenditure increase. A decision to annex a neighborhood can
cause expenditure growth in the area. Third, large and unexpected events could also
drive up expenditures or reduce revenues. The damage from natural disasters such
as hurricanes could leave a financial hole amounting to billions, so could man-made
disasters such as terrorist attacks. Most of these events cause both an unexpected
expenditure climb and revenue loss.
Some shortages are short term and one time. Others are long lasting. A shortage
caused by tourist decline due to a major hurricane may last a couple of weeks, while
loss of a major business taxpayer could cause a revenue shortage that lasts for years.
ESTIMATING THE REVENUE SHORTAGE

Estimating the shortage is the most critical part of RDA because all other steps
in RDA depend on it. It is also the most technically challenging because of the
uncertainty involved in the estimate. Accuracy of estimation is influenced by three
factors—availability of data necessary for the estimate, integrity of the existing
data collection system, and assumptions made for the estimation. An accurate
estimate requires that data are available, that the data collection system provides
reliable data, and that the assumptions made for the estimate are proper. The
ultimate purpose of the estimation is to minimize the estimation error, defined
as the difference between the estimated shortage and the actual shortage in the
proportion of the actual shortage: Estimation Error = (Estimated Shortage – Actual
Shortage)/Actual Shortage.
A negative estimation error indicates an underestimate of the shortage, and a posi-
tive sign shows an overestimate. For example, if the estimated shortage is $5 million
and the actual shortage is $6 million, then the estimate error of this underestimate is
(5 – 6)/6 = –16.67 percent. It is an intuitive belief that an underestimate of the reve-
nue shortage is more damaging than an overestimate because underestimates leave
little room for revenue maneuvering.
There are three integrated elements in shortage estimation. They are estimations
of shortage types, the shortage amount, and the time frame of shortage. Shortage
types include revenue loss, expenditure growth, or both. The shortage amount
concerns the size of the shortage. The time frame of shortage concerns how long
the shortage lasts. Thus, a complete estimate of a revenue shortage can be phrased
as, for example, “there will be a $250,000 revenue shortage for the next fiscal year
as a result of hiring additional personnel.” When the type and the time frame of a
shortage are determined, estimating the shortage amount is key. The following sec-
tion presents the methods of estimation. Because a revenue shortage is the result of
revenue loss, expenditure growth, or both, these methods are accordingly classified
as methods of “estimating revenue loss” and methods of “estimating expenditure
growth.”
Estimating Revenue Loss
Revenue loss is the amount of revenue decline between two fiscal periods. For example,
if $500 is collected this year and only $400 is available for the next year, the revenue
loss is $100. Revenue loss can be broadly defined as: Revenue Amount Before the
Loss – Revenue Amount After the Loss.
Revenue loss occurs when the result of the above calculation is positive. In the
above equation, the revenue amount can be simply displayed as a function of the
revenue base and the revenue rate (i.e., Revenue Amount = Revenue Base × Reve-
nue Rate).
Thus, revenue loss is the result of a revenue base loss, or a revenue rate cut, or
both. Revenue base is the source of the revenue. For example, the base of a local real
property tax is the assessed taxable value of real properties. The base of a retail sales
tax can be the value of retail sales. The base of a utility charge could be the amount
of utility consumption.
Revenue base loss can be the contributing factor to revenue loss. For example, in a
city where the sales values are forecast to decline by 5 percent in one year, the reve-
nue decline is also 5 percent when the sales tax rate is unchanged. If the expenditure
level is also kept unchanged, the city will have a revenue shortage equal to 5 percent
of its total sales taxes in one year.
A revenue rate cut can also cause a revenue shortage. The structure of the revenue
rate can be flat or block. A flat rate means the same rate is applied regardless of the
revenue base. For example, a flat-rate sales tax applies the same tax rate to all taxable
sales regardless of the value of each sale. A block rate structure can be progressive or
regressive. A progressive rate increases with larger amounts in the revenue base (or
higher revenue blocks), while a regressive rate increases with smaller amounts in the
revenue base (or lower revenue blocks). For example, the federal personal income
tax rate has a progressive rate structure because taxpayers with higher incomes pay
the tax at a higher rate.
The impact of a flat rate cut on revenue loss can be estimated relatively easily. For
example, a 10 percent rate cut will transform to the same percent of revenue loss if
the revenue base is unchanged. But for a block rate cut, revenue loss for each block
(each rate bracket) of revenue must be estimated, which can be a tedious task. Sta-
tistical estimation may be used.
Let us look at an example to illustrate the estimation process. For a revenue that
has a base of $1,000.00 and a flat rate of 10 percent, what is the total revenue loss
if the revenue base decreases by 7 percent and the rate is reduced to 8 percent? We
know that “revenue amount before the loss” is $100.00 (i.e., $1,000.00 × 10 per-
cent). Since the base loss is 7 percent or $70 (i.e., $1,000.00 × 7 percent), the new
base is $930. Multiplying that by 8 percent, we get $74.40. This is the “revenue
amount after the loss.” So, revenue loss = $100.00 – $74.40 = $25.60 In fact, of the
$25.60 loss, the base loss accounts for $7.00 (i.e., $1,000 × 10 percent – $930.00
× 10 percent), and the rate cut accounts for $18.60 (i.e., $930.00 × 10 percent –
$930.00 × 8 percent).
Table 2.1
Example of Estimating Expenditure Growth
Expenditure
Total expenditure Expenditure per per capita
Year ($) Population capita ($) growth rate
Ten years ago 162,491,969 168,456 964.64
Nine years ago 162,424,561 169,675 957.27 –0.0076
Eight years ago 173,379,035 172,019 1,007.91 0.0529
Seven years ago 185,168,296 170,780 1,084.25 0.0757
Six years ago 190,753,923 170,307 1,120.06 0.0330
Five years ago 197,103,191 173,122 1,138.52 0.0165
Four years ago 229,163,984 176,373 1,299.31 0.1412
Three years ago 229,551,667 180,462 1,272.02 –0.0210
Two years ago 261,833,073 184,639 1,418.08 0.1148
Last year 258,881,807 188,013 1,376.94 –0.0290
Average 0.0418
Note: The growth rate is the result of percentage growth over the last period. For example, the growth
rate of last year over two years ago was (1,376.94 – 1,418.08)/1,418.08 = –0.0290.
Estimating Expenditure Growth
Estimating Purchase Prices (or Cost). The focus of this estimation is on the purchase
prices of expenditure (expense) elements such as personnel, operating, and capital
expenditures. For example, if a new fire station is needed in a newly annexed area in
a city, the estimation can be made regarding the cost of the construction, the cost of
hiring new personnel, the cost of purchasing the new equipment, and the cost associ-
ated with operations (such as training, uniforms, and office accessories). Chapter 3
describes the technique of cost estimation for a variety of cost items.
Estimation Based on Demographics. Expenditure growth is often caused by increasing

public demand for services, and public demand can be measured by population growth.
Thus, population growth can be used to estimate the size of expenditure increase.
For example, if we can establish that the expenditure increases by $100,000 for an
increase of 100 in population (i.e., $1,000 per person), we can expect an expenditure
growth of $1 million for a forecast increase of 1,000 in population. Similarly, if we
know the average number of residents served by one fire station, we can forecast
when we may need another station for a growing population.
Table 2.1 shows the expenditure and population data in an urban city for the past
ten years. If the city wants to annex an area that has 4,000 residents this year, what
is the estimated expenditure for the annexation?
Both the expenditure and the population data showed a general trend to increase
over the past ten years. Expenditures per capita have increased from $964.64 per
resident ten years ago to $1,376.94 last year, for an average annual growth of 4.18
percent (or 0.0418) over the past decade. If this growth rate continues, the city will
Table 2.2
Two Possible Spending Scenarios
City A City B
Total expenditure ($) 17,911,569 22,539,480
Population 38,349 42,738
Expenditure per capita ($) 467.08 527.39
expect to spend $1,376.94 × 1.0418 = $1,434.50 per resident this year. So the total
expenditures for the annexation of 4,000 residents this year would be $1,434.50 ×
4,000 = $5,738,000.
Other demographics, such as the income and educational levels of the population,
may also be used to estimate the growth for certain types of expenditures. For example,
a highly educated population may suggest a strong need for expenditure growth on
certain amenities such as community libraries.
Estimation Based on Comparable Scenarios. This method is particularly useful when

little reliable information on purchase prices or demographics is available. The es-
sence of the method is to develop comparable spending scenarios. If a city wants to
construct and operate a community park, the expenditures of existing parks can be
used in the estimate. If a city wants to operate an emergency management service
(EMS), it can use EMS expenditures of similar cities as an estimation basis. The fol-
lowing example illustrates a simple process of estimation.
Suppose that Community X (population estimate 35,000) wants to know the total
expenditure of becoming an incorporated municipality. It has selected two recently
incorporated cities (City A and City B) in developing spending scenarios. These two
cities are comparable to Community X because they are all located in the same geo-
graphical region, they are all mainly residential areas, and they have similar socio-
economic characteristics in residential income and population. These two cities also
provide a list of services that Community X intends to provide. The annual spending
level of these two cities is shown in Table 2.2.
If Community X wanted to become City A, the estimated expenditure would be
$467.08 × 35,000 = $16,347,800. If it were to become City B, the estimate would be
$527.39 × 35,000 = $18,458,650.
Notice that this scenario method involves several critical assumptions. Mainly, it
assumes the compared entities provide similar services, and have similar demograph-
ics. The violation of these assumptions leads to an inaccurate estimate.
DEVELOPING REVENUE OPTIONS

Once the amount of a revenue shortage is determined, potential sources should be
identified to cover the shortage. A common strategy to deal with the shortage is to cut
spending. Spending cuts can effectively reduce the revenue shortage. Nevertheless, it
will affect services and people. Also, it is often politically risky for public officials.
The persistent multiple-year spending cut is particularly difficult, making it impos-

sible to use as a long-term strategy to deal with revenue shortages. In this section, we
only look into options of revenue increases.
The choice of revenues to cover a revenue shortage depends on the applicability of
these revenues to the shortage. This section briefly introduces revenue options and their
applicability to cover a revenue shortage. This book does not explain the design detail
of each revenue option, which can be found in almost any public budgeting textbook.
Option 1: Increasing Taxes
If the revenue shortage is caused by a tax revenue loss or an expenditure increase in

supporting governmental activities, the shortage can be covered by a tax increase. Gov-
ernmental activities are those that private businesses by themselves fail to provide in
sufficient quantity or quality. Examples of governmental activities include public safety,
education, and interstate highway transportation. The term “governmental activities” is
used to distinguish them from business-type activities such as the provision of water,
electricity, and other utilities, though both can be provided by a governmental agency.
Both the tax base and the tax rate can be raised. To increase the tax base, there should
be a process of redefining or reassessing it. For example, the tax base of the retail
sales tax could be broadened to include items that were previously exempt. The same
could be done to the personal income tax. A different choice of assessment methods
can increase the taxable property value to collect more property taxes. Technically,
raising a tax rate may be easier than redefining the tax base. Local property tax rates
change often. Nevertheless, for a large revenue shortage, a small and incremental
adjustment of the tax rate may not be enough. Expanding the tax base or developing
new taxes may be necessary.
If increasing existing taxes is not enough to cover the shortage, a new tax can be
considered. However, the development of a new tax requires more work than the
adjustment of existing taxes. Establishing a new tax can be very costly economically,
politically, and legally. The tax law would need to be approved through a referendum.
Additionally, the tax base and the tax rate need to be defined, and the tax collection
and enforcement processes need to be established.
Option 2: Increasing User Charges
If the revenue shortage is caused by the provision of business-type services, user

charges should be considered. Business-type services (activities) are those that can
be exchanged in the market, and a price structure can be established for providers
to at least break even. The provision of public utilities such as water treatment and
electricity is an example. Other examples include charges for use of public highways
(toll roads) and charges for using public infrastructures.
A revenue design for user charges is similar to a tax design in that it has a revenue
base and a revenue rate (i.e., Revenue Amount = Revenue Base × Revenue Rate). For
example, a water charge has the following design elements: Water Charge = Water
Consumption × Water Charge Rate.
Therefore, an increase in either the base or the rate will bring in more revenue. One
advantage of a user charge, compared with taxes, is that the payer benefits directly
and proportionally from the service supported by the charge. With taxes, taxpayers
often do not benefit directly and proportionally from tax-supported services. Because
of this, user charges are considered fair and perhaps more acceptable to the public
than taxes. Therefore, if either is considered applicable to a revenue shortage, a user
charge may be a more feasible and politically acceptable choice.
Option 3: Borrowing
In US state and local governments, borrowing is desirable when the revenue short-
age is caused by an increase in purchasing or building durable capital assets such as
infrastructure and expensive equipment. These capital items often have large price
tags and long, useful lives.
Once the debt is issued to acquire a capital asset, the payoff of the principal and
interest can be matched to the life of the asset so payers (residents) can pay as they
use or benefit from the capital asset. Therefore, borrowing is considered a financing
method fair to taxpayers.
Bonds can be issued to deal with a revenue shortage in governmental activities and
business-type activities. Once a bond is issued to finance governmental activities, it is
often supported by the taxing authority, which means that the repayment of principal
and interest is assured by taxing power. This means that the bond buyer has a claim
on the taxes of the issuing unit equal to their investment in its bonds. Such assurance
may not exist for a bond issued for business-type activities, which can be repaid from
the revenue generated by the activities. The former is called “full-faith-and-credit”
(or “general obligation”) debt, while the latter is called “nonguaranteed” debt (or a
“revenue” bond).
Option 4: Intergovernmental Assistance
Intergovernmental assistance is often in the form of grants and revenue (or tax) sharing.
For local governments, federal grants are sources of revenue to cover revenue short-
ages in areas specified by the federal government. Large and popular federal grants
are in the areas of public safety, economic development, health and social services,
job training, education, public mass transportation, and environmental protection and
sustainability. Federal fiscal support may also be available during emergencies or natu-
ral disasters such as hurricanes and earthquakes. States also provide grants to local
governments in their jurisdictions. Although intergovernmental assistance is consid-
ered an applicable source of revenue to cover revenue shortages, strict requirements
are often associated with acquisition of grants. Uncertainty is involved in acquiring
grants and in their continuation. For example, there is always a time lag between ap-
plying for a grant and receiving it. Also, many grants for local governments provide
funds only for new rather than existing services/programs. Many grants need matched
funds from receiving governments. All these limitations make intergovernmental as-
sistance less attractive than some other revenue sources to cover revenue shortages.
Option 5: Use of Financial Reserves
A financial reserve is the accumulated result of a desirable difference between revenues

and expenditures (i.e., revenues > expenditures). The continuation of this difference
over a long time can accumulate a large amount of financial resources available to
be used to cover revenue shortages. The use of financial reserve is always one of the
first options to deal with revenue shortages. Nevertheless, if the shortage is long and
large, the existing financial reserve will eventually be depleted and other options will
have to be considered.
Option 6: Making Institutional or Policy Changes
Any institutional change may have a financial impact. One policy that has been used
to deal with revenue shortages at the local level is to develop economic incentive
packages to attract business in order to enlarge the revenue base. In addition, efforts
in outsourcing and contracting out may reduce expenditures and indirectly help re-
duce revenue shortages. Nevertheless, institutional changes often take years to have
any significant effect, and the impact of these changes on revenue shortages is likely
to be long term.
Option 7: Combination of the Above Options and a Summary
An organization is likely to use more than one option in dealing with revenue short-
ages. This approach is particularly useful for a large revenue shortage or for a new
community that starts levying its own revenues. Tables 2.3 and 2.4 present a summary,
based on the applicability of the above options to address revenue shortage.
ASSESSING REVENUE OPTIONS

Developing revenue options is the first step in assessing their feasibility in covering
revenue shortages. Once revenue options are considered applicable, they should be
assessed to select the optimal revenue option (or options). If possible, always prepare
multiple revenue options for the purpose of comparison. Considerations in evaluating
revenue options should be placed on their financial, political, legal, and administra-
tive merits.
In assessing financial merit, the financial costs of options should be estimated and
compared. Financial costs include the costs of developing the revenue option (e.g.,
the feasibility study), revenue design (e.g., the rate study), and revenue administra-
tion and collection (e.g., registration, assessment, accounting, delinquency control/
compliance, audit, appeal, and enforcement). The revenue amount should be estimated
to determine whether enough revenue can be generated from an option. The revenue
to cost ratio, which represents the revenue generated for each dollar of cost (i.e.,
Revenue Generated/Cost), can be used to assess the cost-effectiveness of a revenue
option in generating resources. A higher ratio indicates a more financially efficient
revenue option.
Table 2.3
Applicability of Revenue Options According to Activity Type
Revenue shortage caused by

Governmental activities Business-type activities
Taxes Applicable Not applicable
User charges Not applicable Applicable
Borrowing Applicable Applicable
Intergovernmental aids Applicable Questionable
Financial reserves Applicable Applicable
Institutional/policy changes Applicable Applicable
Table 2.4
Applicability of Revenue Options According to Time Frame
Revenue shortage is
Short term Long term
(< 3 years) (* 3 years)
Taxes Applicable Applicable
User charges Applicable Applicable
Borrowing Questionable Applicable
Intergovernmental aids Applicable Not applicable
Financial reserves Applicable Not applicable
Institutional/policy changes Not applicable Applicable
Political merit concerns whether and how much political support exists for a reve-
nue option. Although a revenue option may have high financial merit, the lack of
political support may make it impossible to implement. There are plenty of cases in
which proposals for tax increases are made only to be rejected by citizens or elected
officials. To estimate and understand the level of political support for a revenue option,
an assessment of the possible impact of the option on each group of stakeholders (i.e.,
citizens, elected officials, businesses, and other interest groups) is needed.
In addition to political feasibility, there are legal or regulatory requirements or
merits associated with the development of revenue options. The law may set limits
on tax rates, tax bases, and tax exemptions and deductions. The level of legal compli-
ance related to each revenue option should be assessed. Legal or regulatory require-
ments may be placed on a grantee government in order to receive intergovernmental
assistance.
MAKING DECISIONS
After the assessment, a decision should be made to select a revenue option or op-
tions that are the most feasible. A decision-making matrix can be used to select the
best option or options. The matrix specifies a list of criteria used to evaluate merits
Table 2.5
The Decision-Making Matrix for Revenue Options
Ratings: 0 = Extremely unfeasible. . . . .10 = Extremely feasible
Options
1 2 3
Financial Merits
Cost of the feasibility study
Cost of the revenue design study
Cost of administration and collection
Sufficiency of revenue generated
Revenue/cost ratio
Political Merits
Elected officials’ acceptance
General public’s acceptance
Business community’s acceptance
Other interest groups’ acceptance
Legal Feasibility
Compliance with federal legal requirements
Compliance with state legal requirements
Compliance with local legal requirements
Total score
of each revenue option. In creating the matrix, each evaluation criterion is assessed
and assigned a numeric score for each revenue option. The scores of all criteria are
added to arrive at a total score for an option, which can be used to determine the most
feasible option. Table 2.5 presents a simplified example of the matrix, with three
revenue options being evaluated. More items in each category of financial, political,
or legal merits can be added or eliminated to fit evaluation requirements and condi-
tions of each case.
In the case where only a single revenue option is evaluated, the total numeric score
can be used as a reference in the comparison with an acceptable score. A value higher
than that score indicates the option is acceptable. For example, on a scale system
with 0 being extremely unfeasible and 10 being extremely feasible, a score of 5 may
indicate moderate feasibility. Therefore, a revenue option scoring higher than the
average score of 5 should be considered acceptable.
A CASE STUDY
Woodbury is a residential community located in an unincorporated area in Greenfield
County (county population 1,130,367), Florida. Woodbury’s 8,000 residents rely on
the county for public services in the areas of general government, public safety, parks
and recreation, environmental management, and local transportation. Woodbury’s
community association has a budgeted expenditure of $3,680,373 this year, with

major spending in administrative services ($1,710,737), community landscaping and
maintenance ($1,305,078), recreation activities ($199,232), and the publication of a
community monthly journal and several newsletters ($71,521).
Woodbury is considered an affluent community in the county. A recent issue of
Realtor Today reports that the median value of residential single-family homes in
Woodbury is $199,000, compared with $176,000 countywide. Many Woodbury resi-
dents believe their community pays more in taxes than they receive in services from
the county. These residents are the force behind a movement to seek alternative ser-
vice providers. Woodbury is bordered by Summertown, a city of 196,235 people that
has a reputation for its beauty and amiable weather. Summertown has long courted
Woodbury to leave the county and become part of the city. Summertown’s most recent
proposal to Woodbury includes a package that likely would freeze the property tax
rate for Woodbury residents for three years.
Many officials in Greenfield County are very concerned. They are afraid that if
Woodbury incorporates or is annexed, the county will lose a large revenue base.
Worse, other wealthy unincorporated areas in the county could follow suit and leave
the county. Steve Loveless, a senior financial analyst for the county, offered to perform
an analysis on the potential revenue loss for the county if Woodbury were to leave.
STEP 1: DEFINING THE ISSUE

Steve thought that, although Woodbury might generate a large amount of revenue for
the county, the county also spends a lot of money in the area. Therefore, it is still not
clear if the county will lose money if Woodbury leaves. If Woodbury is a net revenue
generator for the county, its leaving will cause the county a revenue shortage. So, the
first question in the analysis is whether or not there will be a revenue shortage for
the county as the result of Woodbury’s leaving. To answer this question, Steve needs
to estimate the expenditure by the county in Woodbury and the revenue generated
by the area. If a revenue shortage would occur, the size of it will be estimated in the
analysis. Finally, an analysis should be conducted to explore potential revenue options
for covering the revenue shortage, if it occurs.
STEP 2: ESTIMATING THE REVENUE SHORTAGE

How Much Can the County Save in Expenditure If Woodbury Leaves?
How much does the county spend in Woodbury? The county provides Woodbury with
public services. Private contractors provide water and sewer services and garbage/
solid waste management, so these services are excluded from the county’s analysis.
Woodbury will stay in its current fire and rescue and emergency management services
district in the county even after it leaves, so no expenditure saving is expected from
this service for the county.
Steve assumed that Woodbury would make the annexation decision next year, and
he also used a ten-year period in his projection of expenditure saving and revenue
Table 2.6
Estimated Expenditure Next Year in Woodbury ($)
Woodbury estimate by Adjusted

Greenfield County population percentage Woodbury estimate
General government 178,523,456 1,263,473 1,263,473
Police 372,252,665 2,634,561 2,634,561
Parks and recreation 44,276,096 313,357 1,275,152
Environment management 39,145,829 277,049 277,049
Transportation 87,124,143 616,608 2,047,417
Total 721,322,189 5,105,048 7,497,652
loss. In estimation, Steve first calculated a population percentage of Woodbury in the

county (8,000/1,130,367 = 0.71 percent). Then he derived the county’s spending in
Woodbury by multiplying this percentage with the county’s forecast expenditures for
next year in general government, law enforcement, parks and recreation, environmental
management, and local transportation.
Steve realized that using the population proportion might not be accurate for local
transportation. Woodbury has forty-three miles of paved roadway, about 2.35 percent
of the county total. Using this measure, Steven adjusted the county’s spending for
transportation in Woodbury (i.e., $87,124,143 × 2.35 percent) as $2,047,417. Also,
the county has a park in Woodbury. Steve was able to calculate the county’s spending
on the park ($753,456), plus an estimate of expenditures for other recreation activities
($521,696), and therefore estimated that the county would spend about $1,275,152 on
parks and recreation activities in Woodbury. After these adjustments, Steve created
Table 2.6. The figures in the last column represent his estimate of county spending
in Woodbury.
The estimate shows that the county will spend $7,497,652 in Woodbury next year.
But, if Woodbury left, would the county be able to save all of this money? Probably
not in the short term. For example, it would be difficult to cut the spending on county
personnel even if Woodbury leaves. Some members of the workforce might be reas-
signed to other areas. But much of the savings from personnel would have to come from
long-term labor force attrition or early retirement buyouts. Also, in the short term, it
would be impossible to eliminate the spending on capital outlay (i.e., buildings, land,
and durable equipment) that has already been acquired. Therefore, the short-term sav-
ing from Woodbury’s leaving would most likely come from a reduction in operating
expenses such as office supplies, utility overhead, inexpensive office equipment, and
other operating expenditures related to Woodbury. In the county’s operating budget this
year, only 20 percent is for operating expenses, so Steve estimated that if Woodbury
leaves next year, the county will likely save 20 percent of the $7,497,652, which is
$1,499,530. (A detailed discussion on how to calculate the expenditure change due
to a policy or managerial decision is in Chapter 5, “Incremental Cost Analysis.”)
Nevertheless, the savings can grow over time for the next ten years to $7,497,652 at
the end of the period if the county can cut its Woodbury-related personnel and capital
Table 2.7
Expenditure Saving Estimate If Woodbury Leaves
Year Expenditure saving ($)

1 (next year) 1,499,530
2 2,249,296
3 2,999,061
4 3,748,826
5 4,498,591
6 5,248,356
7 5,998,122
8 6,747,887
9 7,497,652
10 7,497,652
Total 47,984,973
outlay by 10 percent every year. Ten years is the average maturity of the county’s cur-
rent bonds, while 10 percent is an estimate from the county Human Resources office
on the attrition rate of the Woodbury-related workforce. Table 2.7 demonstrates the
savings over a ten-year period.
How Much Revenue Does the County Lose If Woodbury Leaves?
The county collects property taxes and utility taxes from Woodbury. The county also
gathers state intergovernmental assistance for Woodbury. The real property taxes are
estimated from the formula: Tax Amount = Total Taxable Value × Tax Rate × 95 Per-
cent Collection Factor. Woodbury’s total taxable value is $2,207,839,560 next year.
The tax rate is 0.21234 percent (or the millage = 2.1234). Assume that only 95 percent
of all taxes levied are eventually collected. The estimated property tax revenue next
year in Woodbury is $2,207,839,560 × 0.21234 percent × 95 percent = $4,453,720.
Utility taxes are levied on the consumption of public utilities that often include
electricity, water, and communication services. It is estimated that annual utility taxes
per household in Woodbury are $289 next year. There are about 2,500 households
in Woodbury. The estimated utility taxes are $289 × 2,500 households = $722,500
next year.
There are two types of intergovernmental revenues that the county collects for
Woodbury: the retail sales tax and the local option gas tax. Both are state revenue
sharing based on the population of an area. If Woodbury leaves, the county will lose
population and its intergovernmental revenue will be proportionally reduced. It is
estimated that the county will collect about $3,049,880 from Woodbury next year.
This is the amount the county will lose if Woodbury leaves.
The total revenue collected by the county from Woodbury is estimated at $4,453,720
+ $722,500 + $3,049,880 = $8,226,100 for the next year. Since it is likely that Wood-
bury’s population and property values will grow about an average of 3 percent an-
nually for the next decade, this growth is used to estimate Woodbury’s revenue after
Table 2.8
Revenue Shortage Estimate If Woodbury Leaves ($)
Year Expenditure saving Revenue loss Revenue shortage

1 (next year) 1,499,530 8,226,100 –6,726,570
2 2,249,296 8,472,883 –6,223,587
3 2,999,061 8,727,069 –5,728,009
4 3,748,826 8,988,882 –5,240,056
5 4,498,591 9,258,548 –4,759,957
6 5,248,356 9,536,304 –4,287,948
7 5,998,122 9,822,394 –3,824,272
8 6,747,887 10,117,065 –3,369,179
9 7,497,652 10,420,577 –2,922,925
10 7,497,652 10,733,195 –3,235,543
Total 47,984,973 94,303,018 –46,318,045
the next year. For example, if Woodbury leaves, the county’s revenue loss would be
$8,226,100 × 1.03 = $8,472,883 in two years. A ten-year estimate of the county’s
revenue loss is given in Table 2.8.
The amount of revenue shortage is the difference between spending saving and reve-
nue loss. The negative sign indicates a shortage. The result indicates that, if Woodbury
leaves the county, the county will lose $6.7 million next year, but the loss declines
over the ten-year period. The total loss for the next ten years is more than $46 million.
STEP 3: DEVELOPING REVENUE OPTIONS

Steve presented the findings to the county administration and the commission. A grim
picture of an annual revenue shortage of $2.9 to $6.7 million concerned officials.
It seemed that the first option was to persuade Woodbury to stay by presenting an
incentive package similar to the one from Summertown. However, the concern was
the domino effect: if the county did this for Woodbury it would have to do it for other
communities in the county, which could cost the county even more.
A large spending cut is hardly a choice for a county that has already faced service
quality fluctuations and many citizen complaints. So the county has to explore its
revenue potentials. The county relies on two major revenue sources: taxes and user
charges. County taxes include real property taxes, utility taxes, sales taxes (shared
with the state and other local governments), local option gas taxes (shared with the
state and other local governments), and tourist development taxes (levied on tourist-
related industries such as hotels, restaurants, and shops). The county’s user charges
include water/sewer treatment charges to some customers that use the county’s treat-
ment facilities, and charges for the use of the county’s convention center.
Since the revenue shortage would mainly occur in governmental activities (the
county mainly provides governmental services to Woodbury), any increase in user
charges was ruled out. Of the major tax revenues, the county’s share of sales taxes
and local option gas taxes was predetermined by the state, based on an established
revenue-sharing formula. Unless the county had a referendum to increase the tax rate
on the top of the current rate, these two taxes should be excluded as revenue options
to cover the shortage. Therefore, the only options left are to increase property taxes,
utility taxes, and tourist development taxes.
STEP 4: ASSESSING REVENUE OPTIONS

Utility taxes generate about 5 percent of total county tax revenues. It would take a
significant increase (4.2 percent) to generate enough revenue to cover the shortage.
The utility tax rate in the county is considered one of the highest in the state. A rate
hike will meet substantial resistance from utility businesses and customers. Also, a
higher rate may curb utility consumption, which will eventually offset the revenue
increase. After careful consideration, the utility tax rate increase is ruled out.
The county property tax rate is considered moderate in the state. Because the
total taxable value has increased over the last decade, the county has been able to
reduce the tax rate over years. So, in theory, there is a potential for an increase in
the property tax rate. Also, the collection cost is negligible for such an increase, as
the administrative process already exists. A calculation shows that a rate increase
of 1.35 percent should bring the county an additional $7 million, which is enough
to cover the revenue shortage. Nevertheless, such an increase is considered signifi-
cant and may face challenge from residents. A substantial amount of persuasion
may be needed.
Another option is the tourist development taxes. Since the taxes are levied on a
limited number of businesses, a rate increase is unlikely to face heavy resistance from
residents. Nevertheless, these businesses already pay a higher rate than others. A rate
increase on top of the current high rate could cause some businesses to close down,
which would reduce the revenue due to a smaller tax base. Word is out that the tourist
industry is lobbying the county commission to eliminate or reduce the current tourist
development taxes. Three (out of seven) commissioners from the county’s business-
heavy districts are likely to support such a proposal. They need only one more vote
to deter any effort to increase these taxes.
STEP 5: MAKING DECISIONS

The final analysis indicates that a rate increase in property taxes is the most likely
revenue option. Steve estimated that the rate increase as the result of Woodbury’s leav-
ing would likely range from 1.350 percent next year to 0.054 percent ten years later.
However, the scope of this rate increase is restricted by the state law and depends on
the taxable property value of the county, which is expected to grow about an aver-
age of 3 percent annually during the next decade. If such growth ceases to exist, the
county then needs a larger rate increase. Three weeks after Steve presented his report,
three consecutive hurricanes struck his county during a period of four weeks, and the
damage to the property was immeasurable. Steve was forced to readjust his analysis.
EXERCISES
1. KEY TERMS
Resource development analysis (RDA)
Revenue shortage
Steps in RDA
Elements in revenue shortage estimation
Estimation error
Revenue loss
Revenue base
Revenue rate
Flat rate
Block rate
Purchase price estimation of expenditure growth
Demographics estimation of expenditure growth
Comparable scenarios estimation of expenditure growth
Increasing taxes as a revenue option
Increasing user charges as a revenue option
User charge design (a revenue design for user charges)
Borrowing as a revenue option
Intergovernmental assistance as a revenue option
Financial reserves as a revenue option
Institutional/policy changes as a revenue option
Applicability of revenue options for activity type
Applicability of revenue options for time frame
Revenue/cost ratio
Financial, political, legal, and administrative merits of a revenue option
Decision-making matrix
2. DISCUSSION
1. Discuss the objective of RDA. Discuss the conditions for performing RDA
or revenue forecasting.
2. State and local governments in the United States often face severe revenue
shortages during economic slowdowns or recessions. Discuss the causes of
the shortages during the most recent economic recession in a state or local
government of your choice. Discuss the circumstances of the shortages when
RDA was performed (or is needed).
3. When a revenue shortage occurs, many people quickly think that tax increase
is the only option. Discuss cases of revenue shortages in your state or local
government when tax increase may not be the best option.
4. Discuss the need to build a financial reserve in your local government.
Table 2.9
A Sales Tax Example
This year Next year

Retail sales value ($) 23,902,346 24,567,390
Exemption ($) 12,345,670 16,345,670
Tax rate (%) 7.5 7.5
3. REVENUE SHORTAGE IN SALES TAX

A state plans to increase the number of items exempted from its retail sales tax. The
tax amount is defined as (Retail Sales Value Exemption) × Tax Rate. Table 2.9 shows
the expected change.
1. What is the revenue shortage (as the result of revenue loss), if any, based on
the information in Table 2.9?
2. If the actual shortage is $345,291, what is the estimation error?
3. If the tax rate increases from 7.5 percent this year to 8.0 percent next year and
all other estimations are unchanged, what is the estimated revenue shortage,
if any?
4. If the tax rate increases from 7.5 percent this year to 8.0 percent next year and
all other estimations are unchanged, and if the actual shortage is $345,291,
what is the estimation error?
Table 2.10
A User Charge Example
Consumption block Rate Consumption this year Consumption next year

(gallons) (per 1,000 gallons) ($) (gallons) (gallons)
0 to 3,000 7.08 243,578,500 231,349,400
Above 3,000 9.54 124,760,340 100,760,350
4. REVENUE SHORTAGE IN USER CHARGE

City A is expecting a decline in its residential water/sewer user charge as a result of
population decline. Table 2.10 shows the estimated consumption change.
1. What is the total estimated amount of the water/sewer user charge this year?
2. What is the revenue shortage of the user charge as the result of the consump-
tion decline?
3. If the actual shortage is $275,654, what is the estimation error of the shortage?
5. EXPENDITURE AND POPULATION GROWTH

Table 2.11 shows police expenditures and population figures for the past ten years.
What is the estimated police expenditure per capita for the next year?
6. TAXES OR USER CHARGES?
In general, taxes and user charges support different types of services. Nevertheless,
sometimes a government may consider these two options simultaneously. For example,
to build a water treatment facility for residential use, a local government may choose
either to increase taxes or to charge for water consumption. Identify some of the fiscal
situations in your local or state governments when both taxes and user charges may
be used. Discuss the pros and cons of these two options.
Table 2.11
An Example of Expenditure Estimation
Year Police expenditure ($) Population

Ten years ago 111,575,000 443,611
Nine years ago 122,258,000 455,367
Eight years ago 131,633,000 465,895
Seven years ago 139,379,000 470,553
Six years ago 154,738,000 507,553
Five years ago 160,490,000 512,628
Four years ago 182,975,000 527,291
Three years ago 188,884,000 551,645
Two years ago 203,431,000 579,684
Last year 211,635,000 594,176
7. CONDUCTING AN RDA IN A GOVERNMENT OF YOUR CHOICE

A government often relies on many revenue sources. This chapter only presents some of
most popular ones in US local governments. Other important local sources include invest-
ment incomes and various user fees. Note that it may be difficult to include all revenue
sources in an RDA. You may need to focus on the largest revenue sources in your analysis.
3 Cost Estimation
LEARNING OBJECTIVES
s #ALCULATE TOTAL COSTS AVERAGE COSTS DIRECT COSTS INDIRECT COSTS PERSONNEL COSTS
operating costs, and capital costs
s 0ERFORM COST ALLOCATIONS
s 5SE COST DEPRECIATION METHODS
s !PPLY AVERAGE COSTS TO DETERMINE EFlCIENCY
Cost is a critical concept in the private sector. It helps calculate profit, which is
the difference between costs and revenues. Cost has limitation in many public agen-
cies because profitability is not the goal of their operations. Nevertheless, cost is still
important to them for several reasons.
First, many public service agencies, including governmental and nonprofit agencies,
provide goods that can be exchanged in the market. Examples include garbage collection,
toll transportation, water and sewer treatments and supply, and other utility supply. The
production of these goods requires a break-even (i.e., revenue = cost), and the production
is inefficient and not viable if a breakeven or profit is not achieved. Second, cost provides
a measure of efficiency—how well a resource is spent to produce a product. Cost helps
managers determine whether resource use is maximized and waste is avoided. Cost also
interests stakeholders, such as elected officials and private citizens who pay for services.
Third, the increasing use of performance-based budgeting requires the availability of per-
formance measures including cost measures. In performance-based budgeting, decision
makers use cost information to assess a program’s efficiency and make resource alloca-
tion decisions. Finally, cost is a useful standard in making privatization or outsourcing
decisions. Advocates of privatization have cited the cases of inefficient operations in the
public sector in their argument for contracting out public services to the private sector.
They claim that a service should be produced by a sector that is more efficient in using
resources. Therefore, the selection of service providers should be based partly on costs.
41

Cost is different from expenditure or expense. The terms expenditure or expense are
often associated with the budget cycle, as in “expenditures of the police department
for this fiscal year.” These terms convey a clear sense of the annual or biennial time
frame of a budget cycle. Cost is not necessarily a budget concept. It does not have
to be associated with a particular fiscal period. Strictly speaking, cost is the resource
consumption of a product, a service, a program, or a process for a given time frame.
Cost and expenditure may be different in dollar amounts. Expenditure is the
amount of money spent during a fiscal cycle. However, money spent does not neces-
sarily translate into costs. For example, the amount spent to purchase an expensive
computer system is the expenditure during the year of the purchase. If the computer
is used for more than one year, only part of the expenditure should be counted as the
cost for the year of the purchase.
Two concepts are important for cost estimations: cost objective and cost time frame.
Cost objective concerns the cost of “what.” It can be a program, project, process, or
function. A well-defined cost objective is critical for cost estimations. Cost time frame
concerns the time period for which the estimation is made: the lifetime of a program,
annual estimation, or biennial estimation. Both cost objective and cost time frame
should be determined prior to a cost estimation.
COST CLASSIFICATION
Total Costs and Average Costs
Cost is the resource consumed to produce a product or a service. For example, to

provide a police patrol in a community, patrol officers have to be paid and provided
with patrol vehicles and the necessary equipment. The payments for police salaries,
vehicles, and weapons are called cost items (or cost elements). They are resources
consumed to produce a product, in this case, the police patrol. The total cost (also
called the full cost) is the dollar value of all related cost items that should be assigned
to a cost objective. Although this concept is relatively clear, calculating the total cost
is rather difficult in the real world. Complete accuracy is almost impossible to achieve
for most public services. In most cases of cost estimations, assumptions have to be
made on the time frame of a cost objective, on the inclusion (or exclusion) of cost
items, and on the distribution of certain cost items. We will come back to this point
later in this chapter.
If we know the total cost of a police patrol program, and we also know the total
number of patrols conducted, we can compute the cost per patrol. This measure is
called the average cost (or the unit cost).
Average Cost = Total Cost/Quantity
In this equation, the quantity (also called the volume) is a measure of the output of
a product or service. Examples of average costs include “the cost of making a police
COST ESTIMATION 43
arrest,” “the cost of providing a gallon of water,” or “the cost of providing elementary
education to one student.”
The average cost allows us to compare efficiency. For example, we can compare
the average cost of two elementary schools. Let us say School A has 500 students
with an annual cost of $5 million, and School B has 1,000 students with an annual
cost of $7 million. The average cost is $10,000 per student ($5 million/500 students)
for School A, and $7,000 per student ($7 million/1,000 students) for School B. We
can say that School B is more efficient than School A in this measure.
Why is the average cost a measure of efficiency? Notice that, in the above example,
it tells us how much a school spends on each student. We say School B is more ef-
ficient because it consumes less to educate a student.
Direct Costs and Indirect Costs
Some cost items can be directly assigned to a cost objective. For example, the salary of
a police officer in a local police department is a direct cost to the department. Indirect
costs cannot be directly assigned to a cost objective. They should be allocated to it in
some manner. One example is a city manager’s salary as a cost of the police depart-
ment. Although the manager is not involved in the daily operation of the department,
he or she does contribute to the planning and management of the department. So the
city manager’s salary is an indirect cost item of the police department and should be
distributed to its cost in an indirect fashion.
The process of distributing costs to goods or services is referred to as the cost al-
location. Let us look at a simple example to illustrate this process. Suppose that the
total cost of a purchasing department is $25,000 this year, and we need to allocate
this cost to two service departments: Public Safety and Public Utilities. Let us say that
the purchasing department issues a total of 500 purchase orders (POs) this year. So,
the cost per PO is $25,000/500 = $50. In cost allocations, this is called the overhead
rate. The $25,000 is the cost pool, which is the cost that needs to be allocated. The
500 POs, or “the number of POs issued,” is the cost base. The cost base is a very
important concept in costing. It is a measure of an activity that incurs the cost. Later
in this chapter, we will show that the choice of a cost base largely determines the
cost allocated to a program. The above example illustrates that the overhead rate is
determined as follows:
Overhead Rate = Cost Pool/Cost Base
Let us say that, of the 500 POs issued, 300 are for Public Safety and 200 for Public
Utilities. The cost allocated to Public Safety is $50 × 300 = $15,000. Similarly, the
cost for Public Utilities is $50 × 200 = $10,000. That is
Costs Allocated to a Program = Overhead Rate × Cost Base Shared by the Program
The complexity of cost allocation methods varies. Some methods, such as activity-
based costing, can be quite complicated. Activity-based costing (ABC) is a method
of cost allocation that emphasizes allocation precision. It requires careful study of

the process and activities that incur costs so that a cause–effect relationship can be
established between activities and costs. In the above example, some purchases con-
sume more resources than others do (the purchase of expensive policing equipment is
much more complex than the purchase of simple office stationery). In ABC, the actual
resource consumption of the purchasing department for each service department is
measured and used to distribute the cost of the purchasing department.
Personnel Costs, Operating Costs, Capital Costs
Personnel costs are the costs of providing personnel services. They often include
salaries, bonuses, and fringe benefits. Operating costs are the costs of sustaining daily
operations. Costs of office supplies are examples. Capital costs refer to the costs as-
sociated with acquisition of long-lived, nonrecurring, and expensive items. Examples
include costs to acquire buildings, lands, and expensive equipment.
This classification helps managers in many ways. First, the personnel cost is the
largest cost element for many governmental agencies. Reporting it separately from
other cost elements helps management to track it and develop the means to control
it. Second, capital items are expensive and long term in nature, and their financial
impact to an agency is often more than that of an operating item. The separation of
capital costs from other costs improves the financial accountability of capital projects.
TOTAL COST ESTIMATION

The total cost (TC) provides useful information to management. It is important for a
manager to know the cost of providing a service, supporting a program, or operating
a production process. Also, the total cost is necessary for calculating the average cost.
In the following section, we explain how to estimate the total cost.
The key to the estimation is to identify all cost items related to a cost objective,
and distribute them in a rational and accurate fashion. Cost items can be identified
through detailing personnel, operating, and capital cost items, as discussed in the
following section.
Personnel Costs
Personnel costs of a program include salaries, bonuses, and benefits of employees

who work for the program. One way to identify personnel costs is to use an hourly
rate. Consider this example: If an employee makes an annual salary and benefits of
$40,000 and works a total of 2,080 hours a year, the hourly rate of the salary and
benefits is $40,000/2,080 = $19.23. If the employee works 400 hours annually for
a program, then the program’s annual personnel cost for this employee is $19.23 ×
400 = $7,692. Realize that, in this example, the hourly rate is the overhead rate, and
the 400 hours is the cost base shared by the program. To calculate total personnel
costs for the program, we need to include personnel costs of all employees that are
involved in the program.
COST ESTIMATION 45
In this example, we use “working hours” for cost allocation. Another measure is
the full-time equivalent (FTE), which converts working hours into a previously de-
fined time unit. If FTE is defined as forty working hours a week, a person who works
twenty hours weekly is assigned a half FTE.
Operating Costs
Operating costs support and sustain daily operations and service provisions. They
may include costs associated with travel, maintenance of equipment or buildings,
purchases of office supplies, renting of facilities and equipment, acquisitions of in-
expensive equipment, and overhead—electricity, water, and so forth. For example,
if a printer costs $500 a year to maintain (paper, toner, maintenance fees), and if it
makes 1,000 copies a year and 300 of them belong to Program A, then the printing
cost for Program A is $500/1,000 × 300 = $150 a year. This is a simplified example. In
reality, because there are numerous operating cost items, the cost allocation for all of
them is a huge task (think about how many items there are in an office). So it is often
a good idea to classify operating cost items into several cost groups and to allocate
costs for these groups. Cost groups could be “stationery expenses,” “equipment,” and
“utility expenses.” For example, if an agency spends $1,000 on stationery this year,
and if 10 percent of the stationery is utilized by Program A, then the stationery cost
for Program A is $100. Notice that we use a “utilization” rate here (i.e., 10 percent)
to allocate the stationery cost. The determination of this utilization rate often requires
careful observation, good bookkeeping practices, and accurate human judgment.
Capital Costs
These are costs for the acquisition or construction of fixed long-term assets such as
buildings, lands, and equipment. Because capital items are used for a long time, it is
necessary to spread the costs over the lifetime of these items. The effort to distribute
capital costs is called cost depreciation. Depreciation determines the capital cost of
any particular time period. There are several methods of depreciation, including the
straight-line depreciation method shown in this equation.
D= C–S
N
In the equation, D is the cost allocated during a time period, C is the cost of the
asset, S is the salvage or residual value of the asset, and N is total number of time
periods in the lifetime of the usage. Let us say that a police vehicle is purchased for
$30,000. The vehicle will be used for five years. The residual value of the vehicle
after five years is $4,000. Therefore, the annual capital cost of the vehicle is ($30,000
– $4,000)/5 = $5,200.
Realize that the straight-line method allocates the same amount ($5,200) each year.
In reality, the vehicle will perhaps be used differently over time. Suppose that it is
driven more during the first three years—20,000 miles a year for the first three years
and 10,000 miles a year for the remaining two years. We want to allocate the cost
according to the use of the vehicle—more cost for years of heavy use. How do we do
that? As we know, the total cost for the allocation is $30,000 – $4,000 = $26,000; we
also know that the number of total miles during the five years is 80,000 (i.e., 20,000
miles each year for the first three years plus 10,000 miles each year for the last two
years). So we know that it costs $26,000/80,000 = $0.325 for a mile. For the 20,000
miles in the first year, the cost is $0.325 × 20,000 = $6,500. This depreciation method
is called usage rate, shown in this equation.
D= C–S ×u
U
U is the total estimated usage units during the estimated time of the asset, and u is
the estimated usage units during a particular time period. In this example, the annual
cost for the second or the third year is $6,500 each year. The annual cost in the fourth
or fifth year is $3,250 each year.
AVERAGE COST ESTIMATION

If it costs $10,000 to produce 100,000 gallons of water, the cost for each gallon is
$10,000/100,000 = $0.10. If we know an elementary school spends $10,000,000 a
year for 5,000 students, then the cost for each student is $10,000,000/5,000 = $2,000.
The average cost (AC) is the total cost (TC) divided by the quantity.
The average cost is a measure of efficiency. It tells us the resource consumed in
producing one unit of a product or service. For example, if elementary School A
educates a student for $2,000 and School B does that for $1,000, we know School
B is more efficient than School A in this measure. So a smaller AC indicates a more
efficient production.
To calculate the average cost, a measure of quantity is needed. In the above example,
it is the number of students for each school. It should be realized, though, that many
governmental agencies have multiple measures of quantity. For instance, instead of
using the “number of students” in the above example, we can use the “number of
student credit hours” to calculate the “average cost per student credit hour,” which is
also an average cost measure. It is possible that, by this measure, School A is more
efficient than School B, because students in School A take more courses and have
more credit hours. So, it is always a good idea to look at multiple measures to get a
complete picture of efficiency.
A CASE STUDY
The City of Northenville (population 41,200), Illinois, is located close to a major
metropolitan area in the state. The city seldom experiences serious crimes, but it
has recently witnessed an increase of misdemeanor cases. Its police department has
twenty-three employees, including twenty sworn officers. The police have four main
functions—street patrol (including emergency response), crime investigations, internal
affairs, and a community-oriented policing (COP) program. The COP program was
COST ESTIMATION 47
initiated two years ago, with a two-year federal grant of $500,000 ($250,000 each
year). The grant expires this year, and the city must make decisions on the continua-
tion of the program. The results of a recent program evaluation indicated the program
had moderately improved citizen perceptions on safety; but it had no impact on the
crime rate.
Chief James Smith is a strong advocate for the COP program. In a recent budget
preparation meeting, he argued that the program was very popular among citizens. Its
elimination or cutback in any form would face citizens’ criticism. James suggested that
the city make the effort to renew the grant, or support it from its own budget. He also
stated that, since the program had already purchased its equipment in the first year of
its operation, it would cost much less than $250,000 to operate the program annually.
Edward Nortew, the finance director, disagreed. Edward pointed out that, although
the equipment purchases were made and there was no need to purchase new equipment
in the next year, the equipment would be replaced eventually. He also indicated that
some communication equipment in the COP unit was old and needed replacement
very soon. He said in conclusion, “the true cost of the program is more than $250,000.
The city is going to pay for that sooner or later.”
To determine the true cost of the program and to make a budget decision related to
it, the city manager asked her management analyst, Al Stevens, to calculate the cost
of the COP program. Al recently received his master of public administration degree
and was eager to apply his education. He first requested the related information from
James and then used the following steps to develop a spreadsheet of costs.
STEP 1: DETERMINING PERSONNEL COSTS

There are four employees currently working for the COP program—three COP of-
ficers and a bookkeeper. An examination of COP financial records shows that Officer
A made an annual salary with benefits of $100,852 last year. She worked 2,045 hours
(including 210 overtime hours). Officer B made $58,900 in salary and benefits last
year. He worked 2,180 hours that included 100 overtime hours.
Officer C works for both the COP program and other programs in the department.
She made $68,450 in salary and benefits last year. Of a total of 2,080 hours, 832
were for the COP program. The bookkeeper also works for multiple programs. Her
annual salary and benefits were $40,000 for 2,080 hours last year. It is estimated that
she contributed 210 hours to the COP program last year. From the information, Al
calculated the personnel costs and found that the COP program cost the city $191,171
in personnel costs last year, tallied in Table 3.1.
STEP 2: DETERMINING OPERATING COSTS

COP officers conduct vehicle and bike patrols in two residential communities of the
city. They also organize regular crime watch meetings with community advocates.
Recently, James assigned the COP unit the responsibility of conducting an annual
citizen satisfaction survey.
Last year, the program spent $12,523 on uniform allowance and bikes, $5,342
Table 3.1
Cost Estimation for the Northenville COP Program
Total
work Hours Individual
Salary/ benefit hours Hourly rate ($) for COP personnel cost ($)
($) (1) (2) (3) = (1)/(2) (4) (3) × (4)
1. Personnel Cost
Employee
A 100,852 2,045 49.32 2,045 100,852
B 58,900 2,180 27.02 2,180 58,900
C 68,450 2,080 32.91 832 27,380
D 40,000 2,080 19.23 210 4,039
Total personnel cost 191,171
2. Operating Cost ($)

Uniform and bikes 12,523
Crime meetings 5,342
Survey 5,000
Utility 934
Office supplies 3,932
Total operating cost 27,731
3. Capital Cost ($)

Police vehicle 10,012
ECN 7,670
Total capital cost 17,682
to organize community meetings (renting locations, sending flyers, and paying one
outside speaker). The program also spent $5,000 on a citizen survey conducted by a
consulting company. The items that should be allocated to the program include utili-
ties and office/other supplies. The utility bills (telephone, water, and electricity) of the
department were $5,370. The office supplies cost the department a total of $22,597.
To determine the cost base to allocate the utility bills and office supplies, Al con-
ducted interviews with James and several other administrative officers in the city. It
became clear to Al that it was almost impossible to reach a consensus on how much
of the utility bills and office supplies should be allocated to the COP program. Al
finally decided to use the “number of employees” as the cost base to allocate these
two items. His logic was that, since four of twenty-three officers were working in
COP (or 17.40 percent), it was reasonable to assume that 17.40 percent of utility bills
and office supplies should go to the COP program. Since there was no clear evidence
that COP officers spent differently from non-COP officers, all parties finally agreed
with Al on the use of this cost base. The operating cost was estimated as $27,731,
shown in Table 3.1.
STEP 3: DETERMINING CAPITAL COSTS

The COP program has two capital items—a police patrol vehicle and Electronic
Communication Networking (ECN) equipment. The vehicle was purchased and
COST ESTIMATION 49
equipped two years ago for $55,000. The car has 26,730 miles on it; the annual av-
erage is 13,365 for the first two years. After several calls and an Internet search, Al
found that the average lifetime of police vehicles in the city was five years, and the
residual market value for a five-year-old car of this type was $4,940. Using the usage
rate depreciation method, Al made the following estimation: the vehicle cost of last
year = ($55,000 – $4,940)/66,825 × 13,365 = $10,012. Notice that Al assumes that
the annual mileage on the vehicle is the same for the remaining three years, so the
total mileage 13,365 × 5 = 66,825. Also, the maintenance for the vehicle is included
in office/other supplies.
The ECN is a communication networking system that is shared by all sworn
officers in vehicle patrols and bike patrols. The system was purchased five years
ago for $1,750,000. The estimated life of the system is ten years, with an annual
maintenance cost of $12,470 in the factory contract. The total cost in the lifetime
of the system is $1,750,000 + ($12,470 × 10) = $1,874,700. The system has no
residual value.
Al used the “number of patrol hours” as the cost base in the cost allocation. After
examining the department patrol records, he found that the annual average of patrol
hours was 21,900. So the estimated number of patrol hours for a ten-year period is
219,000. He also knew that COP had 896 patrol hours last year. Using the usage
rate depreciation method, he arrived at: the ECN cost shared by COP last year =
($1,874,700/219,000) × 896 = $7,670.
STEP 4: DETERMINING TOTAL PROGRAM COSTS

Table 3.1 shows the result of cost estimations for different cost items. The total pro-
gram cost last year was $191,171 + $27,731 + $17,682 = $236,584. Al reported this
figure to the city manager. He told the city manager that, according to his previous
experiences, there was a ± 5 percent error margin in this type of estimation. So the
true cost was between $224,754 and $248,412.
Neither James nor Edward was happy about this estimation. James argued that Al
overestimated some expense items. For example, James said the survey was used for
the entire department, not just for the COP program. The cost should not have been
counted solely toward the COP program. Edward argued to the contrary. He said Al
underestimated the sharing of the ECN cost for COP. Edward challenged Al’s use
of “patrol hours” as the cost base. He said Al should have used “patrol miles.” He
believed COP’s patrol miles per officer was far more than that of a non-COP officer.
STEP 5: DETERMINING AVERAGE COSTS

Nevertheless, the city manager was satisfied with Al’s work. She thought that the
program was at least at breakeven last year. To strengthen her case to support this
program in the upcoming year, she now asked Al to compare the cost of the COP
program with similar programs in other cities.
Al knew that it did not make sense to compare total costs of COP programs, as these
programs vary greatly in size and activities. He needed to compare the average cost.
To calculate the average cost of the COP program, Al needed to first determine the
quantity of products for the program. What is a product of the program? Patrols? But
patrolling is not the only program activity. The program also organizes crime watch
meetings and conducts citizen surveys. After several days of research, Al finally de-
cided to use the population as the cost base in computing the average cost. On average,
the COP program spent $236,583/41,200 = $5.7 for each individual citizen last year.
EXERCISES
1. KEY TERMS
Public service agencies
Break-even production
Cost
Expenditure
Cost objective
Cost time frame
Cost items (or cost elements)
Total cost (or full cost) (TC)
Average cost (or unit cost) (AC)
Direct cost
Indirect cost
Cost allocation
Overhead rate
Cost base
Cost pool
Activity-based costing (ABC)
Personnel cost
Operating cost
Capital cost
Cost depreciation
Straight-line depreciation
Usage rate depreciation
Average cost as a measure of efficiency
2. DISCUSSION
1. Identify some budgetary, financial, or operational circumstances in govern-
ment in which costing should be considered. Discuss the role of costing in
these situations.
2. Discuss the difference between cost and expenditure. Provide examples to
illustrate the difference.
3. Quantity is an important concept in calculating the average cost. Provide
several examples of quantity in a government service of your choice.
4. Use examples to discuss the importance of determining cost base in costing.
COST ESTIMATION 51
5. What is the difference between the straight-line depreciation method and the
usage rate method? When does each apply?
3. CALCULATIONS
1. A public administration department at a state university has a master of public
administration (MPA) program and a bachelor of public administration (BPA)
program. The MPA program has 175 students and the BPA has 134 students.
The department has a total indirect cost of $53,340 this year that includes
office expenses, utility bills, travel expenses, and other expenses. What is
the indirect cost that should be allocated to the MPA program this year if the
number of students is the cost base?
2. A city manager of a major urban city makes $124,200 in salary and benefits
this year. This amount needs to be allocated to twenty-four programs in the
city’s program budget that includes an economic development program that
promotes employment opportunities and economic growth of the city. It is
estimated that the city manager works a total of 1,920 hours a year and about
200 of them are associated with the economic development department. How
much of the city manager’s salary and benefits should be allocated to the
economic development program this year if the number of work hours is the
cost base?
3. If the purchase price of a computer network is $12,000 and the computer will
be used for three years with a residual value of $2,000 at the end of the three
years, what is the annual cost of the network during this period if a straight-
line depreciation method is used?
4. In Question 3, suppose that the use of the network follows a pattern in which
the number of hours in use is 2,920 for Year 1, 2,190 for Year 2, and 1,460
for Year 3. All other conditions are the same. What is the first year’s cost of
the network if a usage rate depreciation method is used?
4. DETERMINING THE COST BASE

Cost allocation is one of most difficult tasks in total cost estimations. The use of
the cost base in allocations determines the accuracy of calculation. Two types of
measures are often used as a cost base. Measures of resource consumption include
measures of time spent (e.g., “the number of hours”) or manpower used (e.g.,
“FTE”). Such measures are readily available, so they are inexpensive to use. How-
ever, it should be understood that the cost is always associated with an activity of
providing a product or service. Scholars sometimes call an activity measure “output
measure.” Following is a list of output cost bases for the distribution of administra-
tive or office expenses.
Accounting costs—the number of invoices processed

Purchasing costs—the number of purchase orders processed
Printer costs—the number of reports produced
Utility costs—square feet of space assigned

Telephone costs—the number of calls made
Vehicle costs—the number of miles used
Identify three administrative or office cost items in a governmental agency. Develop

two possible cost bases for each cost item.
5. COST OF OPERATIONS
US state and local governments are required to report expenses of service func-
tions in their Comprehensive Annual Financial Reports (CAFR). Gain access to
a recent CAFR. Go to the Financial Section of the CAFR and look for the sec-
tion of Basic Financial Statements. Turn to the Statement of Activities. Look for
the expenses of programs or functions (often listed in the first column). As this
statement is prepared on the accrual accounting basis, these annualized expenses
can be used to represent the annual cost of these functions or programs. Work in
an Excel file to:
1. List the three most expensive functions/program activities of the primary

government. (Note: The primary government is the major financial entity of
a government. Its responsibilities will be discussed in more detail in Chapter
9.)
2. Calculate the percentages of these functions’/programs’ expenses in the total
expenses of the primary government.
3. Compare the expenses of these functions/programs over last year’s figures to
see the difference (last year’s figures should be available in last year’s CAFR).
4. Write a statement to describe these differences in expenses.
5. Find the population statistics in the Statistical Section of the CAFR. The CAFR
should have the population figures of the past ten years. Use the population
data to compute the expense per capita for the primary government (i.e., Total
Expenses of the Primary Government/Population). Compare this statistic with
the number in the previous year to see the trend. Are the services becoming
more expensive in this government? Extend this analysis to include the data
of the previous three years. Do you observe any trend of cost changes for the
past three years?
6. USING INFLATIONARY INDEX IN COST ESTIMATION

If you know the cost of a program this year, what will be the cost next year? Gov-
ernments facing challenges in relating their spending to cost inflation in budgeting
can benefit from using a well-constructed inflation index. One such measure is the
Consumer Price Index (CPI) constructed and published by the US Department of
Labor’s Bureau of Labor Statistics. For example, if the index shows that inflation is
3 percent this year from the previous year, and the cost of a program was 1 million in
the previous year, then the estimated cost after inflation adjustment is (1.03 × 1 mil-
COST ESTIMATION 53
lion =) $1.03 million this year. Of course, the estimation is made with the assumption
that the cost items of the program remain unchanged.
The CPI is useful for cost estimation if the historical cost information is available.
Go on the Department of Labor’s CPI website to find the historical CPI data. Now,
choose a function (such as general government, public safety, health, etc.) or a program
in a budget or comprehensive annual financial report of a state or local government.
Use the CPI average of the last five years to estimate the cost or expenditure of the
function or program next year.
4 Cost Comparison
LEARNING OBJECTIVES
s 5NDERSTAND THE CONCEPTS OF PRESENT VALUE FUTURE VALUE THE TIME VALUE OF MONEY
and the discount rate
s !PPLY THE PRESENT VALUE OF COST IN COST COMPARISON
s !PPLY THE ANNUALIZED COST IN COST COMPARISON
Suppose you need a computer that costs $1,000. You can pay $1,000 cash right
now, or a $500 down payment and $600 next year. If you can afford either option,
which one do you take? In this chapter, we learn how to use costs to compare the
efficiency of programs or decisions. We learn to use the present value of cost (PVC)
and the annualized cost in decision making.

In the above example, the total payment of the cash option is $1,000, and the
total payment of the down payment option is $500 + $600 = $1,100. It looks like
the cash option is cheaper. However, it does not make sense to compare these
two figures because the $600 in the down payment option is the payment next
year. In finance, this $600 is called the future value (FV). The future value is the
amount of value realized sometime in the future. To compare these two options,
we must place the values of their payments on equal footing, which requires us
to convert the future value into the value of the present day—the present value
(PV). So the cost comparison question becomes: how to convert the future value
to the present value.
How much is this $600 of the next year worth now? We know it is worth less than
$600. If we were offered $600 now or in the next year, everyone would take the
money now. Economists rationalize the idea that time plays a role in valuation as the
54
COST COMPARISON 55
time value of money (TVM). More specifically, TVM tells us that a given amount of
payment (or value) becomes less in the future.
Exactly how much less? To convert a future value to a present value, the following
equation can be used.
FV
PV =
(1 + i)N
In the equation, i is called the discount rate. It is used to discount the future value.
Many people would like to think of it as the interest rate for an investment. The idea
is that, if the money is not spent on the computer, it can be invested and earn inter-
est. So the interest rate determines the discount rate. We can use the interest rate of
short-term federal debts (e.g., treasury bills) as a benchmark to determine the discount
rate. N in the equation represents the Nth project term in the future (a project term is
designated as a year in this book).
In the above example, suppose that the discount rate is 5 percent, and N is 1 (one
year from now), the PV of $600 in the next year with a 5 percent discount rate is now
worth $600/(1 + 0.05)1 = $571.43. So the PV of the down payment option is $500
+ $571.43 = $1,071.43, which is $71.43 more than the PV of the cash option. This
example illustrates the use of the present value of cost (PVC) to make decisions. The
PVC can also be calculated from the following equation.
C1 C2 C3 Cn
PVC = C0 + + + +...+
(1 + i)1 (1 + i)2 (1 + i)3 (1 + i)n
In the equation, C0 is the cost in this current term, C1, C2, C3 . . . Cn are costs in
project terms 1, 2, 3 . . . n, and i is the discount rate of the term. In our computer
purchase example, the PVC of the down payment option is C0 + (C1)/(1 + i)1 = $500
+ $600/(1 + 0.05) = $500 + $571.43 = $1,071.43.
What is the PVC for a project that costs $500 this year and $600 each year for
the next two years? It is C0 + (C1)/(1 + i)1 + (C2)/(1 + i)2 = $500 + $600/(1 + 0.05) +
$600/(1 + 0.05)2 = $500 + $571.43 + $544.22 = $1,615.65. We can also use Excel to
compute the PV using the following steps.
Step 1: Locate the Insert Function (fx) as instructed in Appendix A.

Step 2: Click the Insert Function button (fx).
Step 3: In the window that says “Or select a category,” select “Financial” from the
drop-down menu.
Step 4: In the window that says “Select a function,” select “NPV” (net present value)
from the drop-down menu and click “OK.”
Step 5: In the NPV window, type interest (or discount) rate, and values.
In our example, we enter 0.05 in the “Rate” window and $600 each for the “Value
1” and “Value 2” boxes. The present value of $1,115.65 is in the “Formula Result”
Excel Screen 4.1 Calculating Present Value
window shown in Excel Screen 4.1. We then need to add $500, the PV of the current
term, to arrive at $1,615.65.
Now, let us change our example a little. Let us say that we have the choice of
purchasing Computer A or Computer B. Computer A costs $1,000 in cash now, and
it can be used for three years. Computer B requires a down payment of $500 and a
future payment of $600 next year. It can be used for four years. Assume that both
computers meet our needs. Which one do we buy?
We know that the PVC for Computer A is $1,000. The PVC for Computer B is
$1,071.43. Computer A costs less, but lasts one year less. To compare these two op-
tions, we need to know the annualized cost of each option. The annualized cost of
Computer A can be obtained from the following equation.
C C C
$1,000 = + +
(1 + i)1 (1 + i)2 (1 + i)3
C represents the annualized cost. Assuming a 5 percent discount rate, the annual-
ized cost is $367.21. This is to say that paying $1,000 now is equivalent to paying
$367.21 annually over the next three years. The annualized cost for Computer B is
$302.16, a result of solving for C using the equation with a 5 percent discount rate:
COST COMPARISON 57
Excel Screen 4.2 Calculating Annualized Cost
C C C C
$1,071.43 = + + +
(1 + i)1 (1 + i)2 (1 + i)3 (1 + i)4
So, for Computer B, paying $1,071.43 now is equal to paying $302.16 every year
over the next four years. The result of the annualized cost comparison shows that
Computer B costs less than Computer A. The following steps show how to use Excel
to calculate the annualized cost.
Step 1: Click the Insert Function button (fx).

Step 2: Select “Financial” in the Category window as instructed in the above ex-
ample about the Excel NPV process.
Step 3: In the window that says “Select a function,” select “PMT” (payments) from
the drop-down menu and click “OK.”
Step 4: Choose the “Rate” (5 percent in this case), and the “Nper” (the number of pay-
ments: three for the Computer A option and four for the Computer B option).
Step 5. Type the present value in the PV box. A negative value should be used for
PV, as it is treated as a cost that is being offset. The example of Computer
A is shown in Excel Screen 4.2.
So far our calculations have been conducted on an annual basis. The previous examples
have used annual future values, annual present values, annual discount rates, and an-
nualized costs. In reality, the term of calculation can be biannual, quarterly, monthly, or
daily. The discount rate can be annual, biannual, quarterly, monthly, or daily, depending
on the number of time periods used in calculation. For example, if we know monthly
future values and want to convert them into present values, we should use a monthly
discount rate, which can be calculated by dividing the annual rate by twelve.
A CASE STUDY
The State University of Greenville, California, has a swimming program for all eli-
gible students. It is an educational program that teaches students how to swim safely.
The program coincides with school semesters. Every semester, about thirty spots are
open for all registered students. The program is managed by the school’s athletic de-
partment, which is headed by Joan Nelson. The program hires one full-time and two
part-time instructors. It uses a swimming pool facility owned by the school. Students
in the program meet every Friday.
The swimming pool, named Phrog Pool, in memory of John Phrog who made this
facility financially possible, is a forty-year-old facility. Because of its age, maintenance
costs have been quite high. For the past several years Joan has been trying to keep the
budget of Phrog Pool under control. Two days ago she got a call from the company
contracted for the maintenance service of the building. She was told that the heating
system broke and the estimate for replacement of the system was more than her total
supplementary budget. Joan knew immediately it was time to make some decisions.
She had long thought about building a new swimming pool in the same location.
However, the university was facing budget cuts. She knew she would have to fight an
uphill battle for any new building in her department. To get ready for the upcoming
budget season, she wanted a cost comparison of the current maintenance option and
a new swimming pool option.
STEP 1: ESTIMATING PROJECT COSTS

She asked the contract company to provide an estimate of the annual maintenance cost
for the next ten years, including the current year. The estimate is shown in Table 4.1.
Table 4.1
Estimated Cost of the Maintenance Option
Year Annual maintenance cost ($)

0 (the current year) 48,000
1 48,000
2 48,000
3 48,000
4 48,000
5 55,000
6 55,000
7 55,000
8 55,000
9 55,000
COST COMPARISON 59
Table 4.2
Estimated Cost of a New Swimming Pool
Year Cost of construction and maintenance ($)

0 (the current year) 300,000
1 15,000
2 15,000
3 15,000
4 15,000
5 15,000
6 15,000
7 15,000
8 15,000
9 15,000
She also consulted several swimming pool contractors. The cost of constructing a
new swimming pool and the maintenance cost thereafter is shown in Table 4.2.
STEP 2: DETERMINING THE PRESENT VALUE OF COST

Joan understood that, to compare the costs of the two options, she needed to convert
them to PV. To determine the discount rate, she assumed that the university could
issue bonds for an annual interest rate of 5 percent. Using Excel, she found that the
PVC of the maintenance option with a 5 percent discount rate is $414,109. The PVC
for a new swimming pool with a 5 percent discount rate is $406,617.
In other words, although the initial cost seemed to be high for a new swimming
pool ($300,000), the option was in fact less costly over the next ten years. The uni-
versity would be better off by $7,491 over this ten-year period. Although the figure
is minor for a ten-year period, Joan argued that, with the second option, the school
would have a relatively new swimming facility after ten years. With the first option,
the school would be left with a very old swimming pool that would desperately need
to be replaced at the end.

Most members in the school’s budgetary committee were impressed by Joan’s finding
and showed an intention to approve a budget request for a new swimming pool. How-
ever, a member from the university’s School of Business challenged Joan’s assumption
about the interest rate. He said that a 5 percent interest rate is perhaps too low, as
the school does not have a strong credit history and the revenue that would be used
to repay the bonds was coming from very limited resources, such as student activity
fees. He argued that a 10 percent interest rate would be a more proper assumption.
With a 10 percent discount rate, the PVC for the maintenance option is $342,557,
compared with the PVC of $386,385 for a new facility. All of sudden, the maintenance
option seemed more attractive. In her budget request, Joan decided to present PVC
results with both 5 percent and 10 percent discount rates to the budgetary committee
to make the decision.
EXERCISES
1. KEY TERMS
Present value
Future value
Time value of money
Discount rate
Present value of cost (PVC)
Annualized cost
2. DISCUSSION
1. Use examples to discuss the need to convert the future value to the present
value in cost comparison.
2. Identify and discuss some decision-making situations in government when
cost (expense) comparison is useful.
3. Discuss the need and rationale of choosing a discount rate in cost com-
parison.
4. If the future value is given, what happens to the present value if the discount
rate is close to zero? Can you identify a situation when that happened?
3. CALCULATIONS
1. What is the present value of $1,000 one year from now, with an annual dis-
count rate of 5 percent?
2. What is the present value of $1,000 two years from now, with an annual
discount rate of 5 percent?
3. What is the present value of a stream of future values that include $200 now,
$500 one year from now, $500 two years from now, and $500 three years
from now? Assume a 10 percent discount rate.
4. What is the annualized cost of $12,000 of computer equipment that lasts five
years with an annual discount rate of 5 percent?
5. Suppose that you obtain a ten-year $100,000 loan to purchase a house and
the annual interest rate is 7 percent, what should be your monthly payment of
principal and interest for the next ten years? (Hint: In the Excel PMT process,
convert the annual interest rate and payment periods to the monthly rate and
payment periods.)
6. Suppose the length of the loan is twenty years in Question 5, what should
your monthly payment of principal and interest be for the next twenty years?
COST COMPARISON 61
4. PRESENT VALUE ANALYSIS

The Education Association of Metro Orlando (EAMO) is a public service organization
that provides after-school services for children. EAMO recently received a federal
grant to improve after-school security for children. The grant amounts to $2 million
and will be received over five years. It is designated to improve the communication
networking system that monitors the traffic in three school districts. After a compre-
hensive review of all similar systems available on the market, EAMO identifies two
systems that meet its specific need. One is EOP (Electronic Operating Patrol) and
another is PMS (Pedestrian Monitoring System). The cost of both systems in the next
five years, including the current year, is listed in Table 4.3.
Table 4.3
Cost Estimates for EOP and PMS
Year EOP ($) PMS ($)

0 (the current year) 1,500,000 750,000
1 100,000 300,000
2 100,000 300,000
3 100,000 300,000
4 100,000 300,000
1. Assuming a 5 percent annual discount rate, what are the PVCs for EOP and
PMS? Which system should EAMO purchase based on your PVC analysis?
2. Assuming a 10 percent annual discount rate, which system should EAMO
purchase?
3. Assume that the life of EOP is six years and that of PMS is five years. Which
system should EAMO purchase? Why? (Make assumptions if necessary and
explain them.)
5. PRESENT VALUE ANALYSIS: LEASE OR BUY DECISIONS

One of the many applications of the PVC analysis and annualized costing is their
use in making a so-called lease or buy decision. Suppose that the purchase price
of a heavy-duty printer is $19,000, with an annual maintenance cost of $200. And
suppose the same printer can be leased for an annual cost of $2,000, with an annual
maintenance cost of $300. Consider a fifteen-year term for the estimation and a 10
percent annual discount rate. Would it be more cost-efficient to lease or buy? (Explain
explicitly any assumption you make.)
6. FULL COST COMPARISON

One great challenge in cost comparison is to ensure accurate cost estimation for each
decision option. You want to make sure the estimation includes all related cost items
during a decision cycle of each option. In this exercise, identify a few viable trans-
portation options for you to go to school, work, or any of your favorite places (by
car, carpool, bike, public transit, etc.). Estimate and compare the costs of the options
for a decision cycle you choose (one year for example).
Cost in this book is referred to as consumption of an economic resource by an
organization or individual. Many people think that the true cost of a project should
also include its cost to the ecosystem and to the society as a whole. Discuss possible
environmental and social cost items in your transportation options that should con-
stitute the true cost of the options.
5 Incremental Cost Analysis
LEARNING OBJECTIVES
s 5NDERSTAND lXED COSTS VARIABLE COSTS MARGINAL COSTS AND INCREMENTAL COSTS
s !PPLY MARGINAL COSTS IN DECISION MAKING
s !PPLY INCREMENTAL COSTS IN DECISION MAKING
Let us say that a city of 20,000 residents would like to provide water and sewer ser-
vices to an adjacent neighborhood of 1,000 residents. The city’s water and sewer treat-
ment program has an annual cost of $2.4 million that includes $500,000 in personnel
costs, $1.5 million in operating costs, and $400,000 in annual capital depreciation of a
water treatment facility. The average annual cost of the services is $2.4 million/20,000
= $120 per customer. How much does the addition of 1,000 customers cost the city?
Some may say $120 × 1,000 = $120,000. However, that may be incorrect. By adding
1,000 new customers, do we really expect a proportional increase in personnel costs,
operating costs, and capital costs? Do we plan to hire more employees as the result of
additional customers? Do we need an additional investment in the treatment facility?
Can the current facility accommodate the additional load?
Suppose that no new investment in the treatment facility is needed and the person-
nel costs also remain the same. Operating costs will increase proportionally with the
number of customers. As the operating costs per customer are $1.5 million/20,000 =
$75, the annual costs for the additional 1,000 customers are $75 × 1,000 = $75,000,
not $120,000.
In this example, the $75,000 is the incremental cost. Incremental cost analysis
examines cost changes of alternative decisions. It tells how much cost we should
expect for a specified decision-making option. The incremental cost is different
from the total cost and the average cost in that it does not consider the cost items
that have been incurred in the past. These items, such as personnel and capital costs
in the example, are not affected by any new decisions. They have occurred and will
63
not change for any decision. These costs are called sunk costs. Managers can also
use the incremental cost to weigh up the cost associated with a decision against the
incremental revenue. In the above example, the city profits if the estimated annual
revenue from the additional 1,000 customers is more than $75,000.

In previous chapters, we introduced the total cost and the average cost. These cost
concepts are calculated for a given level of product or service quantity. They describe
resource consumption in a static state. They do not reflect any change of resource
consumption in response to the change of production or service level.
Economists use a different set of concepts to assess the cost associated with the
change in product or service quantity. Let us again use the above example. Personnel
costs and capital costs do not increase when the number of customers increases. They
are fixed cost items in this production. The fixed cost (FC) remains constant regardless
of variation in the production quantity. Operating costs are variable cost (VC) items,
which fluctuate with variation in the production quantity. Realize that the total costs
(TC) are the sum of fixed costs and variable costs (TC = FC + VC).
It is possible that a fixed cost item changes for a larger variation of quantity. For
example, when the number of additional water/sewer customers increases by 2,000,
the city needs to hire new staff to handle billing. The personnel cost becomes a vari-
able cost at this point. So a fixed cost is “fixed” only for a particular quantity range.
Sometimes it is difficult to classify a cost item as fixed or variable. For example,
the cost of electricity is a fixed cost when the use is for lighting and a variable cost
when used for the oven (i.e., more cooking, more consumption). These cost items
are called mixed costs.
The incremental cost (IC) is the change in the total cost due to a production quantity
change or the change of decision options. If we use 6 to represent the incremental
change, then IC can be defined as
IC = 6TC = 6FC + 6VC
6TC is the change in total costs. 6FC is the change in fixed costs. 6VC is the
change in variable costs. Sometimes it is useful to calculate the incremental cost for
a unit change in quantity. This is the concept of the marginal cost (MC).
6TC
MC =
6Q
6TC is the change in total costs. 6Q is the change in the production quantity. In the
above water/sewer example, 6TC is $75,000 and 6Q is 1,000. So MC = $75,000/1,000
= $75. The interpretation is that the cost for serving each additional water/sewer
customer is $75.
Let us look at another example. Suppose that an elementary school has 1,000
students. The fixed cost for running the school includes full-time staff’s salaries and
INCREMENTAL COST ANALYSIS 65
benefits, the land, and school buildings and classrooms, which total $5 million a year.
The variable cost includes utilities, office expenses, and part-time staff’s salaries and
benefits. The variable cost increases with an increase in the number of students, and
each enrolled student incurs $4,000. The total variable cost for the 1,000 students is
1,000 × $4,000 = $4 million. The total cost, including the $5 million in the fixed cost
and the $4 million in the variable cost, is $9 million.
Let us say the school authority would like to increase student enrollment to 1,200.
What is the cost of adding 200 students? How much more should the school propose
in the budget to cover the cost of the additional 200 students? The fixed cost does not
change—no new buildings and no new hiring of full-time staff are required. The vari-
able cost increases proportionally with new students. So the addition of 200 students
will increase the variable cost to 1,200 × $4,000 = $4.8 million. The total cost for the
1,200-student enrollment is $9.8 million. The incremental cost is $9.8 million – $9.0
million = $8000,000. The marginal cost is ($9.8 million – $9.0 million) / (1,2000 –
1,000) = $4,000. Therefore, the school should propose an increase of $800,000 in
total budget, equal to an average of $4,000 for each new student. Table 5.1 shows the
process of calculation.
Table 5.1
Incremental Cost Analysis
Quantity (number of FC VC TC AC IC MC
students) ($) ($) ($) ($) ($) ($)
1,000 5,000,000 4,000,000 9,000,000 ... ... ...
1,200 5,000,000 4,800,000 9,800,000 8,167 800,000 4,000
Notice that the school should not use the average cost to determine the budget
for the new students. Why? The average cost at the 1,200-student level is $8,167. It
includes fixed cost items that do not increase for adding new students. If the school
authority uses the average cost, it will wrongly inflate the cost for adding new students.
Now, suppose the number of new students increases to 1,500 from the 1,200 level
two years from now. To accommodate this increase, some fixed cost items will in-
crease. Suppose that the fixed cost increases to $7.0 million. What are the incremental
and marginal costs? Since the variable cost increases to $4,000 × 1,500 = $6.0 mil-
lion, the total cost is $7.0 million + $6.0 million = $13.0 million. The incremental
cost for the additional 300 students is $13 million – $9.8 million = $3.2 million. The
marginal cost for adding 300 new students is $3.2 million/300 = $10,667. Table 5.2
shows the calculations.
A CASE STUDY
One application of the incremental cost analysis is in outsourcing or contracting-out
decisions. The Spring Park Health Foundation (SPHF) of North Carolina is a public
Table 5.2
Incremental Cost Analysis (Continued)
Quantity (number FC VC TC AC IC MC
of students) ($) ($) ($) ($) ($) ($)
1,000 5,000,000 4,000,000 9,000,000 9,000 ... ...
1,200 5,000,000 4,800,000 9,800,000 8,167 800,000 4,000
1,500 7,000,000 6,000,000 13,000,000 8,667 3,200,000 10,667
service organization that provides child health care and family services in metro-
politan Spring Park, an area of 650,000 residents. SPHF has undertaken three major
projects. A school nurse program provides school-age children with immediate access
to nurses and medications. A comprehensive health care program offers a wide range
of counseling services to schoolchildren and their families. SPHF also operates an
education program that trains schoolteachers about health care issues. For example,
one recent training workshop disseminated the latest research results on nutrition.
The foundation had a budget of $7.5 million last year. Eighty percent of the budget,
about $6.0 million, came from the investment income of a trust fund. A state grant
provided $1.3 million (17.3 percent of the total budget). The remaining 2.7 percent,
about $200,000, came from miscellaneous sources, such as office rental, sales of
publications, and a very insignificant charge on heavy users of school nurses. The
state grant is audited and approved on an annual basis, subject to the results of an
annual performance audit on the foundation’s programs. To satisfy the need for the
audit, the foundation has an in-house evaluation team that consists of three full-time
evaluators. Every year, the team produces a performance audit of the whole founda-
tion and a program evaluation for each of the three programs. The annual budget of
the evaluation is $345,000, which includes $220,000 in personnel services, $50,000
in office rental, $12,000 in office equipment, $10,000 in transportation, $13,000 in
office supplies, and $40,000 in printing and binding.
As a result of declining investment returns in a downward stock market, the foun-
dation faced a tougher budget this year. One proposal to deal with the budget decline
was to cut back the evaluation team and contract out the evaluation to an outside
evaluator. Nancy Winston, the foundation program coordinator, was responsible for
soliciting bids. Of the three entities that participated in the bidding, one asked for a fee
of $450,000 and was immediately rejected. The second firm asked a fee of $330,000.
The third bidder, a state university, asked $310,000. Both of the latter bidders guar-
anteed the quality of the reports. Should Nancy accept the lower bid?
STEP 1: EXAMINING EACH COST ITEM

The purpose of this step is to determine the cost change as the result of contracting
out. During this step, Nancy found that the following costs would be eliminated if
the evaluation were contracted out: personnel services, transportation, office sup-
plies, and printing and binding. Since the evaluation team rents office space from the
Table 5.3
Cost Comparison in Incremental Cost Analysis
TC for in-house TC of
evaluation team ($) contracting out ($) Incremental cost ($)
(1) (2) (2) – (1)
Personnel services 220,000 0 –220,000
Office rental 50,000 50,000 0
Office equipment 12,000 12,000 0
Transportation 10,000 0 –10,000
Office supplies 13,000 0 –13,000
Printing and binding 40,000 0 –40,000
Consulting fee 0 310,000 310,000
Total 345,000 372,000 27,000
foundation, the cost reduction would be offset by the revenue loss of the same amount
to the foundation. So this cost would not be eliminated by contracting out. Also, the
evaluation team owns two computers and uses a network printer. The cost associated
with this equipment would not be immediately saved through contracting out.
STEP 2: DETERMINING THE INCREMENTAL COST (OR THE MARGINAL COST, IF NECESSARY)
Table 5.3 shows the cost comparison of the current in-house operation and the lower
bid contracting-out option. The incremental cost of the contracting-out option is the
change in the total cost due to the contracting out. The result in the table shows a
$27,000 increase if the foundation contracts out.

Based on the analysis, Nancy decided to reject the proposal of contracting out. She,
however, showed a willingness to reconsider if the university reduced its consulting
fee to a figure that was significantly less than $283,000.
EXERCISES
1. KEY TERMS
Sunk cost
Fixed cost (FC)
Variable cost (VC)
Quantity range
Mixed cost
Incremental cost (IC)
Marginal cost (MC)
2. DISCUSSION
1. Compare incremental cost analysis to average cost analysis in decision
making.
2. Discuss challenges of using incremental cost analysis in public sector financial
management.
3. When is the incremental cost negative? Provide examples to describe the rela-
tionship between the total cost and the incremental cost, and the relationship
between the incremental cost and the marginal cost.
4. Many students have taken a basic microeconomics course in which the mar-
ginal cost is introduced with examples of production in businesses. Recall
that knowledge and discuss the role of the marginal cost analysis in the public
sector.
3. CALCULATIONS
Table 5.4 shows the cost information for a product at the 15,000-units level.
Table 5.4
Incremental Costing Exercise
Quantity FC ($) VC ($) TC ($) IC ($) MC ($)

15,000 3,000,000 1,500,000 ? ... ...
20,000 ? ? ? ? ?
30,000 ? ? ? ? ?
1. What are the incremental and marginal costs for producing 5,000 additional
units?
2. Suppose that, at a new production level of 30,000, the fixed cost increases to
$4.5 million, what are the incremental and marginal costs for the additional
10,000 units?
4. INCREMENTAL COST ANALYSIS

A county’s recycling program collected 46,280 tons of recyclable refuse this year. The
cost of the program includes five vehicles that can partly process the recyclables. The
county does not have the depreciation information for these trucks; but they estimate
annual maintenance costs of up to $10,000 for each truck. The fuel expense totaled
$69,000 this year. The county also hires fifty workers in the program. The annual
personnel expense this year was $1.5 million. Other expenses this year included office
expenses of $15,000, overhead of $189,000, and miscellaneous expenses of $150,000.
Recently, a small nearby city asked the county to provide recycling services. The
city offered a fixed fee of $6.00 for every ton of recyclable material pickup. It is
estimated that there will be 3,500 tons of pickup during the next year from the city.
County analysts studied the proposal. They reckoned that, to add 3,500 tons of
pickup, the county did not need new vehicles or new hiring. Office and miscellaneous
expenses would also remain the same, but the fuel consumption and the overhead
would increase.
Treating fuel and overhead as variable costs and others as fixed costs, calculate
the incremental cost and the marginal cost for the county. Should the county accept
the city’s offer? Discuss in detail the logic of your decision. Explain explicitly any
assumption you make.

Referring to the above problem, suppose that the city wants a two-year deal. In the
second year of the deal, the recycling materials from the city will be 5,000 tons.
The county analysis shows that a new vehicle is needed for the increase. The annual
depreciation of the vehicle is $30,000, and the annual maintenance cost is the same,
$10,000.
Considering this change, and also treating the fuel and the overhead as variable
costs and others as fixed costs, calculate the incremental cost and the marginal cost
for the county. If the city still wants to pay the same rate for the service, $6.00 per
ton, should the county accept the offer?
6. INCREMENTAL COST ANALYSIS AND ZERO-BASED BUDGETING

Incremental cost analysis is a potentially useful tool for zero-based budgeting (ZBB).
ZBB requires the development of program costs in an agency’s budget request. The
programs need to be evaluated and ranked according to their relative importance to
the agency’s mission. Decision makers then make funding decisions based on the
relative importance of a program and its cost. Conduct an Internet search on the topic
of ZBB to identify an agency, if any, that claims to use ZBB. Study its ZBB budget to
find out whether IC is used, and if not, discuss how to use it to enhance the budget.
6 Cost-Benefit Analysis
LEARNING OBJECTIVES
s #ALCULATE THE NET PRESENT VALUE AND THE BENElTCOST RATIO

s 5NDERSTAND CONDITIONS TO WHICH A COST BENElT ANALYSIS APPLIES
s !PPLY THE COST BENElT ANALYSIS IN DECISION MAKING
If you buy a house that costs $10,000 a year, and you earn revenue of $15,000 by
renting it out, your annual profit is $5,000. You have made a good financial decision.
In economics, a decision that can bring profit is described as “economically feasible.”

INTRODUCTION TO COST-BENEFIT ANALYSIS
Cost-benefit analysis (CBA) assesses the economic feasibility of a program, a policy, or
an activity. It rationalizes decision making through careful examination of a program’s
objectives and the costs and benefits associated with the program. It is useful when
decision makers are required to judge the economic value of a program or choose one
program among several options. For this reason, CBA can be used to evaluate capital
projects in budgeting, which is the focus of this chapter.
The first step in CBA is to predict costs and benefits of a project. As capital proj-
ects often take multiple years, the forecast involves the estimation of multiple-year
costs and benefits in the future. For the purpose of comparison, the future value of
costs and benefits must be converted to the present value (review Chapter 4, “Cost
Comparison,” for the discussion of present value and future value). The result of the
comparison is net present value (NPV).
NPV = Present Value of Benefits (or PVB) – Present Value of Costs (or PVC)
70
COST-BENEFIT ANALYSIS 71
Let us look at a five-year project that costs $1,000 in the first year (the current
year) and $200 every year from the second to the fifth year. Let us assume a 5 percent
discount rate. The PVC for the project is $1,000 + ($200)/(1.05)1 + ($200)/(1.05)2 +
($200)/(1.05)3 + ($200)/(1.05)4 = $1,709 (review Chapter 4 for the PVC calculation).
Suppose that the project has an annual revenue of $500 beginning with the first year
(the current year), for five years. Its PVB is $500 + ($500)/(1.05)1 + ($500)/(1.05)2
+ ($500)/(1.05)3 + ($500)/(1.05)4 = $2,273. Therefore, the NPV = $2,273 – $1,709 =
$564. Similar to the way PVC is defined in Chapter 4, PVB is defined here as
B1 B2 B3 Bn
PVB = B0 + + + +...+
(1 + i)1 (1 + i)2 (1 + i)3 (1 + i)n
B0, B1, B2, B3 . . . Bn are benefits generated by the project in project terms 0, 1, 2,
3 . . . n (B0 is the current term’s benefit), and i is the discount rate of the project term
(the project term is designated in years in this book).
In CBA, a project is economically feasible when its NPV is positive (NPV > 0),
which means that project benefits exceed project costs. If there are two projects and
only one can be funded, and both projects will produce a positive NPV, then the one
that has a larger positive NPV should be chosen.
In addition to NPV, the benefit/cost ratio, defined as PVB/PVC, can also be used
to make the decision. Since NPV = PVB – PVC, when NPV > 0, (PVB – PVC) >
0, or PVB > PVC, or PVB/PVC > 1. This means that, when the NPV is larger than
zero, the benefit/cost ratio is larger than 1. The benefit/cost ratio represents the bene-
fit received for every dollar of cost. For example, a ratio of 0.5 means a half-dollar
benefit is earned for every dollar of cost. Of course, both benefits and costs are in the
form of the present value.
Even if a project is economically feasible, that does not necessarily mean that it
will be funded. Students of American public administration should know that funding
decisions are the result of a political process in which economic value is only part
of the consideration.
Let us look at a simplified CBA example. A city faces an increasing demand for
its garbage collection service. Two options have been considered to improve the
city’s garbage collection capacity. Option A requires the purchase of a garbage
collection vehicle that needs a three-person crew. The vehicle will cost $50,000,
and each worker will be paid $20,000 a year. The city would pick up 400 tons of
garbage annually, and for each ton of garbage collected, it would charge a $400
fee. The city would have annual revenue of 400 × $400 = $160,000 from this
operation.
Option B requires a vehicle for a two-person crew. The vehicle will cost $90,000,
and each worker will be paid $20,000 annually. With this option, the city’s garbage
collection capacity would be 300 tons annually, so the annual revenue would be 300
× $400 = $120,000. Using a five-year period and a discount rate of 5 percent, which
option should be recommended in the budget request? Table 6.1 shows the CBA
analysis for these two options.
Table 6.1
CBA for Garbage Pickup Options ($)
Year Present value of cost Present value of benefit

Option A
0 (the current year) 50,000 + 60,000 = 110,000 400 $400 = 160,000
1 60,000/(1 + 5%) = 57,143 160,000/(1 + 5%) = 152,381
2 60,000/(1 + 5%)2 = 54,422 160,000/(1 + 5%)2 = 145,125
3 60,000/(1 + 5%)3 = 51,830 160,000/(1 + 5%)3 = 138,214
4 60,000/(1 + 5%)4 = 49,362 160,000/(1 + 5%)4 = 131,632
Total 322,757 727,352
NPV for Option A is 727,352 – 322,757 = 404,595
Option B
0 (the current year) 90,000 + 40,000 = 130,000 300 $400 = 120,000
1 40,000/(1 + 5%) = 38,095 120,000/(1 + 5%) = 114,286
2 40,000/(1 + 5%)2 = 36,281 120,000/(1 + 5%)2 = 108,843
3 40,000/(1 + 5%)3 = 34,554 120,000/(1 + 5%)3 = 103,661
4 40,000/(1 + 5%)4 = 32,908 120,000/(1 + 5%)4 = 98,724
Total 271,838 545,514
NPV for Option B is 545,514 – 271,838 = 273,676
Since the NPV of Option A is larger than that of Option B, Option A should be
recommended in the capital budget request.
ISSUES IN COST-BENEFIT ANALYSIS

Although CBA is a useful tool, it is not applicable for every project. When it is ap-
plied, it is important to ensure it is done right. In this section, we discuss some critical
issues concerning how to do CBA.
Measuring Benefits
First, a clearly defined and achievable project objective is needed. For example, a high-
way project that connects two busy districts in a metropolitan area can be designed to
reduce traffic accidents and save travelers’ time. Time saving is a clearly defined and
achievable objective of the project. The “achievable” means that designated project
results can be empirically observed.
Many projects have multiple project objectives. For example, in addition to time
saving, a goal of the highway project is also reducing traffic accidents. Both time sav-
ing and accident reduction are project objectives. For multiple objectives, we need to
determine whether they are mutually inclusive—the fulfillment of one affects another.
For example, if we determine that a highway with reduced accidents also saves travelers’
time, then time saving and accident reduction are two mutually inclusive objectives.
Mutual inclusion of objectives indicates that benefits of two objectives are also mutually
inclusive and that caution should be exercised to avoid double-counting of benefits. On

the other hand, if a project has two mutually exclusive benefits, both should be included
in the analysis. For example, an educational program benefits both employees and busi-
ness owners. The benefit to employees can be mutually exclusive from that to owners.
Second, an objective should be measurable and quantifiable. Time saving can
be measured by “the amount of time saved for an average traveler daily.” Accident
reduction can be measured by “the number of accidents daily.” There are different
types of measures, such as outputs and outcomes, that can be used to measure project
benefits. Outputs are a project’s direct products or immediate effects. An example of
an output for a job-training program is “the number of people trained” or “the number
of training hours produced.” Outcomes refer to a project’s intermediate or long-term
impact and achievement. An outcome of the job-training program is an increase in the
employment rate or, more specifically, “the percentage of trainees who are employed
again” after a period of time. In general, the relationship between a project and its
outcomes is difficult to observe empirically; therefore outcomes may be less useful
than outputs in determining project benefits. For instance, can we really credit the
training program for the improvement of the employment rate? Or could the economy
and characteristics of the job market also play a role? Oftentimes, it is difficult to
distinguish the project impact from other nonproject factors on an outcome.
Third, project benefits must be converted to monetary gain. The benefit of a garbage
collection project can be converted to gains in revenue. A traveler’s time saving can
be transformed into his or her financial gain. This monetary conversion is critical to
CBA. When it is impossible or very costly to measure benefits in monetary terms,
we may apply cost-effectiveness analysis (CEA).
Let us look at a simple example of CEA. Suppose that we compare two possible
highway projects designed to reduce the number of traffic accidents. Project A costs
$10 million in present value during a ten-year period, and Project B costs $14 million.
The benefit of the projects is “the number of traffic accidents reduced.” Suppose that
Project A can reduce the accidents by 1,000 counts and Project B by 1,500 counts, then
the present value of cost for each accident reduced is $10,000,000/1,000 = $10,000
for Project A and $14,000,000/1,500 = $9,333 for Project B. We will choose Project
B because it is more cost-effective. In CEA, we compute a project’s present value of
cost for its designated effectiveness. There is another example of CEA in the exercises
of this chapter, but a full discussion of this technique is beyond the scope of this book.
Finally, measuring benefits becomes controversial when social values are considered
or human lives are involved. Which project do you prefer—one that saves one life a
year and costs $1 million, or the second one that saves two lives but costs $10 million?
What is the value of human lives? What is the value of your own life? Another dif-
ficult issue in CBA is to determine benefits and costs to “whom.” A project laying off
workers to reduce costs may be beneficial to an organization, but costly to the society.
Estimating Costs
There is a difference between the project cost (the accounting cost or financial cost)
and the opportunity cost. The former is the summation of all the resources consumed
by the project during its lifetime. It includes all cost items associated with producing
a product or a service. The estimation of these cost items is discussed in Chapter 3.
What is the opportunity cost? Think about the cost of getting a graduate degree. Is it
tuition? Many would perhaps disagree. Many value family time greatly, and if it is
lost because of time spent on an education, then the opportunity cost of the education
can be the value of family time lost. If attending college reduces your time at work,
the opportunity cost is the money you would have earned if you worked instead. In
general, the opportunity cost of a project is the value of the best alternative forgone
because of the project. If the project cost is the resource consumed for Project A,
the opportunity cost of Project A is the value of the best alternative project forgone
because of Project A.
Choosing the Discount Rate
Discounting is necessary when benefits or costs stretch over several years in the fu-
ture. Both benefits and costs must be converted to the present value for comparison.
The discount rate, or the opportunity rate of return, adjusts costs and benefits to their
present values. In theory, the discount rate of a project is determined by the answer
to the question: What is the return of the best alternative to the project? If, instead of
investing in the project, the best investment option of the money will bring a 5 percent
increase in value in a short-term government bond fund, then the discount rate is 5
percent. If the best alternative investment option is a high-yield cooperate bond that
would bring 10 percent interest, the discount rate is 10 percent.
A CASE STUDY
The Public Works Department in Sunny Village, California, has a mechanical shop
responsible for maintaining the city’s vehicles. The shop director, Steven Douglas, has
five employees and a budget of $845,000 this year. In addition to the regular checkup
and maintenance services, the shop also provides short classes for city employees on
how to efficiently operate cars and trucks. The goal of the shop is to let no vehicles
break down in service, but breakdowns do happen. When they happen, a diagnostic
checkup is performed to find out the possible cause.
The current diagnostic system was purchased five years ago. It is a manual tester,
called Vehicle Testing Monitor 2000 (or VTM 2000). It includes a communicator that
connects a vehicle with a computer screen. A vehicle consists of several major systems
(e.g., the engine system, the electric circuit system, the fuel system, and the steering
system). Each system also has accessory parts. If one part breaks, the whole system
fails to work. To find out the problem part, a mechanic needs to connect the VTM
with the vehicle system. If a system consists of several parts, VTM has to check these
parts one by one until the problem part is identified. Figure 6.1 shows a diagnostic
process for a system that has three accessory parts.
Steven believes the VTM is slow in diagnosis and yields a high possibility of re-
placing good parts. In this year’s budget request, Steven requested a new diagnostic
system, Quality Test System (or QTS). QTS includes an information database, a test
Figure 6.1 VTM Diagnostic Process
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instrument module, and an expert diagnostic software system. During a diagnosis, a

mechanic first enters a vehicle’s identification code. After analyzing the meter read-
outs and problem symptoms, the expert system identifies the problem part and then
gives repair instructions, shown on a computer monitor. So, instead of a step-by-step
diagnosis for each part at a time by VTM, QTS checks all parts of a system simulta-
neously. Figure 6.2 shows how it works for a system that has three parts.
In a recent budget preparation meeting, Steven presented his case to his supervisor,
Public Works Director Lisa Jones. He estimated that the price of QTS was $21,400.
The estimated operating cost was $280 each year. The estimated life of the system
was six years (including the current year).
He expected that the benefits of QTS would come from two sources. First, diag-
noses would be quicker, so diagnostic time would be saved. Diagnostic time is the
time from the beginning of a diagnosis to the discovery of a problem. The VTM’s
multiple-step diagnostic process would be replaced by a single-step process of QTS.
Time saving for each diagnosis problem would differ. For instance, it takes VTM
45 to 60 minutes to test an infected flow, compared to 3 minutes by QTS. For most
engine problems, VTM needs 60 to 120 minutes, compared to 10 minutes by QTS.
Steven estimated that, on average for each diagnosis, VTM would take 150 minutes,
while QTS would take about 30.
Figure 6.2 QTS Diagnosis

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The city has ninety vehicles: thirty police cars and sixty trucks. All the vehicles are
in relatively good shape. The police cars are replaced every two years. Only a small
number of vehicles need diagnostic services. The mechanic shop in the department
does fifty-two diagnoses a year (once a week for fifty-two weeks a year). Also, on
average, a mechanic’s hourly wage and benefits are $12.
The second major benefit comes from an accurate diagnosis. QTS is more ac-
curate than VTM in diagnosis. With VTM, mechanics are more likely to mistakenly
replace a good part. This is called ineffective replacement. With the new system, the
problem part could be identified accurately. The cost for ineffective replacement is
$50 a diagnosis for VTM. This cost for QTS would be $0. Finally, Steven said, “if we
get QTS, we can sell VTM for about $692 in today’s market.” Lisa thought Steven’s
analysis was too broad and asked for a CBA.
STEP 1: FORMULATING THE QUESTION IN COST-BENEFIT ANALYSIS

First, there is no need to conduct a CBA for the existing system, VTM. The decision
of purchasing the system was made and the cost associated with VTM is a sunk cost.
To estimate the cost and benefit of QTS, we need to know the objective of the vehicle
diagnostic system. The goal of the mechanic shop in the Public Works Department is
stated as “protection of the city’s vehicles through efficient and effective maintenance
and repair.” So the CBA question can be formulated as: What are the costs and benefits
of purchasing QTS in maintaining and repairing the city’s vehicles?
STEP 2: DETERMINING THE BENEFIT

First, we need to identify the benefits that should be included in the CBA. Three QTS
benefits serve the goal of the mechanic shop—diagnostic time saving, improved diag-
nostic accuracy, and the residual value of the old system if it is sold. Second, benefits
should be converted to monetary terms. For diagnostic time saving, information on
salaries and benefits is needed. As we know, QTS saves two hours (i.e., 150 minutes
Table 6.2
Present Value of Benefits for QTS ($)
Time Accurate Salvage

Year saving diagnosis value
0 (the current year) 1,248 2,600 692
1 1,135 2,364 0
2 1,031 2,149 0
3 938 1,953 0
4 852 1,776 0
5 775 1,614 0
Total 5,979 12,456 692
Note: Discount rate = 10 percent.
– 30 minutes) for each diagnosis and, for fifty-two diagnoses a year, there would be
a saving of $1,248 a year (i.e., two hours × fifty-two weeks × $12 per hour). We also
know that QTS is more accurate in diagnosis. By reducing the ineffective replace-
ment of parts, the system would save $50 on each diagnosis, for an annual saving
of $50 × 52 = $2,600. The last benefit is the salvage value of selling the VTM. The
market value is estimated at $692. Table 6.2 presents the PVB calculation for QTS
(refer to Chapter 4 for using Excel in the process of converting the future value to
the present value).
STEP 3: DETERMINING THE COST

The purchase cost of QTS is $21,400 with an annual operating cost of $280. Table
6.3 shows the process of calculating PVC.
Table 6.3
Present Value of Costs for QTS ($)
Year Purchasing cost Operating cost

0 (the current year) 21,400 280
1 0 254
2 0 231
3 0 210
4 0 191
5 0 174
Total 21,400 1,340
Note: Discount rate = 10 percent.
STEP 4: DETERMINING THE DISCOUNT RATE

Lisa believes that if the project is approved, the funding will come from a capital project
fund that is funded by city debts. The city now pays an approximate 10 percent interest
rate for issuing long-term debts. So the discount rate is appropriate at the 10 percent.
STEP 5: CALCULATING THE NET PRESENT VALUE

The PVB of QTS is $5,979 + $12,456 + $692 = $19,127. The PVC is $21,400 +
$1,340 = $22,740. Thus, NPV = PVB – PVC = $19,127 – $22,740 = -$3,613. For
the lifetime of six years, a CBA on QTS shows a NPV of –$3,613.

Since the NPV is negative, the funding of QTS does not appear to be economically feasible.
So a decision was made not to fund QTS. Steven argued back. He said that the number
of diagnoses was based on this year’s data. The number should double to two vehicle di-
agnoses a week. Would this change the NPV of QTS and therefore the funding decision?
EXERCISES
1. KEY TERMS
Cost-benefit analysis (CBA)
Net present value (NPV)
Present value of benefit (PVB)
Benefit/cost ratio
Achievable project objectives
Mutually inclusive project objectives
Mutually exclusive project objectives
Measurable and quantifiable project objectives
Project (accounting or financial) cost
Opportunity cost
Opportunity rate of return
Outcomes of a project
Outputs of a project
Cost-effectiveness analysis (CEA)
2. DISCUSSION
1. Use examples to discuss the role and value of CBA in government.
2. Give examples to illustrate the differences between output and outcome of a
public service, and why output is more useful than outcome in CBA.
3. Discuss the difference between CBA and CEA. Provide examples of circum-
stances when CEA is appropriate.
Table 6.4
Cost-Benefit Analysis for Two Public Infrastructure Projects ($)
Cost
Year Personnel Operating Capital Benefit
Project A
0 (the current year) 300,000 0 200,000 0
1 150,000 2,000 100,000 0
2 100,000 15,000 25,000 30,000
3 0 21,000 0 150,000
4 0 21,000 0 200,000
5 0 21,000 0 200,000
6 0 21,000 0 200,000
7 0 21,000 0 200,000
8 0 25,000 0 200,000
9 0 25,000 0 200,000
10 0 25,000 0 200,000
Project B
0 (the current year) 500,000 0 125,000 0
1 100,000 12,500 25,000 187,500
2 0 25,000 0 187,500
3 0 25,000 0 187,500
4 0 25,000 0 187,500
5 0 25,000 0 187,500
6 0 25,000 0 187,500
7 0 25,000 0 187,500
8 0 25,000 0 187,500
9 0 25,000 0 187,500
10 0 25,000 0 187,500
4. Illustrate the concept of opportunity cost with examples in personal finance.

5. Discuss the limitations of CBA in the public sector. Comment on the statement:
“economical feasibility does not guarantee that a project will be funded.”
3. CALCULATIONS
Table 6.4 shows cost and benefit flows of two public infrastructure projects.
1. Use a 5 percent discount rate to compute the NPV for both projects.
2. Recalculate the NPV for both projects with a 10 percent discount rate.
3. Write a paragraph to discuss the economic feasibility of the two projects.
4. THE SENSITIVITY ANALYSIS IN CBA

In CBA, assumptions must be made about benefits, costs, the discount rate, and
the lifetime of a project. In reality, these assumptions change. For example, in this
chapter’s Sunny Village case study, the discount rate can be lower if the interest rate
of the city’s long-term debt is lower. The change of assumption inevitably changes
CBA results. The type of analysis that examines the impact of assumption change on
CBA results is called sensitivity analysis.
1. Now, assume that the discount rate is reduced from 10 percent to 5 percent,
and everything else is unchanged—conduct a CBA for Sunny Village’s Di-
agnostic System.
2. Conduct a CBA in which the cost of ineffective replacement increases to $65,
with everything else unchanged.
3. Finally, if the city decides to purchase QTS regardless of the CBA results,
but wants to extend its lifetime of use until a positive NPV is produced, how
long should the city keep QTS?
5. COST-EFFECTIVENESS ANALYSIS
Sometimes it is rather difficult to convert benefits into monetary gains. In the Sunny
Village case, we can choose not to convert the benefit to monetary terms, but rather,
measure the benefit by “the number of vehicles diagnosed correctly the first time.”
With PVC, we can calculate a ratio that indicates PVC for one correct diagnosis. This
is a case of cost-effectiveness analysis.
Here is another example of cost-effectiveness analysis. A school district is consid-
ering two options for a new school. Option A has a capacity to accommodate 1,000
students in the current year and an annual increase of 100 thereafter. The option costs
$10.0 million in the current year and $2.5 million annually thereafter. Option B offers
spaces for 300 students in the current year, with an annual increase of 200 students
every year thereafter. The plan costs $7.0 million in the current year and $3.0 million
annually thereafter. Consider a seven-year term (including the current year) and a 5
percent discount rate. Conduct a cost-effectiveness analysis for the options. Which
option should the school choose?
6. CBA FOR EDUCATION

Conduct a CBA for obtaining a master’s degree from a public college. Explain ex-
plicitly any assumptions in your analysis.
7. PROBABILITY IN CBA
In an exercise problem in Chapter 1, we introduced the concept of probability in
revenue forecasting. Probability can also be used in estimating costs and benefits in
CBA. For example, in Option A in Table 6.1, if there is only 70 percent chance that
we receive the revenue ($160,000) this year and 30 percent chance that the project
does not make any money, then the estimated revenue this year is (160,000 × 70 per-
cent) + (0 × 30 percent) = $112,000. Please identify two to three CBA cases in which
probability estimation may apply. Explain how you may decide on the probabilities.
8. ESTIMATING THE VALUE OF SUSTAINABILITY IN A FULL CBA

This chapter introduces the process of conducting a traditional CBA that focuses on
economic value of a project. This traditional method of CBA ignores environmental
and social values of a project. A project to restore natural habitats from human develop-
ment may not yield immediate monetary gains, but it can bring environmental benefits
from a more sustainable ecosystem. A project to reduce residential water consumption
through water conservation may reduce financial benefit (in form of water charge) of
a government, but it can produce environmental benefits for future generations. In a
full CBA analysis, environmental and social values should be considered along with
economic value in estimating costs and benefits. Identify a capital budgeting project
of your choice to conduct a full CBA.
PART II
TOOLS FOR FINANCIAL IMPLEMENTATION

7 Financial Performance
Monitoring
LEARNING OBJECTIVES
s $ETERMINE PROPER INDICATORS FOR MONITORING

s $ETECT UNACCEPTABLE PERFORMANCE
s $ETECT PERFORMANCE TRENDS
s $EVELOP A COMPLETE PICTURE OF lNANCIAL PERFORMANCE
s )DENTIFY CAUSES OF UNDERPERFORMANCE
s 4AKE PROPER ACTIONS TO IMPROVE PERFORMANCE
Imagine that your family has budgeted $400 per month on entertainment, but when
the credit card bill comes, it turns out that $500 has been spent. A budget monitoring
system, balancing the credit card bill in this case, tells you that you have overspent,
and that you need to limit your subsequent spending to balance the budget.
A financial monitoring system serves three purposes. First, it provides an ongoing
check on the budget. By comparing actual financial results against budgets, it can be
determined how well financial objectives have been achieved and whether the budget
is realistic. In the above example, if the family keeps spending more than $400 on
entertainment, that is an indication that the budget of $400 is too low and should be
increased.
Second, a monitoring system helps uncover inefficient practices and operations.
In the above case, maybe the family spends too much on popcorn and drinks at the
movie because they attend late-afternoon matinees when they are becoming hungry
for dinner. Overspending on snacks could be avoided by going to the movies in the
evening, just after dinner. Of course, a monitoring system can also discover desirable
practices and operations. A consistent revenue surplus uncovered by a monitoring
system may indicate enhanced efforts in revenue collection, and such efforts should
be encouraged. Nevertheless, the detection of inefficient and undesirable behaviors
should be the focus of a monitoring system, as the costs of such behaviors, if not
corrected quickly, are often high.
85
86 TOOLS FOR FINANCIAL IMPLEMENTATION
Third, and perhaps most important, a monitoring system helps avoid further de-
terioration of financial condition. Imagine that, in the above case, the overspending
goes unnoticed for long enough that you have trouble paying your entertainment bill.
The consequences of such behavior are paying unusually high interest or penalties,
or in rare cases of personal finance, filing for personal bankruptcy. Severe financial
consequences have occurred in governments. Orange County, California, made poor
investment choices and filed for bankruptcy in 1994. In 1996, the City of Miami had
an enormous budget deficit that sent the city to the brink of financial insolvency. In
2011, Jefferson County, Alabama, filed for bankruptcy after a series of exotic bond
deals with bankers went wrong, and the interest on its debts ballooned like a bad
subprime mortgage. The city of Stockton, California, declared bankruptcy in 2012
after overspending and a sharp decline in its revenue base caused by the property
market collapse. The city found itself $167 million in debt.

Financial performance monitoring is a system designed to detect undesirable financial
performance and provide possible solutions to enhance performance. Three essential
elements are needed in developing an effective financial monitoring system:
s )NDICATORS THAT ASSESS lNANCIAL PERFORMANCE

s 4ECHNIQUES TO DETECT UNACCEPTABLE lNANCIAL PERFORMANCE
s 4ECHNIQUES TO DIAGNOSE CAUSES OF UNDERPERFORMANCE AND TO PROVIDE SUGGESTIONS
for performance improvement
DETERMINING MONITORING INDICATORS

What Indicators Are Available?
Numerous indicators are used to evaluate a wide range of organizational objectives

and operations. These indicators can be broken down into two categories: financial
indicators, which evaluate an organization’s financial operations and financial condi-
tion, and nonfinancial indicators, which assess elements of an organization’s perfor-
mance that are not characterized by financial transactions, financial operations, or
monetary success. Examples of nonfinancial performance indicators include citizen/
client satisfaction measures.
Financial indicators can be further classified into three categories: financial input
indicators, financial process indicators, and financial results indicators. Financial
input indicators assess the availability of financial resources and the level of financial
resource consumption. Indicators 1 and 2, defined below, are in this category.
Indicator 1: Total Revenues or Revenues Per Capita. The variations of total reve-
nues include total revenues by fund and revenues by source (i.e., taxes, fees, charges,
intergovernmental revenues), which indicate the level of resources available for service
provision. The percentage of a particular revenue source in total revenues can also be
FINANCIAL PERFORMANCE MONITORING 87
monitored to assess whether an organization over relies on the revenue. For example,
the percentage of intergovernmental revenues in total revenues (Intergovernmental
Revenues/Total Revenues) assesses how much an organization relies on the revenues
from other governments. Revenues per capita (Total Revenues/Population) demon-
strates the revenues in relation to the population, which measures resources available
for each individual resident served. This indicator controls the impact of population
on resources and is a better measure of resource availability for a community with a
changing population.
Indicator 2: Total Expenditures or Expenditures Per Capita. One variation of

total expenditures is the expenditures by function, such as personnel, operating, or
capital expenditures. These indicators assess the level of resources consumed for
service provision. The percentage of a particular expenditure in total expenditures
can also be monitored to identify major expenditure items. Expenditures per capita
(Total Expenditures/Population) measures the resource consumption for each in-
dividual resident.
Financial process indicators are used to address issues in financial operations,
such as cash liquidity, borrowing capacity, operating deficits, pension liability, and
capital outlays. Monitoring financial process indicators is often tailored to a specific
monitoring need. For example, a manager may be concerned about cash liquidity as
the result of a recent purchase of an expensive capital item. Or operation deficits be-
come the center of discussion among managers due to a recent economic slowdown
and erosion of tax bases. Indicators 3 to 6, described below, are process indicators.
Indicator 3: Liquidity. Liquidity evaluates whether an organization has enough cash

and cash equivalents to meet its short-term obligations. Insufficient liquidity affects
an organization’s financial viability. Excessive liquidity suggests a possible loss of
investment opportunities. One common liquidity indicator is the current ratio (Cur-
rent Assets/Current Liabilities). Current assets are cash, cash equivalents, or assets
convertible to cash within one year. Cash equivalents are assets that can be easily
converted to cash. They often include marketable securities, money owed by others
in exchange for goods and services (accounts receivable), and inventories. Current
liabilities are financial obligations that are expected to be paid within one year. They
mainly include the amount an organization owes to suppliers for equipment or product
purchases and to employees for wages and benefits. In accounting, many of these
expenses are reported in payable accounts. A rule of thumb for an acceptable current
ratio is 2.0. Any value smaller should cause concern about liquidity. We will further
study current assets and current liabilities in Chapter 9.
Indicator 4: Net Assets or Change in Net Assets (i.e., Operating Surplus or Defi-
cit). Assets are what an organization owns, or more formally, the valuable resources
in an organization. They include current assets described above and long-term (or
noncurrent) assets, such as land, buildings, and equipment. Liabilities are what an
organization owes to others. In addition to current liabilities, there are long-term li-
abilities, such as long-term debts. Net assets are the difference between assets and
liabilities. Positive net assets are often in the form of investment in an asset reserve.
Since 2012, US state and local governments refer to net assets as net position. An
asset reserve can be used to measure an organization’s financial ability to withstand
financial emergency. Change in net assets is the difference between total revenues
and total expenses for the year in an organization. Since 2012, US state and local
governments refer to this as change in net position. Known as “earnings” in private
firms, this measure can be seen as an organization-wide operating surplus (or deficit)
in public organizations. A positive figure indicates an increase in total net assets. A
negative number eats up the asset reserve. We will come back to these concepts in
Chapters 9 and 10.
Indicator 5: Fund Equity (Balance) or Fund Operating Surplus (or Deficit).

Operating deficits occur when expenditures exceed revenues, which indicates that
an organization consumes more than it receives. The constant recurrence of deficits
exhausts an organization’s reserves and puts its financial viability on the line. Defi-
cits can occur in different funds of an organization. A fund is a fiscal and accounting
entity that reports its own financial assets and liabilities and fund balances. Different
funds are used to record and report financial activities of different natures. For ex-
ample, in a US local government, the financial activities of a police department are
different in nature from those of a water treatment facility. The former is considered
a governmental activity while the latter is a business-type activity. They are reported
in different funds—likely, the police activities in a general fund, and the water treat-
ment activities in an enterprise fund. A fund has its own revenues and expenditures.
The difference between revenues and expenditures is the change in fund equity (bal-
ance), which can be seen as a fund’s operating surpluses (or deficits). We can choose
to monitor deficits of a particular fund (such as a general fund). The fund-operating
deficit can be covered by reserve. We will discuss funds and fund-level financial
statements in Chapter 11.
Indicator 6: Borrowing Capacity. Debt issuances can be used to finance capital

improvement and occasionally short-term revenue shortages. However, excessive debts
can cause serious financial troubles. How much debt is too much? Many indicators
that assess debt capacity are discussed in detail in Chapter 13, where debt outstand-
ing ratios and the debt service ratio are introduced. One indicator that also assesses
debt capacity is a comparison of debt (i.e., debt outstanding) with total assets (i.e.,
Total Debt/Total Assets). This ratio is known by some as the debt ratio, although the
indicators in Chapter 13 can also use that name. The larger the ratio, the lower the debt
capacity. Some literature suggests that this ratio should not exceed a benchmark of 0.5.
Financial results indicators evaluate how efficiently an organization uses its finan-
cial resources and how effectively it produces revenues, earnings, or profits for its
operation. Indicators 7 and 8, described below, are in this category.
Indicator 7: Asset Allocation Efficiency. One such indicator is the total asset turn-
over (Total Revenues/Total Assets), which calculates the revenue per dollar of assets.
It is an indicator of asset allocation efficiency. For example, a value of 1.2 shows that
every dollar in assets brings $1.2 in revenue. A higher value indicates a more efficient
asset allocation, as measured by the higher revenue earning potential. Another similar
indicator, the fixed asset turnover (Total Revenues/Total Fixed Assets), is the revenue
per dollar of assets invested in long-term assets such as equipment and properties.
This ratio concerns the efficiency of fixed asset allocation. A higher ratio suggests a
more efficient allocation of fixed assets.
Indicator 8: Indicators of Earnings and Profitability. Earnings and profits (i.e., posi-
tive earnings) are not objectives of many public service organizations. Nevertheless,
some functions in these organizations produce business-type goods and services that
should be evaluated using earnings or profitability. One such indicator is the return
on assets (Change in Net Assets/Total Assets), which evaluates the earnings (i.e., the
change in net assets) per dollar of assets. For example, a value of 0.50 indicates that
50 cents of earnings or profit are made for each dollar spent on assets. A higher value
of this ratio suggests a higher earning capacity and higher profitability. Notice that a
negative change in net assets leads to a negative ratio, which shows net asset loss per
dollar of assets. A similar indicator is the return on net assets (Change in Net Assets/
Net Assets), which assesses the change in net assets (or profitability) per dollar of net
assets. Because US state and local governments use the term net position to replace
net assets after 2012 in financial reports, this indicator should be renamed as the
return on net position in these governments (Change in Net Position/Net Position).
What Indicators Should Be Monitored?
Because there are numerous indicators available for monitoring, using all of them
would be too costly and time consuming. Selecting limited indicators is necessary.
Consider the following four criteria in the selection.
First, indicators selected should meet monitoring objectives. To ensure zero deficits,
operating deficits and levels of revenues and expenditures should be monitored. To
ensure the availability of sufficient cash to meet obligations, liquidity ratios should
be monitored. If we are concerned about the possibility of resource waste in opera-
tions, indicators of asset allocation efficiency should be monitored. Oftentimes, deficit
compliance, liquidity, and asset allocation efficiency are three major monitoring
objectives. Other monitoring objectives include enhanced borrowing capacity and
increased profitability.
Second, indicators selected should address specific monitoring needs. A surge in
inventory might indicate a need to improve an organization’s inventory management.
A monitoring of the inventory level becomes necessary. Consistent complaints from
citizens or elected officials about the increase of a specific tax point out a need to
monitor the tax base and the tax rate.
Third, indicators selected should meet the requirement of monitoring frequency.
Data for some indicators may not be available frequently enough to meet the require-
ment of monitoring. Many tax bases and tax rates are changed annually, which does
not meet the requirement of a monthly monitoring. Finally, costs associated with
data collection should be acceptable. Costs are lower for indicators that exist in the
current reporting system and are readily available for use; costs are higher for new
indicators that require efforts to collect.
Where Are the Data?
Budgets and financial reports, including the Comprehensive Annual Financial Report
(CAFR) of US state and local governments, are good sources for annual data. Informa-
tion on assets, liabilities, fund finances, and cash flows can be found in CAFRs. CAFRs
should also present demographic information in the “Statistical Section.” A well-prepared
budget should include itemized revenues and expenditure data, information on spending
efficiency and effectiveness, and historical information that demonstrates the trends of
these data. Monthly or quarterly data may be found in a financial division’s internal
reports or financial record books or accounting documents (i.e., accounting ledgers).
Unless required by law, information at this level of detail is usually not presented in
budgets or CAFRs. Efforts need to be made to retrieve this information in a standardized
and systematic way in order to be included in a monitoring system.
DETECTING UNACCEPTABLE PERFORMANCE

This part of a monitoring system detects performance that is out of an acceptable
range, or shows a deteriorating trend. A common detecting scheme consists of three
major steps that include (1) examining indicators, (2) detecting the performance trend,
and (3) developing a complete picture of performance.
Examining Indicators
The first step is to find out whether a financial indicator is within an acceptable perfor-
mance range. To do that, the actual performance of the indicator should be compared
with some form of performance standards or benchmarks, such as budgeted amounts,
state- or nationwide averages, or performance of similar organizations.
Let us say that we examine this year’s CAFR and realize that there is a general fund-
operating deficit (the amount that total expenditures exceeded total revenues) of $150,000.
The deficit is covered by the financial reserve cumulated over years. We have sufficient
reserves. But large and continual deficits would eat up the reserve (assuming borrowing
is too costly). To detect whether this deficit is within our acceptable range, we should
compare this deficit with the budget figure. Suppose that we had expected a $300,000
surplus in the budget. The difference between the budget and the actual is –$450,000 (i.e.,
–150,000 – 3000,000). The negative sign indicates an unacceptable performance.
After detecting an unacceptable performance, we should look into the possible
cause of the underperformance. If the investigation uncovers a random event, for
example, a once-a-decade purchase of land, then we should move on. If we find that
a systematic event—one that will recur, such as increased personnel costs—is the
cause of the deficit, then a strategy should be developed to deal with the deficit. A
strategy may include efforts to increase revenues and/or to reduce expenses, or to
modify budget projections. Discovering causes and taking actions is the subject of a
later discussion in this chapter.
Table 7.1
Operating Surplus (or Deficit) of the Past Three Years ($)
Current year Last year Two years ago

Actual –150,000 –100,000 100,000
Budget 300,000 200,000 150,000
Difference –450,000 –300,000 –50,000
Detecting the Performance Trend
Regardless of whether performance is acceptable or not, it is a good idea to look into

the performance trend. The second step in performance detection involves a study of
the trend of the indicator. A trend will tell us whether an unacceptable performance
is now recurring, so that the possibility for long-term deterioration is identified, or,
if the current performance is within an acceptable range, whether it is a continuation
of a historical trend. In other words, a trend can show a sign of deteriorating, improv-
ing, or stable performance. In the above example, suppose that the data of operating
surplus (deficits) for the past three years is shown in Table 7.1.
Clearly, the trend indicates an increase in a negative actual–budget gap, suggest-
ing a deteriorating performance trend for the past three years. The actual–budget gap
increased by 900 percent (–$450,000/–$50,000) over the last three years. This finding
indicates a stronger need for improvement than single-year data suggest.
Developing a Complete Picture of Performance
In this step, a more complete picture of performance is developed. This step is par-
ticularly important when a negative performance trend is detected. It helps us further
understand what went wrong. It can also be seen as a prelude in understanding why it
went wrong. This step involves the examination of other indicators that are associated
with the initial indicator. In our example, because the deficit is the difference between
revenues and expenditures, an examination of the revenues and expenditures should
provide us with more information about the causes of the deficit.
The deficit can be a result of an unexpected revenue shortfall, overspending, or both.
Table 7.2 shows that $100,000 more revenues were collected than expected, so a reve-
nue shortfall can be ruled out. The data show that $550,000 in overspending caused
the deficit. They also show that the current year’s deficit is $150,000/$5,000,000 = 3.0
percent of the actual revenue, which measures the relative size of the deficit. Revenue
and expenditure data for the previous two years can also be analyzed in the same fashion.
UNDERSTANDING THE CAUSES AND TAKING ACTION

Not all underperformance deserves meticulous analysis. Variations from an expected
performance may be the result of a random event that has little chance of recurring. Or,
underperformance may be caused by measurement inconsistency, such as a change in
Table 7.2
Revenues, Expenditures, and Surplus (Deficit) in the Current Year ($)
Actual Budget Difference

Total revenues 5,000,000 4,900,000 100,000
Total expenditures 5,150,000 4,600,000 –550,000
Surplus or deficit –150,000 300,000 –450,000
the data collection method or definition of an indicator. Random errors, such as typos
in data entry, also occur. At other times, the amount of underperformance is just too
small to warrant any significant investment in investigation. We are not concerned here
with cases of underperformance that are caused by random or insignificant events, but
will rather examine the underperformance that likely results from recurring fiscal or
economic conditions or systematic practices of poor planning or inefficient operations.
Using the budget deficit example above, the initial observation indicates overspend-
ing of $550,000. A further analysis, shown in Table 7.3, indicates that 73 percent
(–$400,000/–$550,000) of overspending was caused by overspending on personnel.
After interviewing the human resource director, it was revealed that there was a sig-
nificant increase in the insurance cost for employees.
Table 7.3
Expenditure by Function ($)
Actual Budget Difference

Personnel 2,900,000 2,500,000 –400,000
Operating 1,100,000 1,000,000 –100,000
Capital 1,150,000 1,100,000 –50,000
Total 5,150,000 4,600,000 –550,000
Data suggest that insurance premiums have increased over the past three years and
that this increase was largely responsible for the budget deficits for the past two years.
Clearly, the increase was not considered in the planning and budgeting process. If
an increase is predicted for next year, the budget should be adjusted to include such
increases.
In general, except for random factors, underperformance can have three causes:
unpredictable socioeconomic changes, poor planning, and/or inefficient or inef-
fective practices in management or operations. Budget deficits caused by a lack of
efforts in revenue collection or deteriorating employee productivity belong to the
last category. Consequently, several approaches can be developed to deal with such
underperformance. First, financial goals, objectives, or standards can be modified to
reflect reality in the planning process. Second, efforts can be made to modify organi-
zational strategies, procedures, and activities to improve efficiency and effectiveness
in management or operations. Last, invalid or unreliable indicators can be removed
from the monitoring system. Unrealistic performance standards should be revised.
A CASE STUDY
Linda Ellis is the finance director of Doreen County, Nevada. The county has a popu-
lation of 312,000, with total projected revenues of $308 million this year. Although
the largest revenue item is the property tax (about 35 percent of the total revenues),
the county has seen an increase in service charges, which are about 16 percent of the
total revenues. Part of this increase is due to the county’s policy that, “wherever pos-
sible, the county shall institute user charges for programs and activities in the county.”
The county also has a fiscal policy of “keeping a prudent level of financial reserves
for future unexpected expenses and revenue declines.” The county has always tried
to set apart 3 to 5 percent of appropriations for contingency.
The finance department has a financial monitoring system in place. The system
monitors all major financial indicators. Nevertheless, Linda’s monthly monitoring
focuses on a very limited number of indicators of liquidity and fund balance. She
believes that having sufficient cash and cash equivalents on hand is important, and
she also knows that it is impossible to follow all indicators closely, as the county’s
resources for record keeping are limited and only the most important indicators are
available on a monthly basis. Most other indicators are examined during an annual
review. In a recent monitoring analysis, Linda used the following steps.
STEP 1: DETERMINING AND ASSESSING INDIVIDUAL FINANCIAL INDICATORS

One liquidity indicator Linda reviews monthly is the current ratio (Current Assets/
Current Liabilities). The current ratio indicates the short-term assets available to pay
short-term liabilities. For example, a ratio of 2.0 indicates that there is $2 in current
assets for every dollar of the current liabilities. She uses a benchmark of 2.0, and
any ratio lower than that number is a warning sign that indicates the county may not
have sufficient liquidity.
In addition to the current ratio, Linda also reviews different current assets for pos-
sible troubles in asset allocation that could lead to liquidity problems. The county’s
current assets include cash, short-term investments, receivables, and inventories. In
a recent monthly monitoring analysis, Linda noticed a steady increase in the “receiv-
ables” account, which indicates an increase in what others owe the county. “Receiv-
ables” are a current asset account that typically represents amounts due to the county
within sixty days. Although an increase doesn’t negatively affect the current ratio, it
does indicate a slowed pace of cash inflow. In other words, the more money people
owe to you, the less cash you have. Because the increase in “receivables” suggests
slow cash inflow and a possible problem in payment collection, Linda’s alert was up
when she noticed the increase.
STEP 2: DETECTING UNACCEPTABLE PERFORMANCE

The latest monthly report showed a 5 percent increase in “receivables” over the pre-
vious month. Linda thought that it was fine if this was just a one-time increase that
was caused by some customers’ delayed payments. However, if the increase had been
continuing over time, that would be a problem. She knew that she needed to look at
past data to make a determination.
Linda reviewed the monthly averages of the “receivables” account for the past six
months. To adjust the seasonal impact, she also reviewed the data of the same month
for the past five years. The data showed a clear trend of increase. For example, the
percentage of “receivables” in the current assets increased from 12 percent to 16
percent over the last five years in the month of July. A similar increase occurred in
most of the other months.
At the same time, Linda noticed a slight decrease in the cash balance. For example,
cash was 59 percent of all current assets five years ago at the end of July, but was
now 56 percent—a 3 percent decrease over the last five years. To determine that the
decrease was caused by the “receivables” increase, Linda analyzed the data of other
current assets and found that little change had occurred in them over the past five
years. After consulting with two financial specialists on this matter, her final conclusion
was that the decline in cash balance was largely due to the increase in “receivables.”
STEP 3: UNDERSTANDING CAUSES OF UNDERPERFORMANCE

The average monthly balance of current assets is $336,000,000 for the past six
months. A 3 percent decrease in cash balance indicates a decrease of $10,080,000
(i.e., $336,000,000 × 3 percent) in cash, and, with an estimated annual interest of 4
percent from investments, this decrease represents an interest income loss of $403,200
(i.e., $10,080,000 × 4 percent) this year.
This would be a significant loss to the county. Linda decided to investigate the causes
of the “receivables” increase. She focused on the two largest revenue resources—prop-
erty taxes and user charges. No significant payment discrepancy was found for the
property taxes. Most taxes were paid on time. When analyzing the payment collection
for the user charges, Linda noticed a large and increasing amount in delayed pay-
ments for the county’s water and sewer services. She called the public utility director
and was told that an outdated address database was responsible for that. Apparently,
the old database had not been updated for the past several years as the result of the
budget cut. The database included many old addresses, and payment notices to these
addresses were often returned. The public utility director estimated that the address
error rate was about 5 percent, which was much higher than a 1 percent benchmark
established by the county. The director also told Linda that the county commission
had noticed the problem, and he invited Linda to attend the next commission meeting,
in which the billing address database was an issue on the agenda.
STEP 4: DEVELOPING A MONITORING REPORT

Linda agreed to attend the commission meeting. She is preparing a monitoring report
that will be presented at the meeting. In the report, she plans to present the monitoring
results and causes of the problem. In conclusion, she suggests an immediate update of
the address database and the establishment of multiple bill payment methods, including
mail, the Internet, and in-person payments, for the convenience and speed of payments.
EXERCISES
1. KEY TERMS
Purposes of financial performance monitoring
Three elements in financial monitoring
Financial indicators
Nonfinancial indicators
Financial input indicators
Total revenues
Revenue per capita
Total expenditures
Expenditures per capita
Financial process indicators
Liquidity
Current ratio
Current assets
Current liabilities
Assets
Net assets
Change in net assets
Long-term (or noncurrent) assets
Liabilities
Asset reserves
Fund equity (balance)
Fund operating surplus (or deficit)
Funds
Debt ratio
Financial results indicators
Total asset turnover
Fixed asset turnover
Return on assets
Return on net assets
Return on net position
Comprehensive Annual Financial Report (CAFR)
Three steps in detecting unacceptable performance
2. DISCUSSION
1. Why monitor financial performance in government? Use examples to discuss
the needs, purposes, and importance of financial performance monitoring.
2. What are the differences between financial and nonfinancial indicators? Can
you provide some examples of nonfinancial indicators?
3. Besides the examples given in the book, can you provide several more ex-
amples of financial indicators? Are they financial input, process, or results
indicators? Discuss the differences between financial results indicators and

financial input (or process) indicators.
4. Comment on the statement “liquidity is more important than financial results
in government.”
5. What is required in financial performance monitoring? Comment on the
monitoring requirements for indicator selection, data requirements, and tools
to use.
6. This book gives four criteria for selecting indicators to monitor. Can you think
of more criteria?
3. OBTAINING INFORMATION FROM THE CAFR

The CAFR typically has three sections: an introduction, a financial section, and a
statistical section. The financial section is the most important section. It includes a
“Management Discussion and Analysis” (MD&A), which gives a description of a
jurisdiction’s financial policies and significant changes in the financial condition over
the previous year. This section also includes a list of financial statements that are used
to reveal the financial condition and the financial performance of the jurisdiction.
Information needed to calculate the financial indicators discussed in this chapter can
be found in these statements.
The first two statements in the financial section are the statement of net assets (or
the statement of net position) and the statement of activities. They are organization-
wide statements, presenting the financial information for a whole organization. Use
a government’s CAFR to obtain the following indicators:
1. Total assets for the primary entity in the statement of net assets (net position).
The primary entity is often known as “the primary government” in a CAFR,
a concept discussed in detail in Chapter 9.
2. Total net assets (or net position) for the primary entity in the statement of net
assets (net position).
3. Total revenue for the primary entity in the statement of activities (general
revenues plus program revenues).
4. Total expenses for the primary entity in the statement of activities.
5. Change in net assets (or net position) for the primary entity in the statement
of activities.
6. Current assets for the primary entity in the statement of net assets (net posi-
tion) (i.e., Total Assets Noncurrent or Capital Assets).
7. Total liabilities for the primary entity in the statement of net assets (net posi-
tion).
8. Current liabilities for the primary entity in the statement of net assets (net
position) (i.e., Total Liabilities Noncurrent or Long-Term Liabilities).
9. Population. (Note: To find out the population figure, you may want to
check the “Statistical Section” of CAFR, call the organization, or search
the Web.)
4. CALCULATION OF FINANCIAL INDICATORS

Use the information gathered in the previous section (“Obtaining Information from
the CAFR”) to compute the following financial indicators. Discuss briefly the mean-
ing of each indicator.
1. Total revenues per resident.

2. Total expenditures per resident.
3. The current ratio.
4. The return on net assets (net position).
5. Total asset turnover.
6. Fixed asset turnover. (Sometimes fixed assets are listed as “long-term assets,”
“noncurrent assets,” or “capital assets.”)
7. Return on assets.
5. HISTORICAL COMPARISON OF THE INDICATORS

Make an effort to obtain CAFRs for the past three years and compare the indicators
in the above two questions (“Obtaining Information from CAFR” and “Calculation
of Financial Indicators”) over time. Report your monitoring findings. (Note that some
of indicators may not be comparable due to reporting format changes. If that is the
case, ignore these indicators in your comparison.)
6. FINANCIAL PERFORMANCE AND ORGANIZATIONAL PERFORMANCE

Improving organizational performance, not financial performance, is the goal of
management in government. But better financial performance can lead to better orga-
nizational performance. Increased revenue can help hire more police officers to fight
crimes, improve roads, or hire better teachers. How can financial performance help
improve organizational performance in general? The Government Finance Officers
Association recommends the following steps:
1. Determine how much money is available. The budget should be built on ex-
pected revenues. This would include base revenues, any new revenue sources,
and the potential use of fund balance.
2. Prioritize organizational outcomes. The outcomes that matter most to citizens
should be defined. Elected leaders should determine what programs are most
important to their constituents.
3. Allocate resources among high-priority outcomes. The allocations should be
made in a fair and objective manner.
4. Conduct analysis to determine what strategies, programs, and activities will
best achieve desired outcomes.
5. Budget available dollars to the most significant programs and activities. The
objective is to maximize the benefit of the available resources.
6. Set measures of annual progress, monitor, and close the feedback loop. These
measures should spell out the expected outcomes and how they will be mea-
sured.
7. Check what actually happened. This involves using performance measures
to compare actual versus expected outcomes.
8. Communicate performance outcomes. Internal and external stakeholders
should be informed of the outcomes in an understandable format.
Use examples to discuss the role of financial performance monitoring in the above
steps of organizational performance improvement.
8 Cash Management
Determining the Optimal Cash Balance
LEARNING OBJECTIVES
s $EVELOP A CASH BUDGET

s $ETERMINE AN OPTIMAL CASH BALANCE
s 5SE THE OPTIMAL CASH BALANCE IN CASH MANAGEMENT DECISION MAKING
There are three objectives in cash management. Cash safety refers to the pre-
vention of loss of cash as the result of poor decision making or criminal behavior
in cash collection, disbursement, investment, and other cash handling practices.
The other two objectives are liquidity and investment return. A good cash manager
maintains a sufficient amount of cash to meet financial obligations and also earns a
large return through investment. These two objectives often contradict each other.
Because a high level of liquidity requires readily available cash that could other-
wise be invested, higher liquidity often means less investment and therefore less
investment return. On the other hand, investing a large amount of cash in the market
in order to achieve a good return can compromise liquidity. In fact, a fundamental
challenge in cash management is to seek an optimal cash balance that meets the
daily demand for cash and earns a large investment return. Determining the optimal
cash balance is the focus of this chapter.
To understand the concept of optimal cash balance, think of your own personal
finances. If you have a daily cash income of $500, daily cash spending of $200, and a
balance of $10,000 cash in hand, you keep too much cash. You are better off investing
some of the $10,000. On the other hand, if you only keep $200 cash in your pocket,
you are at risk of running out of cash. So you want to find a cash balance somewhere
between $200 and $10,000 that provides you with sufficient cash for daily spending
and, at the same time, earns you a good investment return.
99

CREATING A CASH BUDGET
The first step in determining the optimal cash balance is to create a cash budget that
includes future cash receipts and cash disbursements. The idea is that if cash reve-
nues and cash spending for a given time are known, then how much or how little is
left for investment is known. Table 8.1 shows the sources of future cash receipts in a
local government. Monthly cash receipts are forecast.
Table 8.1
Expected Cash Receipts by Source in January ($)
Sources Amount
Property taxes 200,000
Sales taxes 100,000
Licenses and permits 50,000
Fines and forfeits 50,000
Total 400,000
Effective cash collection is important in managing cash receipts. The objective

of cash collection is to get the cash as quickly as possible and to keep it as long as
possible in order to increase liquidity or investment earnings. Consider the following
approaches to facilitate cash collection.
s 0ROVIDING MULTIPLE PAYMENT METHODS SUCH AS PAY IN PERSON PAY BY MAIL AND
electronic transfer.
s %NSURING CORRECT ADDRESSES BY UPDATING THE ADDRESS DATABASE AND CORRECTING WRONG
addresses.
s %STABLISHING POLICIES FOR LATE PAYMENTS
s 5SING RETURN ENVELOPES ADDRESSED DIRECTLY TO A BANK lockbox to reduce the travel
time of payments.
s &OCUSING ON THE PAYMENT SPEED OF MAJOR TAXPAYERS SERVICE USERS AND LARGE
revenue sources.
s (AVING A CUSTOMER SERVICE HOTLINE TO ANSWER ACCOUNT BALANCE AND OTHER QUESTIONS
Cash disbursements are results of receiving or prepaying services or products.

Table 8.2 shows the cash disbursement plan in the above local government. Monthly
disbursements by disbursement functions are forecast in the plan.
The objective of cash disbursement management is to hold on to cash as long as
possible. A cash payment should be made only when it is necessary and at the last
possible moment without penalty for the late payment. Consider the following ap-
proaches in managing cash disbursements.
CASH MANAGEMENT 101
Table 8.2
Expected Cash Disbursements by Function in January
Function Amount ($)

Personnel services 250,000
Operating expenses 50,000
Capital outlays 50,000
Total 350,000
Table 8.3
Cash Budget ($)
January February March April

Balance on the first of the month 50,000 100,000 ... …
Expected receipts 400,000 ... ... …
Cash available 450,000 ... ... …
Expected disbursements 350,000 ... ... …
Balance at the end of the month 100,000 ... ... …
Note: “. . .” represents any possible hypothetical figures.
s +EEPING THE PAYMENT DEADLINE IN MIND

s #ONSIDERING PAYMENT TRAVEL DAYS IN THE MAIL
s -AKING SURE THE ADDRESSES ARE CORRECT
s #ALLING TO ENSURE RECEIPT OF THE PAYMENTS
s 5SING SECURE ELECTRONIC PAYMENT MODES TO IMPROVE THE PAYMENT SPEED
After the forecast of cash receipts and disbursements is completed, a cash budget
can be created. Table 8.3 illustrates a cash budget that combines monthly cash receipts
and disbursements of the above local government. It also includes the cash balance,
which is what is left in an organization’s cash account at the end of the month. Monthly
forecasts of cash for the rest of the year should be made to complete the table.
Clearly, creating a cash budget requires the forecast of cash flows of revenues and
expenses. Cash flows in the past can be used in the forecast. Nevertheless, accurate
forecasting of cash flows is difficult, as numerous socioeconomic, demographic, and
organizational factors could potentially affect cash flows. The revenue forecasting
techniques introduced in Chapter 1 can be used in forecasting cash flows as well.
After a cash budget is completed and the cash balance is determined, an investment
plan should be developed. An investment plan should include investment types, invest-
ment amounts, and the duration of investments. Safety is always a major consideration
in investing public dollars. Low-risk investments such as US federal government
debts and other guaranteed securities should be favorite investment instruments in
state and local governments. Short-term (within twelve months) investments include
bank savings accounts, certificates of deposit (CDs), federal treasury bills, and money
market mutual funds. Long-term investments (maturity > twelve months) include US
treasury notes and bonds, corporate bonds, and common stocks. In general, the safer
the instrument, the lower the investment return.
DETERMINING THE OPTIMAL CASH BALANCE

How much cash should be invested? An experienced cash manager’s judgment is
often as good as any quantitative model. Managers’ intuition and judgment are often
good predictors of cash inflows (receipts) and outflows (disbursements), and therefore
the cash balance. However, some quantitative models, such as the Miller-Orr model,
can provide insights about managing cash balances and developing effective cash
management strategies.
Compared with other models, such as the Economic Ordering Quantity (EOQ), the
Miller-Orr model is more flexible in dealing with fluctuating cash flows and balances.
The model determines a cash balance interval that includes a low cash limit—a point
where the cash balance is too low—and an upper cash limit—an indication that the
cash balance is too high. A return point is used to help managers make investment
or cash replenishment (liquidity) decisions. Figure 8.1 shows how the Miller-Orr
model works.
Figure 8.1 The Miller-Orr Model
&DVKEDODQFH
,QYHVWWKLVDPRXQW
8SSHUOLPLW
5HWXUQSRLQW
/RZHUOLPLW
7LPH
5HSOHQLVKWKLVDPRXQWRIFDVK
The lower limit (or the minimum cash balance) could be from zero to any number
deemed to be the minimum cash amount. The upper limit is the point at which the cash
balance is more than sufficient and part of the cash should be invested. If the distance
between the lower limit and the upper limit is defined as the spread, then Upper Limit
= Lower Limit + Spread, and the spread can be derived from the following equation.
CASH MANAGEMENT 103
1/3
⎛ 0.75 × B × V ⎞
Spread = 3 × ⎜ ⎟
⎝ I ⎠
B is the transaction cost. V is the variance of daily net cash flow. I is the daily inter-
est rate. ( )1/3 is the cube root for the arithmetic in the ( ). The transaction cost (B) is
the cost per transaction to convert cash to securities or vice versa. If a broker is hired,
the commission (brokerage) should be included in the transaction cost. Rather than
hiring an external broker, an organization could choose to manage its cash internally
by using its own personnel, and then the transaction cost is the cost associated with the
hire and use of these people. The daily interest rate (I) is the daily rate of return on an
investment. In public organizations, where safety is a major concern for investment,
the interest rate for US treasury bills, one of the safest investment choices, can be used.
The variance of daily net cash flow (V) is used to measure the fluctuation of the
cash balance. A larger value of V indicates that a cash flow fluctuates more. It can be
calculated by using daily net cash flow (Daily Receipts – Daily Disbursements) for a
selected number of days (e.g., 100 days), and by computing the variance of the cash
flow for these days. It is important to note that the selection of these days should reflect
the true fluctuation of cash flows for an organization at a given time (e.g., a year). If
the organization has different patterns of cash flows in different seasons of a year, then
the days selected should include days in different seasons. Let us first look at a simple
example to illustrate what the variance is, and then use Excel in the calculation. Let
us say that, during the past five days, we have a series of net cash flows of $10.00 in
Day 1, $20.00 in Day 2, –$5.00 in Day 3, $7.00 in Day 4, and –$10.00 in Day 5. The
five-day average is ($10.00 + $20.00 – $5.00 + $7.00 – $10.00)/5 = $4.40. Table 8.4
includes the statistics needed to compute the variance.
Table 8.4
An Example of Computing Variance of Daily Net Cash Flow
Net cash flow ($) Average Difference Difference Squared

Day (1) (2) (3) = (1) – (2) Square of (3)
1 10.00 4.40 5.60 31.36
2 20.00 4.40 15.60 243.36
3 –5.00 4.40 –9.40 88.36
4 7.00 4.40 2.60 6.76
5 –10.00 4.40 –14.40 207.36
The total of the difference squared is 31.36 + 243.36 + 88.36 + 6.76 + 207.36 =
$577.20. Variance is $577.20/4 = $144.30, where 4 is the number of days minus 1
(i.e., 5 – 1). Statisticians use the following formula to compute the variance.
n
∑( X i −+
μ )2
VV== i =1
( n − 1)
Excel Screen 8.1 Calculating Variance of Net Cash Flow
Xi represents individual cases (like $10.00, $20.00, . . . , in the example), where i is

the representation of the individual case number. For example, X1 is individual Case
1; X2 is individual Case 2. μ is the average. In our example, it is $4.40. So (Xi – μ) is
the difference between an individual case and the average. is the summation sign
used to calculate the sum of (Xi – μ)2, which is $577.20 in this example. Finally, n
is the number of cases. The variance can be easily calculated from the Excel Insert
Function (fx).
Select “Statistical” in the function category window and choose “VAR” (variance)
in the function window. Click the “OK” button. Select the numbers for the calculation.
The calculation process is shown in Excel Screen 8.1. Notice that we have only five
cases in this example. If you have large databases, you may want to run the Excel
VAR function from an Excel datasheet as shown in Excel Screen 8.2. Notice that the
numbers are selected in “Number 1” from Cell 1 to Cell 5 in Column A (i.e., A1:A5
in the screen). The variance (144.3) is shown in “Formula result.”
Use the data in Table 8.4 to practice the Excel VAR process. You should be able to
obtain the variance 144.3. To make cash balance decisions, you also need the return
point, which is the cash balance point that indicates the amount of the transfer.
Return Point = Lower Limit + (Spread/3)
The decision rules in the Miller-Orr model are: (1) No transaction is needed if the
cash balance falls between the lower limit and the upper limit. (2) If the cash balance
CASH MANAGEMENT 105
Excel Screen 8.2 Calculating Variance from a Datasheet
rises to the upper limit, invest cash by the amount of Upper Limit – Return Point. (3)
If the cash balance falls to the lower limit, sell investments by the amount of Return
Point – Lower Limit to replenish cash. (Review Figure 8.1 to visualize this decision-
making process.)
Let us look at an example. Suppose that an agency has a minimum cash balance of
$20,000 (lower limit) required by its bank. Suppose that the variance of daily net cash
flows is $6,250,000, a daily interest rate is 0.025 percent, and the transaction cost is
$20. So, the spread = 3 × (0.75 × 20 × 6,250,000/0.00025)1/3 = $21,600. Lower limit
= $20,000. Upper limit = $20,000 + $21,600 = $41,600. Return point = $20,000 +
($21,600/3) = $27,200.
Thus, the agency does not need to do anything if its cash balance fluctuates between
$20,000 and $41,600. Nevertheless, if the cash balance rises to $41,600, it should
invest the cash in the amount of $41,6000 – $27,2000 = $14,400; if the cash balance
falls to $20,000, it should sell $27,200 – $20,000 = $7,200 of investment instruments
to replenish cash.
A word of caution is warranted here. A cash manager should always use his or her
experience and combine it with a rational way of thinking in determining the optimal
cash balance. The Miller-Orr model provides such a way of thinking, but it should
not replace human judgment based on careful observation of the cash flow history.
Also, the Miller-Orr model should be used on a trial-and-error basis before it can be
fully integrated into a cash management and investment strategy. Finally, it is always
a good practice to modify the strategy by frequently calculating new lower and upper
limits to accommodate changes of cash flows.
A CASE STUDY
William Jackson is the finance director of Riverside, a city of 64,560 residents. The
city experienced tremendous revenue growth during the last decade due to a flourish-
ing local economy and a growing population. However, for the past two years, there
have been signs of a slowdown in revenue growth. On the other hand, the population
growth has already created a large demand for city services. William and his financial
staff are required to explore every possible means to increase revenues. At a recent
Government Finance Officers Association (GFOA) annual conference, William at-
tended a panel in which a speaker talked about various investment strategies used in
local governments across the country.
William has noticed the trend of using the financial market to earn investment in-
comes to offset the impact of the revenue decline. He has long thought about changing
the investment strategies of his own city. Riverside invests its cash in a state invest-
ment pool that meets the cash needs of participating governments. The pool is like
a bank that allows a participating government to borrow. The pool also guarantees
a safe return of the city’s cash with interest. Nevertheless, the interest rate is lower
than a comparable market return. What is unclear is how much more income the city
can make if it decides to use the market instead of the cash pool. Is it worth a try?
To determine a possible market return for the investment of the city’s cash, William
did the following analysis.
STEP 1: DATA COLLECTION AND A REVIEW OF THE DATA

William first forecast cash flows for the next year. His forecast was largely based on
last year’s cash flows with minor modifications due to assumptions of next year’s
financial condition. Table 8.5 presents monthly forecasts of cash receipts, disburse-
ments, and cash balances for the next year.
The data show that the city has an average monthly cash balance of $18,135,904,
an average monthly cash receipt of $2,080,211, an average monthly disbursement
of $1,882,778, and an average monthly net cash flow of $ 2,080,211 – $1,882,778
= $197,433. A closer look at the data shows that cash receipts peak in December,
when the city’s property tax bills are due. Accordingly, the cash balance surges in
January and then decreases every month until the next January. So, more cash should
be available for investment after the New Year, and the amount declines gradually
throughout the year.
CASH MANAGEMENT 107
Table 8.5
Cash Flows and Balances of Riverside ($)
Cash balance Net cash flow in

on the 1st Receipts Disbursements the month
January 22,437,583 1,680,014 3,609,873 –1,929,859
February 20,507,724 1,683,064 818,270 864,794
March 21,372,518 1,113,609 1,828,521 –714,912
April 20,657,606 1,606,122 2,051,595 –445,473
May 20,212,133 1,326,972 986,256 340,716
June 20,552,849 983,573 2,979,870 –1,996,297
July 16,187,359 153,870 1,094,120 –940,250
August 15,247,109 1,254,447 810,883 443,564
September 15,690,673 511,129 629,332 –118,203
October 15,572,470 1,562,141 2,660,760 –1,098,619
November 14,473,851 870,592 625,471 245,121
December 14,718,972 12,216,997 4,498,386 7,718,611
Monthly average 18,135,904 2,080,211 1,882,778 197,433
STEP 2: USE OF THE MILLER-ORR MODEL

But William still needs to know exactly how much cash can be invested. First, he
decided to keep a minimum cash balance of $3,000,000. His reasoning was that the
figure should cover the average monthly withdrawals, $1,882,778, and a minimum
balance of $1,000,000 in a bank for free banking services. This is the lower limit in
the Miller-Orr model, and any balance lower than this is considered too low.
To calculate the variance of daily net cash flow, William first used Excel to determine
the variance of monthly net cash flow, $6,432,190,674,028. Because this is such a
large number, Excel may present 6.43219 E + 12, which means twelve zeros after the
decimal. For calculation purposes, a proximate number, 6,432,190,000,000, can be
used. This is the monthly net cash flow. To get the daily net cash flow, William divided
it by thirty days of a month to arrive at $6,432,190,674,028/30 = $214,406,355,801.
To calculate the interest rate, William weighed the safety of his investment very
heavily, so he chose a short-term rate of federal treasury bills as the benchmark, which
paid an annual interest of 5 percent at the time. The daily interest rate is .05/365 =
0.000137. Also, the city uses an investment broker who charges a $200 fee for each
transaction. According to the Miller-Orr model, the cash spread = 3 × (0.75 × 200 ×
214,406,355,801/0.000137)1/3 = $1,850,649. Therefore, the upper limit is $3,000,000 +
$1,850,649 = $4,850,649. The return point is $3,000,000 + $1,850,649/3 = $3,616,883.
STEP 3: CONDUCTING THE ANALYSIS

Several things became clear to William after the analysis. First, the city does not want
to have a cash balance lower than $3.0 million. However, keeping a balance of about
$4.8 million (the upper limit) appears to be sufficient to meet the cash demand of the
city. The city’s current cash balance, an average of about $18.0 million, is simply too
high. Second, if the city keeps a balance of $4.8 million, it can invest $18.0 million
– $4.8 million = $13.2 million. The current annual interest rate in the state investment
pool is 4 percent. So the annual investment income in the state pool is $13.2 million
× 4 percent = $528,000. In comparison, if the city invests in the federal treasury bills
that pay 5 percent interest annually, it can make $13.2 million × 5 percent = $660,000
annually in interest. That is $660,000 – $528,000 = $132,000 more than the invest-
ment earning in the state cash pool. Third, of course, the above analysis is based on
estimated cash flows that may change. Significant socioeconomic, organizational,
or policy changes could lead to fluctuations in revenues and expenditures and thus
changes in cash flows and cash balances.

Based on the results of the Miller-Orr model and the above analysis, William proposed
the following cash management strategy. First, the city should consider withdrawing
from the state cash pool, or at least gradually reducing its investment in the pool. Sec-
ond, the city should reduce its cash balance to $3,616,883, the return point, and invest
the cash in ninety-day federal treasury bills. If the cash balance reaches $4,850,649,
the city should invest $4,850,649 –$3,616,883 = $1,233,766 in the market (likely in
federal treasury bills); if the cash balance falls below $3,000,000, the city should sell
$3,616,883 – $3,000,000 = $616,883 in investments to obtain needed cash. Finally, the
city should closely monitor the daily cash balance in order to detect possible liquidity
problems. The city should also conduct a thorough review of its cash management
and investment strategy every year.
EXERCISES
1. KEY TERMS
Cash safety
Liquidity
Investment returns
Cash budget
Cash receipts
Cash disbursements
Cash balance
Optimal cash balance
Investment plans
Low-risk investments
Miller-Orr model
Lower limit in the Miller-Orr model
Upper limit in the Miller-Orr model
Spread in the Miller-Orr model
Return point in the Miller-Orr model
CASH MANAGEMENT 109
Transaction cost
Daily interest rate
Net cash flows
Variance of daily net cash flows
Decision rules in the Miller-Orr model
2. DISCUSSION
1. Though it is clear that chasing investment return could hurt a government (e.g.,
the bankruptcy in Orange County, California, in 1994), keeping too much
cash in hand, which happens much more often in local government, is also
detrimental. Discuss the importance of striking a balance between liquidity
and investment return in cash management in government.
2. Discuss how cash management is related to financial investment strategy in
government. What factors should be considered in developing an investment
strategy for a government?
3. Discuss various methods of paying your bills in your personal finances. Do
you pay bills electronically? Do you use various automatic payment meth-
ods? Use this personal experience to discuss pros and cons of various cash
disbursement practices in government.
4. Discuss the goal and benefit of a cash budget.
3. CALCULATIONS
Table 8.6 consists of cash flow data for a selected ten days.
Table 8.6
Cash Flows of Selected Days ($)
Day Receipts Disbursements

1 50 70
2 90 40
3 80 80
4 100 120
5 70 140
6 50 50
7 80 40
8 130 110
9 60 100
10 110 80
1. Calculate the variance of net daily cash flows.

2. Assuming a lower limit of $200, a transaction cost of $10, and an annual in-
terest rate of 10 percent, what is the upper limit and what is the return point
using the Miller-Orr model?
4. CASH MANAGEMENT IN BRIDGETOWN

You are a financial analyst in the Bridgetown Foundation—a public service agency in
Chicago that provides specialized mental care services to the poor. The foundation’s
financial resources are mainly from various state and federal grants and business or
individual donations. In a recent financial audit, an independent auditor suggested the
foundation explore the possibility of investing in the market as an additional revenue
source. You are assigned the responsibility of analyzing the foundation’s cash flows
to determine whether such a possibility exists and, if it does, how much the founda-
tion should invest and what the investment strategy should be. You pull out the cash
flow information for the last three years as shown in Table 8.7.
Table 8.7
Monthly Cash Flows: Bridgetown Foundation ($)
Two years ago Last year Current year

Cash balance (January 1st) 610,000 1,245,000 2,016,770
Receipts 865,000 873,650 871,903
Disbursements 1,050,000 930,000 928,140
Net cash flow, January –185,000 –56,350 –56,237
Cash balance (February 1st) 425,000 1,188,650 1,960,533

Receipts 250,000 250,500 249,999
Disbursements 240,000 240,480 239,999
Net cash flow, February 10,000 10,020 10,000
Cash balance (March 1st) 435,000 1,198,670 1,970,533

Receipts 300,000 303,000 302,394
Disbursements 280,000 282,800 282,234
Net cash flow, March 20,000 20,200 20,160
Cash balance (April 1st) 455,000 1,218,870 1,990,692

Receipts 570,000 575,700 574,549
Disbursements 325,000 328,250 327,594
Net cash flow, April 245,000 247,450 246,955
Cash balance (May 1st) 700,000 1,466,320 2,237,647

Receipts 1,096,000 1,106,960 980,500
Disbursements 320,000 323,200 945,000
Net cash flow, May 776,000 783,760 35,500
Cash balance (June 1st) 1,476,000 2,250,080 2,273,147

Receipts 134,000 135,340 135,069
Disbursements 320,000 323,200 322,554
Net cash flow, June –186,000 –187,860 –187,484
(continued)
CASH MANAGEMENT 111
Table 8.7 (continued)
Two years ago Last year Current year

Cash balance (July 1st) 1,290,000 2,062,220 2,085,663
Receipts 280,000 282,800 282,234
Disbursements 508,000 513,080 512,054
Net cash flow, July –228,000 –230,280 –229,819
Cash balance (August 1st) 1,062,000 1,831,940 1,855,844

Receipts 370,000 373,700 372,953
Disbursements 325,000 328,250 327,594
Net cash flow, August 45,000 45,450 45,359
Cash balance (September 1st) 1,107,000 1,877,390 1,901,203

Receipts 285,000 287,850 287,274
Disbursements 315,000 318,150 317,514
Net cash flow, September –30,000 –30,300 –30,239
Cash balance (October 1st) 1,077,000 1,847,090 1,870,963

Receipts 270,000 272,700 272,155
Disbursements 335,000 338,350 337,673
Net cash flow, October –65,000 –65,650 –65,519
Cash balance (November 1st) 1,012,000 1,781,440 1,805,445

Receipts 892,000 900,920 899,118
Disbursements 320,000 323,200 322,554
Net cash flow, November 572,000 577,720 576,565
Cash balance (December 1st) 1,584,000 2,359,160 2,382,009

Receipts 116,000 117,160 116,926
Disbursements 455,000 459,550 458,631
Net cash flow, December –339,000 –342,390 –341,705
Average monthly
Beginning cash balance 936,083 1,693,903 2,029,204
Receipts 452,333 456,690 445,423
Disbursements 399,417 392,376 443,462
Net cash flow 52,917 64,314 1,961
1. Create a cash budget for the next year. Use the proper forecasting techniques
(from Chapter 1) and defend your reasoning for your choice of technique.
2. Assuming a lower limit of $1,000,000, a transaction fee of $200, and a 5
percent annual interest rate, use the Miller-Orr model to determine the upper
limit and the return point of the cash balance.
3. Do you see any investment opportunities for the foundation’s cash? If yes,
develop an investment strategy for the foundation.
5. REVIEW GFOA’S BEST PRACTICE RECOMMENDATIONS ON CASH FLOW FORECASTING

In recognizing the need for cash flow forecasting, the Government Finance Officers
Association (GFOA) recommends that state and local governments consider the fol-
lowing in cash flow forecasting:
1. All operating departments should be involved in developing reasonable ex-

pectations of timing and amounts of planned expenditures. This ensures all
possible outflows of resources are measured and, if necessary, prioritized.
Forecast time frames should accurately reflect the cash transactions of the
organization.
2. The organization’s goals should drive the prioritization of expenditures.
Further, fixed items such as payroll, employee benefits, insurance, and debt
service should have priority of cash demand over discretionary expenditures.
3. Historical data should be used to measure activity of a cyclical nature, both
for receipts and disbursements. A well-established base of financial activity
predicated on historical data enables the cash forecaster to anticipate disburse-
ments and receipts. This activity should be verified by the operating department
for its likely recurrence. Analytical software can be used to maintain histori-
cal data and provide an enhanced ability to forecast future liquidity needs.
Analytical software can also enhance the organization’s ability to perform
statistical analysis to compare the forecast to actual activity.
4. A forecast for receipts should include expected inflows and investment maturi-
ties. Inflows include payments such as property taxes, utility payments, and
user fees. Maturities include all items held in investments that will mature
during the forecast time frame.
5. A forecast for disbursements should include regular expenditures, such as
payroll, and recognize nonrepetitive expenditures. Historical data can assist
in forecasting disbursements.
6. Cash flow forecasts should be used to recognize the factors that influence
the organization’s cash position. Organizations should develop strategies to
implement effective and efficient cash management techniques such as col-
lecting receipts as soon as possible and managing disbursements judiciously.
7. Forecasts should be made conservatively. Fluctuations may occur in both
receipts and disbursements for a variety of reasons. The level of precision
required in a forecast or tolerance for variance should be determined at the
organizational level and not on an ad hoc basis.
8. Forecasts should be updated on a regular basis, for example, monthly. The
frequency of such updates is determined by the volatility of revenues and
expenditures. Daily monitoring and recording of actual revenues and expen-
ditures by major categories can greatly enhance the organization’s ability to
prepare timely updates to the cash flow forecast.
Incorporate the above recommendations in developing a cash management strategy

for a government of your choice.
PART III
TOOLS FOR FINANCIAL

REPORTING AND ANALYSIS
9 Financial Reporting and Analysis
The Statement of Net Assets and the
Statement of Net Position
LEARNING OBJECTIVES
s 5NDERSTAND KEY ELEMENTS IN THE STATEMENT OF NET ASSETS AND THE STATEMENT OF NET
position
s 5NDERSTAND THE ACCOUNTING PROCESS
s 5SE THE INFORMATION IN THE STATEMENT OF NET ASSETS AND THE STATEMENT OF NET POSI-
tion in financial analysis
Why care about financial information? There are two fundamental reasons for a
manager to obtain and understand financial information. One is to use the information
to make managerial and operational decisions. The manager can better plan, manage,
and evaluate a service if he or she knows how much it costs, and that information can
be obtained from the financial reporting system. Another reason is to demonstrate
accountability by keeping stakeholders informed about the financial condition and
operation of the organization. Stakeholders in government organizations include citi-
zens, elected officials, other governments, nonprofit organizations, and businesses.
They have vital interests in government finances as taxpayers, oversight bodies,
evaluators, or contractors of governmental services. A manager has a responsibility
to answer their questions about the organization’s finances.
How is financial information reported? When a close friend asks you how you are
doing financially, how do you respond? There are two ways to tell a financial story.
You can reveal how much you earn, but that is not a complete financial picture, be-
cause you also spend. If you make $50,000 and spend $50,000, you save nothing. If
you spend $45,000 instead, you save $5,000. So another way to report your finances
is to use net worth. In the above example, where does the $5,000 in savings go? It
The statement of net assets was replaced by the statement of net position in 2012 for state and local
governments in the United States. This chapter introduces both statements but focuses on the latter.
115
116 TOOLS FOR FINANCIAL REPORTING AND ANALYSIS
goes to your net worth. We use the term net worth to measure what you possess or
own after taking out what you owe. Say that you have a house, some furniture, a car,
a retirement account, a bank checking account, and some cash for a total of $200,000.
Your bills include a mortgage, a car loan, and other payments totaling $160,000. Your
net worth is $200,000 – $160,000 = $40,000.
In finance, net worth is often called net assets. Assets are what you own, and li-
abilities are what you owe. The financial statement prepared to disclose these financial
figures is generally called the balance sheet. In US state and local governments, the
balance sheet information for a government as a whole (i.e., government-wide) is
reported in the statement of net assets (before 2012) or the statement of net position
(after 2012). The financial statement used to report annual revenues and expenses for
a government as a whole is the statement of activities. We focus on the statement of
net assets (net position) in this chapter and the statement of activities in Chapter 10.

WHAT INFORMATION IS IN THE STATEMENT OF NET ASSETS?
Obviously, what you own minus what you owe is what is left. In accounting language,
“what you own” is called assets, “what you owe” is liabilities, and “what is left” is
net assets, so
Assets – Liabilities = Net Assets

or
Assets = Liabilities + Net Assets
This is the fundamental accounting equation. This equation is true regardless of

the types of financial transactions that occur. Your assets are always equal to the sum
of your liabilities and net assets. If they are not equal, an error(s) must have occurred
in your accounting or reporting practices or calculation processes.
More formally, assets are defined as economic resources available and liabilities are
amounts owed to outside entities or employees. It is important to note that the terms
assets and liabilities are used as accounting concepts here, not in any other way. For
example, we often say a good reputation is an “asset” to an organization and a bad
reputation is a “liability.” But they are not accounting definitions. What types of assets
does a government have? Assets can be broken down into current assets and noncur-
rent assets. In general, current assets are cash, cash equivalents, or resources that can
be converted to cash within a year or that will be consumed within a year. Noncurrent
assets are long-term assets or fixed assets such as land, buildings, infrastructures,
equipment, and long-term investments over a year. Note that a year is used as a divi-
sion of assets into current and noncurrent assets because it represents the length of a
fiscal and operational cycle in many governmental organizations. Noncurrent assets
may also include assets designated for specific purposes so they are not available for
immediate and general use. The following is a list of common asset accounts.
FINANCIAL REPORTING AND ANALYSIS 117
s Cash or cash equivalents. This category may include bank savings and checking
accounts, short-term certificates of deposit, and other assets that can be converted
to cash quickly and easily.
s Investments. This category includes marketable securities such as stocks and
bonds, real estate, and other investment vehicles.
s Accounts receivable. When an organization has provided a product or a service
to a citizen or a customer and has not received the payment, the amount is re-
ported as receivable, which suggests that the payment will be collected in the
future. There can be many types of receivables. Examples include property taxes
receivable and interest and penalty receivable.
s Inventory. This category is for the materials and supplies that will be used in
producing goods or services.
s Restricted cash and cash equivalents. These resources may be reported as noncurrent
assets. They are monies designated for specific purposes and therefore not available
for immediate and general use by the government. Restricted cash can be used for a
range of purposes such as loan repayment, equipment purchase, or investment.
s Capital (or long-term assets or fixed) assets. These noncurrent assets are often
in the form of land, buildings, infrastructure, and equipment. Long-term assets
or fixed assets cannot be easily converted to cash. They are often compared with
current assets, which are sometimes called liquid assets.
Liabilities represent the financial obligations of an organization. Organizations

typically have liabilities that will require payments to suppliers, employees, finan-
cial institutions, bondholders, and other governments. Like assets, a liability can be
classified as a current liability or noncurrent liability. Current liabilities will be paid
within a short time, often a year, while noncurrent liabilities are due beyond a year
(or a fiscal and operational cycle). Some common liability accounts are as follows.
s Accounts payable. These accounts show the amount an organization owes others.
There are various payable accounts, such as wage payable, interest payable, or
claims payable, etc.
s Long-term debt (obligations). This could include an organization’s long-term
loans or leases. Long-term obligations can be reported as current liability (due
within one year) or noncurrent liability (due in more than one year).
If an organization has more assets than liabilities, it has a positive figure in net
assets. Net assets can be restricted or unrestricted. Restricted net assets are net as-
sets whose use has been restricted for specified purposes or for the time of use. For
example, net assets could be restricted for the purposes of paying debts. Unrestricted
net assets are net assets whose use has not been restricted.
WHAT INFORMATION IS IN THE STATEMENT OF NET POSITION?

The statement of net assets was prepared by state and local governments in the United
States before 2012. It has since been replaced by the statement of net position to
reflect the increasing need to report resources related to future years in government. In
accounting, the reporting of assets and reliabilities is related to a particular reporting
period. Oftentimes, the reporting period is the current fiscal year. Nevertheless there
are cases in which the reporting involves future years; for example, if a city govern-
ment and a private company enter into an agreement that allows the company to pay
the city $5 million in cash now for the right to collect solid waste in the city for the
next five years. Because it is a five-year contract, in general, only $1 million should
be reported as the revenue for the city for this current fiscal year. The balance of $4
million should be reported as the revenue for the future years.
To capture the resources related to future years, state and local governments in the
United States have been required to use two accounting concepts since 2012, deferred
inflows and deferred outflows, in the way that
Assets + Deferred Outflows of Resources =

Liabilities + Deferred Inflows of Resources + Net Position
or
(Assets + Deferred Outflows of Resources) – (Liabilities + Deferred Inflows

of Resources) = Net Position
Assets and liabilities are still included in the statement of net position, but the term
“net assets” is replaced by “net position” to reflect reporting deferred outflows and
inflows. Deferred outflow of resources is consumption of net assets that is applicable
to a future reporting period instead of the current period. It has a positive effect on net
position so it is reported with assets in the first equation. Deferred inflow of resources
is an acquisition of net assets that is applicable to a future reporting period instead
of the current period. It has a negative effect on net position so it is reported with li-
abilities in the equation (see further explanation of these two terms in the Glossary).
In US state and local governments, the difference between assets (plus deferred
outflows of resources) and liabilities (plus deferred inflows of resources) is called net
position (post-2012). Like net assets, net position can be restricted or unrestricted. The
net position information can be found in the statement of net position—the first financial
statement in the CAFR in state and local governments in the United States. Table 9.1
presents an example of that statement for the hypothetical city of Evergreen, Florida.
It should be noted that, in reporting net position, state and local governments are
asked to specify the net value of capital investment in addition to restricted and un-
restricted net positions. This item can be called net investment in capital assets. As
an example from personal finance, for those who borrow to purchase a capital item
(e.g., a house), it is the net value of the item after deducting the loan amount.
THE ACCOUNTING PROCESS

Where does the information in the statement of net assets (net position) come
from? Accounting is the process by which financial data are recorded, pro-
Table 9.1
Statement of Net Position: City of Evergreen, Florida,

for the Year Ending December 31, 20x4 ($)
Assets
Current assets
Cash 1,500,000
Accounts receivable 560,000
Inventory 690,000
Total current assets 2,750,000
Fixed assets
Land 3,000,000
Equipment, net 2,000,000
Total fixed assets 5,000,000
Total assets 7,750,000
Deferred outflows of resources 0
Total assets + deferred outflows 7,750,000
Liabilities
Current liabilities
Accounts payable 3,000,000
Wages payable 1,300,000
Total current liabilities 4,300,000
Long-term liabilities
Bonds payable 1,000,000
Total liabilities 5,300,000
Deferred inflows of resources 0
Net position
Net investment in capital assets 1,000,000

Unrestricted 500,000
Restricted 950,000
Total net position 2,450,000
Total liabilities + deferred inflows + net position 7,750,000

cessed, and reported. In an accounting cycle, the raw financial information is ob-
tained and processed to be reported in the final statements. There are four phases in
an accounting cycle, and each phase represents a step to ensure the information is
accurately recorded and presented, so adherence to the accounting cycle is a means
to ensure financial accountability.
Below are the phases in an accounting cycle:
Evidence of Transactions A The Accounting Journal A

The Accounting Ledger A Financial Statements and Reports
Evidence of transactions can be receipts of purchases, payments, purchase orders,

or anything that indicates that a transaction has occurred. These pieces of evidence
are reported by either the accounting department or user departments for initial entries
in the accounting system. An accounting journal is simply a chronological listing of
every financial event (transaction) that has occurred in an organization. It is similar
to a diary in that events are listed in the order they occur and as concurrently as pos-
sible. A journal entry often includes the transaction description, transaction dates,
related accounts, transaction amounts, and a reference number. Figure 9.1 illustrates
the accounting journal record for a transaction in which the city of Evergreen paid
its December 20x4 salaries, totaling $50,000, on January 1, 20x5.
Figure 9.1 Example of an Accounting Journal
City of Evergreen General Journal, 20x5
Reference Transaction Description Account Debits Credits

number
001(1/1/20x5) Pay salaries $50,000 Wages payable $50,000
Cash $50,000
002(1/1/20x5) ... ... ... ... ...
... ... ... ... ... ...
Note: “. . .” represents information of any possible transactions.
Notice that two accounts, wages payable and cash, are used to record this transac-
tion. In fact, every accounting transaction must be recorded in at least two accounts.
This accounting practice is called double-entry accounting. It is one way to ensure
reporting trueness and accuracy.
Another accounting practice in recording transactions is the use of debit and credit
balances. Use of debits and credits ensures that transactions are reported in such a
fashion that they can be traced and checked according to the following equation.
Amount Debited = Amount Credited

Figure 9.2 Example of an Accounting Ledger
City of Evergreen General Ledger, 20x5
Account 101: Cash

reference number Debits Credits Balance
Balance 12/31/20x4 $1,500,000
001 (1/1/20x5) $50,000 $1,450,000
002 . . .
003 . . .
...
...
Note: “. . .” represents the related information of other transactions.
Figure 9.3 The Accounting Equation with a Transaction
Assets = Liabilities + Net Assets

Cash Wages Payable
–$50,000 –$50,000
The accounting rules of reporting transactions with debits and credits are: asset
accounts are increased by debits and decreased by credits; liability and net asset (net
position) accounts are increased by credits and decreased by debits. In the above
example, cash is an asset account. It decreases by $50,000 because cash was used to
pay the salaries. So it is credited by $50,000. Wages payable is a liability account. It
decreases by $50,000 because the amount owed for salaries decreases. Therefore, we
record it on the debit side. As you may have noticed, the amount debited ($50,000)
is equal to the amount credited ($50,000) in this example.
The next phase in the accounting cycle is the use of the general ledger. A ledger is
used to summarize and accumulate the transaction information. Unlike a journal, which
is organized by dates of transactions, a ledger is arranged by account. For example,
we could summarize all transaction information concerning cash under a cash ledger
account. A ledger account typically contains an account name, transaction dates, transac-
tion reference numbers, debit amounts, credit amounts, and balances. Figure 9.2 shows
elements of a general ledger account with the information from the Evergreen example.
The last phase in the accounting cycle is to present the financial information in a
set of financial statements, including the statement of net assets (net position). Re-
member that the accounting equation is always true for any transaction. Figure 9.3
demonstrates this with the transaction in the Evergreen example. Notice that both
sides of the equation decrease by $50,000, so the equation still holds true. All other
transactions are recorded in a similar way, and they are summarized and reported in
financial statements.
PRINCIPLES THAT GOVERN ACCOUNTING PRACTICES

Accounting practices involve recording and reporting financial information. These
practices rely on accounting principles for guidance and standardization. Just like traffic
signals are the same in all US cities, uniform accounting principles regulate ways that
financial transactions are recorded and reported. The Financial Accounting Standards
Board (FASB) and the Governmental Accounting Standards Board (GASB) develop
so-called Generally Accepted Accounting Principles or GAAPs. The FASB establishes
accounting and reporting standards for not-for-profit and for-profit organizations, and
accounting and reporting standards for state and local governments are established by
the GASB. GAAPs are conventions or rules in financial accounting and reporting. Here
is a brief discussion of some GAAPs related to state and local governments.
Who reports? A reporting entity should be determined in any financial reporting.
A primary government is defined as a state or local government that has a separate
elected governing body and is fiscally independent of other state or local governments.
Governments also use the term component units for the entities that are legally separate
from the primary government but have close financial or governing relationships with
the primary government. Examples of component units include public universities,
housing authorities, and retirement systems.
The concept of monetary denominator refers to the fact that all actions that have
a financial element must be monetized. Land and inventories need to be converted to
monetary terms. There is a preference to use objective evidence rather than subjec-
tive estimation in financial reporting. The cost convention refers to the practice that
assets should be valued at their cost at the time of acquisition unless another rule
governs the valuation of the assets. The concept of conservatism concerns the need
to consider risk in collecting revenues and the fact that less than 100 percent of them
can be collected. The going concern concept refers to the assumption that the report-
ing entity is going to continue in business for the foreseeable future. The principle
of materiality requires that an auditor report significant (material) reporting errors.
Finally, the accrual concept requires that organizations recognize all economic and
financial transactions as they report their financial positions and operations. That is,
revenues are recorded at the time goods and services are provided regardless of when
the payment is received; expenditures are recorded at the time that assets have been
consumed or liabilities incurred in the process of providing goods and services. We
will come back to this concept in more detail in the next chapter.
A CASE STUDY
Joe Klein is the city manager of Evergreen in Heaven County, Florida, a city that
serves about 5,000 residents. Joe was hired early this year when the previous city
manager retired. The city has a police department, a parks and recreation department,
a public works department, a local library, and an administrative department. It relies
on the county for other local services such as fire protection, code enforcement, and
health and human services.
The financial division in the administrative department prepares the city’s CAFR. In
Table 9.2
Asset and Liability Allocations: City of Evergreen, Florida,

as of December 31, 20x4
Dollars Percent
Assets
Current assets
Cash 1,500,000 19.4
Accounts receivable 560,000 7.2
Inventory 690,000 8.9
Total current assets 2,750,000 35.5
Fixed assets
Land 3,000,000 38.7
Equipment, net 2,000,000 25.8
Total fixed assets 5,000,000 64.5
Total assets 7,750,000 100.0
Deferred outflows of resources 0 0
Assets + deferred outflows 7,750,000 100.0
Liabilities
Current liabilities
Accounts payable 3,000,000 38.7
Wages payable 1,300,000 16.8
Total current liabilities 4,300,000 55.5
Bonds payable 1,000,000 12.9
Total liabilities 5,300,000 68.4
Deferred inflows of resource 0 0
Net position
Net investment in capital assets 1,000,000 12.9
Unrestricted 500,000 6.5
Restricted 950,000 12.2
Total net position 2,450,000 31.6
Total liabilities + deferred inflows +

net position 7,750,000 100.0
the past, the previous city manager never bothered to read the document. He claimed
that the CAFR was too long, included too many numbers, and confused, rather than
helped, him. When he had a financial question, he called the finance director.
Joe is a firm believer that financial management is at the center of governance, and
that good financial management practices ensure the efficient use of resources and
provide a solid foundation for quality services. He is reluctant to rely completely on
financial personnel for interpretations of the financial information. He believes that his
Table 9.3
Statement of Net Position Comparison: City of Evergreen ($)
12/31/20x4 12/31/20x3
Assets
Current assets
Cash 1,500,000 2,000,000
Accounts receivable 560,000 300,000
Inventory 690,000 250,000
Total current assets 2,750,000 2,550,000
Fixed assets
Land 3,000,000 3,000,000
Equipment, net 2,000,000 2,500,000
Total fixed assets 5,000,000 5,500,000
Total assets7,750,000 8,050,000
Deferred Outflows of Resources 0 0
Total assets + deferred outflows 7,750,000 8,050,000
Liabilities
Liabilities
Current liabilities
Accounts payable 3,000,000 3,000,000
Wages payable 1,300,000 1,050,000
Total current liabilities 4,300,000 4,050,000
Bonds payable 1,000,000 1,500,000
Total liabilities 5,300,000 5,550,000
Deferred Inflows of Resources 0 0
Net Position
Net investment in capital assets 1,000,000 1,000,000
Unrestricted 500,000 1,000,000
Restricted 950,000 500,000
Total net position 2,450,000 2,500,000
Total liabilities + deferred inflows +

net position 7,750,000 8,050,000
own analysis may tell a different story and that, with a solid knowledge of the city’s
finances, he will have a better idea about how to improve the city’s services. To do
his analysis, he first reviewed the Management Discussion and Analysis (MD&A) in
the CAFR, and then pulled out the city’s statement of net position from the CAFR.
His analysis consisted of several simple steps.
STEP 1: REVIEWING AND ANALYZING THIS YEAR’S STATEMENT OF NET POSITION

First, Joe calculated the percentage for each asset category in total assets as shown
in Table 9.2 (notice that deferred outflows and inflows are zeros so they do not have
any effect in this analysis). By doing this, he found that 19.4 percent of total assets
were in cash and 35.5 percent were current assets. These numbers gave him an idea
of what assets were available. He also did the same calculation for liabilities and net
position. He found that liabilities took up a very high percentage (68.4 percent) of
total liabilities and net position, which might be a warning sign that the city’s level
of liabilities is too high. He was also concerned that a large amount of net position
was restricted (12.2 percent). To better understand the meaning of these numbers, Joe
compared them with the numbers from the previous year.
STEP 2: COMPARING WITH LAST YEAR’S STATEMENT

The comparison in Table 9.3 shows a few changes from the previous year that caused
Joe concern. He wrote them down in a note and planned to discuss them with the
finance director.
On assets:
s #ASH DECREASED FROM THE PREVIOUS YEAR BY $OES IT POSE A LIQUIDITY
problem?
s )NVENTORY INCREASED SHARPLY FROM TO A WHOPPING
– $250,000)/ = 176 percent! What has happened? Should we do an inventory
analysis?
s 4HE VALUE OF NET EQUIPMENT DECREASED FROM TO $OES THIS
mean our equipment is aged and needs replacement soon? If so, how soon?
s 4OTAL ASSETS DECREASED FROM TO A PERCENT DECLINE
We should look at more data to see if there is a trend of total asset decline.
On liabilities and net position:
s 4HERE WAS AN INCREASE IN RESTRICTED NET POSITION FROM TO !S
the use of this net position is restricted, an increase indicates less flexibility for
the city to use this resource.
s 5NRESTRICTED NET POSITION DECREASED FROM TO )S THERE ANY
indication that this decrease reflects a trend?
s 4HERE IS A DECREASE IN NET POSITION FROM TO !
closer examination of the causes of this decline is warranted.
STEP 3: SEARCHING FOR SOLUTIONS AND TAKING ACTIONS

Joe then reviewed the CAFR to see whether his above questions were addressed. In
the MD&A, the finance director attributed the total asset decline mainly to the de-
preciation of equipment. Nevertheless, none of Joe’s other concerns was addressed

in the analysis. He picked up the phone to call the finance director.
EXERCISES
1. KEY TERMS
Net worth
Balance sheet
Statement of net assets
Statement of net position
Statement of activities
Fundamental accounting equation
Assets
Liabilities
Net assets
Net position
Current assets
Noncurrent assets
Cash or cash equivalents
Investments
Accounts receivable
Inventory
Prepaid expenses
Long-term assets or fixed assets
Current liabilities
Noncurrent liabilities
Accounts payable
Long-term debt
Deferred outflows of resources
Deferred inflows of resources
Restricted net assets (position)
Unrestricted net assets (position)
Net investment in capital assets
Accounting cycle
Accounting journal
Accounting ledger
Double-entry accounting
Debit and credit
Primary government
Component units
Monetary denominator
Objective evidence
Cost convention
Conservatism
Going concern
Materiality
Accrual basis accounting
2. DISCUSSION
1. The best way to learn the balance sheet is to create one. Build a balance sheet
for you or your family. Describe the process of defining and estimating your
assets, liabilities, and net wealth. Discuss the need to track your net wealth
over time.
2. State and local governments use a large number of accounts in their balance
sheets. Sample the statements of net assets (net positions) for ten cities or
counties to determine popular accounts used by these governments. Discuss
the types of accounts (whether they are assets, liabilities, or net assets ac-
counts) and the financial transactions they handle.
3. What does the term “financial accountability” mean to you in your personal
finance? What does it mean in government? How is financial accountability
served by the accounting process?
4. There are two important financial documents in government: budgets and
financial reports (e.g., CAFRs in US state and local governments). Can you
identify some of the key differences between them in management?
5. It is generally perceived that financial reports are used less often than budgets
by government stakeholders (e.g., the public, elected officials, researchers
etc.). Discuss possible reasons for underuse and propose some solutions for
increasing their use.
3. FINANCIAL ANALYSIS OF THE CAFR

Obtain the CAFRs for the three most recent years of a government. Refer to the state-
ment of net assets (net position) to conduct an analysis of assets, liabilities, and net
assets (net position) to identify any changes that cause concern about the financial
condition of the government.
10 Financial Reporting and Analysis
Statement of Activities
LEARNING OBJECTIVES
s 5NDERSTAND KEY ELEMENTS IN THE STATEMENT OF ACTIVITIES

s 5NDERSTAND THE CONCEPT OF ACCOUNTING BASIS
s !PPLY THE INFORMATION IN THE STATEMENT OF ACTIVITIES IN lNANCIAL ANALYSES
In Chapter 9, we learned how to evaluate an organization’s finance by examining

its assets, liabilities, and net assets (net position). Now we discuss another aspect of
finance—revenues and expenses. What is the relationship between net assets and
revenues/expenses? Think of your personal finances. If your revenues are larger than
your expenses (i.e., you save) for a long time, you will accumulate a large amount of
wealth over time. Net assets are cumulative wealth, while the revenue and expense
information represents financial performance over a particular time period. A combina-
tion of both net asset and revenue/expense information provides a relatively complete
picture of an organization’s finances.

The financial statement that presents revenues and expenses is called the statement
of activities in US state and local governments (or, the statement of operations, the
income statement in many business organizations). Like the statement of net assets
(net position), the statement of activities presents the financial information for a gov-
ernment as a whole. Fund-level financial information (Chapter 11) is not presented in
the statement of net assets or the statement of activities. It is included in the fund-level
financial statements, such as the balance sheet of governmental funds. The following
section presents the key elements in the statement of activities and the accounting
bases on which this statement is prepared.
128
STATEMENT OF ACTIVITIES 129
WHAT INFORMATION IS IN THE STATEMENT OF ACTIVITIES?

Expenses
First, expenses are classified and presented by functions or programs. For example, a
city can present expenses in the major service functions of public safety, transporta-
tion, education, health, and human services. Or it can choose to present expenses in
a more detailed fashion. Public safety can be further broken down into police, fire
protection, emergency rescue, corrections, and so forth. How detailed the presenta-
tion is depends on the needs of the user and the cost of data collection. In general,
expenses for different types of services should be presented. If a government also
provides business-type services, such as water/sewer services and utility provision,
then the expenses of these services should be presented separately from governmental
activities. This separation is necessary because the expenses of business-type activi-
ties can be offset by the revenues generated from these activities, and such breakeven
is not possible in most governmental activities. Additionally, if a government has
component units, the expenses of component units should be presented in a separate
column from expenses of the primary government.
If a government allocates overhead expenses, interest expenses, and other indirect
expenses to direct services, it can also present the allocated expenses in a separate
column. Direct services are those provided to customers, residents, or clients outside
the government. For example, a police department provides services directly to resi-
dents, while a vehicle maintenance division of the government offers services only to
other departments within the government. The expenses in the vehicle maintenance
division are indirect expenses and can be allocated to direct services.
Table 10.1 shows how expense information can be presented. Only primary gov-
ernment expenses are shown. The percentage of each expense of the total is also
presented. Realize that the percentage information is not reported in the actual state-
ment of activities; you will have to calculate it by yourself.
The table shows that the largest expense item is public safety, which accounts for
almost half of the total expenses. A distant second is the 14.0 percent spent on trans-
portation, while 13.4 percent is spent on general government, which is mainly the cost
of general management, planning, personnel management, and financial management.
Governmental activities make up 84.7 percent of spending, and 15.3 percent is spent
on business-type activities. The percentage information is more useful when compared
with percentages from past years. Percentage changes can be identified and analyzed
in a historical context to demonstrate trends in spending patterns.
Revenues
The sources of revenue are presented in the statement. In governments, revenue sources
include taxes, fees and charges, grants, investment earnings, and other revenue sources.
In general, revenue sources can be classified into two categories: program revenues
and general revenues. Revenues generated through specific functions or programs
are called program revenues. For example, a city Clerk’s Office could charge a fee
Table 10.1
Expenses in the Statement of Activities: City of Evergreen, Florida, for

the Year Ending December 31, 20x4
Function/Program Expenses ($) Percentage

Governmental activities
General government 420,000 13.4
Public safety 1,500,000 47.7
Transportation 440,000 14.0
Health and human services 300,000 9.6
Total 2,660,000 84.7
Business-type activities
Water 150,000 4.8
Sewer 210,000 6.7
Parking 120,000 3.8
Total 480,000 15.3
Total primary government 3,140,000 100.0
for providing a copy of a record or document. Since the Clerk’s Office performs a
general government function, this fee should be presented as program revenue for the
general government. Another example of program revenues is a grant contributed to
a specified program or function. A grant designated for public safety is an example.
It should be presented as program revenue for public safety. The difference between
expenses and program revenues is net (expenses) revenues. Table 10.2 shows the
presentation of net (expenses) revenues.
It should not be a surprise that governmental activities have a net expense of $2,268,000,
because these services are “governmental” by nature; that is, they are not designed to
generate net revenues. On the other hand, business-type activities produce net revenues of
$60,000. Among three business-type activities, the parking service is losing money. The
city has a total net expense of $2,208,000, which should be covered by general revenues.
The revenues that are not associated with specific programs or functions are called
general revenues. General revenues include taxes, intergovernmental revenues, grants
and contributions not restricted to specific programs, investment earnings, and mis-
cellaneous revenues. General revenues should also be presented in the statement of
activities. Table 10.3 gives an example of the presentation.
Total general revenues are $2,158,000, and they are $50,000 less than the net ex-
penses of $2,208,000. As general revenues are often the largest revenue sources, it is
useful to identify the major sources of general revenues. In our example, the property
Table 10.2
Expenses, Program Revenues, and Net (Expenses) Revenues in the Statement of
Activities: City of Evergreen, Florida, for the Year Ending December 31, 20x4 ($)
Program Net (expenses)
Expenses revenues revenues
Functions/program (1) (2) (2) – (1)
General government 420,000 140,000 (280,000)
Public safety 1,500,000 53,000 (1,447,000)
Transportation 440,000 49,000 (391,000)
Health and human services 300,000 150,000 (150,000)
Total 2,660,000 392,000 (2,268,000)
Water 150,000 180,000 30,000
Sewer 210,000 300,000 90,000
Parking 120,000 60,000 (60,000)
Total 480,000 540,000 60,000
Total primary government 3,140,000 932,000 (2,208,000)
taxes are $1,250,000/$2,158,000 = 57.9 percent of total general revenues. The revenue
collection effort should be concentrated on this revenue.
If an organization collects revenues from a special source, they should be reported
as a special item. Revenue from the sale of public land is an example. When resources
are transferred from business-type to governmental activities (or vice versa) without
receiving anything in return (i.e., a subsidy), they are called transfers. If an organiza-
tion has revenues generated from special items and transfers, it should present total
general revenues, special items, and transfers in the statement of activities.
Change in Net Assets (Net Position)
The $50,000 difference between general revenues and net expenses is called the change
in net assets (before 2012) or change in net position (after 2012) in US state and local
governments. In fact, the $50,000 is the difference between total revenues (program
revenues and general revenues) and total expenses (i.e., $932,000 + $2,158,000 –
$3,140,000 = -$50,000). Table 10.3 shows this figure and net position at the beginning
and the end of the year. The balance of net position is $2,500,000 at the beginning of
20x4 (see Table 9.3 for the source of this figure). The balance decreases by $50,000
to $2,450,000 at the end of 20x4 as the result of the $50,000 net expenses in opera-
tions. As discussed in Chapter 7 on financial performance monitoring, the change in
net assets (net position) is a measure of financial results. A decline of $50,000 in net
position shows that the city’s financial condition is worse than it was at the beginning
of the year by this measure.
Table 10.3
Expenses, Program Revenues, Net (Expenses) Revenues, and General Revenues

in the Statement of Activities: City of Evergreen, Florida, for the Year Ending December
31, 20x4 ($)
Expenses Program revenues Net (expenses) revenues

Function/Program (1) (2) (2) – (1)

Public safety 1,500,000 53,000 (1,447,000)
Transportation 440,000 49,000 (391,000)
Health and human services 300,000 150,000 (150,000)
Total 2,660,000 392,000 (2,268,000)
Water 150,000 180,000 30,000
Sewer 210,000 300,000 90,000
Parking 120,000 60,000 (60,000)
Total 480,000 540,000 60,000
Total primary government 3,140,000 932,000 (2,208,000)
General revenues
Taxes
Property taxes 1,250,000
Sales taxes 320,000
Franchise taxes 230,000
Grants not restricted for specific programs 260,000
Investment earnings 43,000
Miscellaneous 55,000
Total general revenues 2,158,000
Change in net position (50,000)
Net position—beginning 2,500,000
Net position—ending 2,450,000
ACCOUNTING BASES
Suppose that you are a car dealer and you sold a car for $50,000 today, but the
payment won’t be collected until next year. Do you count the $50,000 as revenue
in this year or next year? If you report the revenue in a period when it occurs,
regardless of the payment status, you are using accrual basis accounting. If you
record the revenue only when you receive the payment, you are using cash basis
accounting. One advantage of accrual basis accounting is that it helps accurately

calculate earnings (or profits) from operations. This is why the private sector uses
accrual basis accounting in its financial reporting. In US state and local govern-
ments, the statement of net assets (net position) and the statement of activities are
prepared on the accrual basis.
However, sometimes, the purpose of financial reporting in government is not to
determine earnings, but rather to reflect whether sufficient financial resources are
collected timely and legally to meet financial responsibilities and whether net finan-
cial resources are available for future use. This is why the modified accrual basis
is used to prepare some fund-level financial statements in governments. According
to the modified accrual basis, revenues are reported as they become available and
measurable, and expenditures are reported as they become legally obligated to be
paid. The following is a summary of different accounting bases for reporting reve-
nues and expenditures.
Accounting Bases for Reporting Revenues
s 4HE CASH BASISTHE REVENUE IS REPORTED WHEN THE CASH PAYMENT IS RECEIVED
s 4HE ACCRUAL BASISTHE REVENUE IS REPORTED WHEN IT IS EARNED
s 4HE MODIlED ACCRUAL BASISTHE REVENUE IS RECORDED WHEN IT IS MEASURABLE
and available. “Available” means that it must be collectible within the year or
shortly after it ends. Sixty days or less after the end of the year is the time period
widely used as a measure of availability. Note that because taxes levied during
a year are expected to be collected within sixty days after the completion of
the year, they are considered to be both measurable and available. Therefore,
except the portion that is not collectible within sixty days after the end of a
fiscal year, taxes levied are considered as revenues under the modified accrual
basis.
Accounting Bases for Reporting Expenses (Expenditures)
s 4HE CASH BASISAN EXPENSE IS RECORDED WHEN THE CASH PAYMENT IS MADE
s 4HE ACCRUAL BASISAN EXPENSE IS INCURRED WHEN RESOURCES HAVE BEEN USED IN THE
process of producing goods or services.
s 4HE MODIlED ACCRUAL BASISAN EXPENSE OCCURS WHEN THE ORGANIZATION BECOMES
legally obligated to pay and that the payment will be made.
A CASE STUDY
In the case study in Chapter 9, Joe Klein used the statement of net position to learn
about the city of Evergreen’s finances. In that case, Joe compiled a list of questions
during his review of the statement, and one question concerned the cause of the
$50,000 net position decline. Since this decline reduced the city’s financial reserve, it
was one of the first concerns to be addressed. To understand what caused the decline,
Joe did the following.
Table 10.4
Comparison of Net (Expenses) Revenues and General Revenues:

City of Evergreen, Florida, for the Year Ending December 31, 20x4
Net (expenses) revenues

Function/Program 12/31/20x4 12/31/20x3
General government (280,000) (260,000)
Public safety (1,447,000) (1,540,000)
Transportation (391,000) (360,000)
Health and human services (150,000) (130,000)
Total (2,268,000) (2,290,000)
Water 30,000 20,000
Sewer 90,000 90,000
Parking (60,000) (30,000)
Total 60,000 80,000
Total primary government (2,208,000) (2,210,000)
General revenues
Taxes
Property taxes 1,250,000 1,240,000
Sales taxes 320,000 330,000
Franchise taxes 230,000 230,000
Grants not restricted 260,000 200,000
Investment earnings 43,000 179,000
Miscellaneous 55,000 51,000
Total general revenues 2,158,000 2,230,000
Change in net position (50,000) 20,000
STEP 1: EXAMINING THE STATEMENT OF ACTIVITIES

Joe first reviewed the city’s revenues and expenses in the statement shown in Table
10.3. In the review, he realized that public safety accounted for 63.8 percent of total
net expenses of governmental activities (i.e., $1,447,000/$2,268,000 = 63.8 percent).
He also realized that the parking service, which should break even as a business-type
activity, lost $60,000. On the revenue side, property taxes accounted for 57.9 percent
of total general revenues (i.e., $1,250,000/$2,158,000 = 57.9 percent), which may
suggest that the city overrelies on this revenue source. Overreliance on any single
revenue source is dangerous, as any decline of the revenue would significantly reduce
the city’s total revenues.
STEP 2: COMPARING WITH LAST YEAR’S STATEMENT

To further understand the cause of the net position decline, Joe compared the statements
of activities for the past two years. The comparison in Table 10.4 indicates that net
expenses changed very little during the period. In fact, net expenses for the primary
government decreased by only $2,000 (i.e., $ 2,208,000 – $2,210,000), although the
increase in the parking net expense was a concern. On the other hand, general reve-
nues declined by $72,000 (i.e., $2,158,000 – $2,230,000). A closer examination of
this decline reveals a dramatic drop of investment earnings by $136,000 (i.e., $43,000
– $179,000). This decrease completely wiped out the revenue increases in grants not
restricted (i.e., $60,000 = $260,000 – $200,000), and in property taxes (i.e., $10,000
= $1,250,000 – $1,240,000).
STEP 3: SEARCHING FOR SOLUTIONS AND TAKING ACTION

Joe suspected that the investment decline was the result of last year’s bond market
meltdown. His suspicion was confirmed by his conversation with the finance director.
The finance director told him that the city’s investment in a state investment pool had
been largely placed in the bond market. On the basis of this analysis, Joe decided to
make the following adjustments. First, he asked for a review of the city’s investment
policies. The review would be conducted by the finance department. The purpose of
the review was to evaluate investment risks and explore potential new ways of invest-
ment. Second, he asked for a forecast of investment return for the next three years and
the potential revenue shortfall as a result of decline in investment incomes. Third, he
told the finance director to develop a strategy to diversify the city’s revenue sources
to avoid possible negative consequences of overreliance on property taxes.
EXERCISES
1. KEY TERMS
Statement of activities
Expenses
Indirect expenses
Direct services
Revenues
Program revenues
General revenues
Net (expenses) revenues
Special items
Transfers
Change in net assets
Change in net position
Accrual basis accounting

Cash basis accounting
Modified accrual basis accounting
2. DISCUSSION
1. Discuss the differences and connections between the statement of net posi-
tion and the statement of activities. Comment on the following remark: “A
combination of both net assets (net position) and revenue/expense information
provides a relatively complete picture of an organization’s finances.”
2. Prepare a statement of activities for you or your family. Describe and discuss
the most challenging aspects of the preparation (classifying expenses and
revenues, tracking them, using the proper accounting basis to report them?).
Decide on the reporting period.
3. State and local governments classify their expenses differently in the state-
ment of activities. Sample statements of activities for ten cities or counties
to determine popular expense classifications. Now, refresh your knowledge
of budgeting reforms in government that require program-based expense (or
cost) information to evaluate effectiveness or outcome of public programs.
Comment on the pros and cons of presenting such program-based information
in the statement of activities.
4. Discuss the pros and cons of using the accrual basis of accounting in prepar-
ing the statement of activities in your personal finance and in government.
3. CAFR
Obtain the CAFRs of a government for the past three years. Refer to the statement
of activities to compare changes in expenses, program revenues, net (expenses) reve-
nues, general revenues, and changes in net assets (net position). Identify any changes
that cause concern.
Financial Reporting and
11 Analysis
Fund-Level Statements
LEARNING OBJECTIVES
s 5NDERSTAND THE USE OF FUNDS IN GOVERNMENTS

s 5NDERSTAND KEY ELEMENTS IN FUND LEVEL STATEMENTS
s 5SE THE INFORMATION IN FUND LEVEL STATEMENTS IN lNANCIAL ANALYSES
Let us say that you are a working professional and you have two bank accounts.
You use a checking account to handle daily expenses and an investment account to
grow your retirement income. Each time you get a check, you split the money into
these two accounts. Why do you use two separate accounts? Because the separation
helps you control, plan, and manage your financial life. Each account serves a different
financial goal and requires different financial strategies and practices in operation. For
example, the purpose of a checking account is the facilitation of daily operations, so
the convenience of banking is necessary. On the other hand, the investment account
is designed to grow income in keeping with your long-term investment strategy.
Similarly, governments have different financial operations. As discussed in previ-
ous chapters, they have operations that support governmental activities, as well as
operations related to business-type activities. Governments may also play the role of
trustees or guardians for certain financial resources. Financial operations of differ-
ent activities have different goals and require different strategies and practices. For
these and other reasons, governments’ financial operations should be accounted for
differently—in separate funds. This is why governments use fund accounting and
reporting. Fund accounting and reporting has a unique advantage. When transactions
of financial resources are accounted for in separate funds, monitoring these transac-
tions becomes relatively easy. So the use of funds serves the ultimate purpose of
financial accountability in the public sector. In last two chapters, we learned about
two government-wide financial statements: the statement of net assets (net position)
137
and the statement of activities. In this chapter, we study the key components of fund-
level financial statements and how to use them in financial analysis.

As introduced in Chapter 7, a fund is a fiscal and accounting entity in which financial
transactions of specific types of activities are recorded and reported. Two conditions
must be met to construct a fund. First, a fund is a fiscal entity in which assets are set
aside for liabilities incurred in supporting specific activities of the fund. A fund reports
its own assets, liabilities, and the fund balance, which is the difference between as-
sets and liabilities. Second, a fund is an accounting entity in which the double-entry
mechanism must be used in recording transactions. The accounting equation for a
fund can be expressed as:
Assets = Liabilities + Fund Balance
Two concepts are important in understanding a fund. One is the accounting basis
discussed in previous chapters. Another is the measurement focus of a fund. The mea-
surement focus refers to the subject of reporting, or what information is expressed in
reporting. Since a fund is an accounting entity, it needs to specify what information
it accounts for. If the accounting and reporting of a fund focuses on net assets, net
position, earnings, or incomes, its measurement focus is the income determination
(or the economic resources measurement). If a fund focuses on the availability of
financial resources to support its financial obligations of providing services, the mea-
surement focus is the current financial resource measurement. In general, funds used
in US state and local governments are classified into several fund types that include
governmental funds, proprietary funds, and fiduciary funds.
GOVERNMENTAL FUNDS
In previous chapters we learned that governments provide public goods and services,
such as public safety and fire protection, as well as business-type activities, such as
power, water, and toll roads. In general, the activities involved in providing public
goods and services are governmental activities. The financial transactions incurred in
supporting governmental activities are accounted for and reported in governmental
funds. As you can imagine, because governments are mainly involved in govern-
mental activities, governmental funds typically track basic and major activities of a
government.
Because governmental funds account for basic activities of a government, they
are concerned with financing these activities on a current basis, and they stress the
availability and accountability of financial resources for current financial obligations.
Therefore, governmental funds use a current financial resource measurement focus,
accounting for financial resources (i.e., cash and other current assets) used in provid-
ing basic government services. Governmental fund statements report current assets
and current liabilities only. Noncurrent assets and liabilities, which are included in
FUND-LEVEL STATEMENTS 139
Table 11.1
Balance Sheet of the General Fund, December 31, 20x4: City of Evergreen ($)
Assets
Cash 225,000
Accounts receivable 84,000
Inventory 0
Total 309,000
Liabilities
Accounts payable 175,000
Due to other funds 70,000
Total 245,000
Fund balance
Reserved 13,000
Unreserved 51,000
Total 64,000
Total liabilities and fund balance 309,000
government-wide statements such as the statement of net assets (net position), are
not reported in governmental fund statements. Governmental funds use the modified
accrual basis of accounting. Revenues are recognized when they become measurable
and available. Expenses are reported when a financial obligation is incurred and pay-
ment will be made from currently available financial resources.
Governmental funds include the general fund, special revenue funds, capital proj-
ect funds, and debt service funds. The general fund accounts for most basic services
provided by a government and most of its daily operations. These services and opera-
tions are often in areas of public safety, transportation, education, human services,
parks and recreation, and general administration. Any activities not accounted for in
any other funds are accounted for in the general fund as well. Special revenue funds
are used to account for resources that are legally restricted for specific identifiable
purposes. For example, a tax on gasoline consumption specifically restricted to
highway construction and maintenance may be accounted for in a special revenue
fund. Special revenue funds are different from the general fund where revenues are
not specifically restricted for certain purposes. Capital project funds are designed to
account for receipts and disbursements of resources used for financing the construc-
tion or purchase of major capital assets. In general, capital project funds should be
used to account for capital projects that are financed through long-term debts or using
accumulated financial resources.
Debt service funds account for the accumulated resources to pay off principal and
interest on debt. The revenues of debt service funds are often in the form of revenues
transferred from the general fund or other funds. Expenditures in debt service funds
are payments of principal and interest on long-term governmental debts.
Table 11.2
Statement of Revenues, Expenditures, and Changes in Fund Balances, the General

Fund, December 31, 20x4: City of Evergreen ($)
Revenues
Property taxes 1,150,000
Sales taxes 320,000
Franchise taxes 230,000
Intergovernmental revenues 300,000
Investment earnings 38,000
Fees and fines 24,000
Total revenues 2,062,000
Expenditures
General government 255,150
Public safety 1,317,500
Transportation 311,850
Health and human services 296,900
Total expenditures 2,181,400
Excess (deficiency) of revenues over expenditures (119,400)
Other financing sources (uses)

Transfer in 200,300
Transfer out (100,000)
Total other financing sources (uses) 100,300
Net change in fund balances (19,100)
Fund balances—beginning 83,100

Fund balances—ending 64,000
In general, there are two financial statements for the governmental funds—the bal-
ance sheet and the statement of revenues, expenditures, and changes in fund balances.
The former contains current assets, current liabilities, and fund balances, while the
latter reports revenues, expenditures, and changes in the fund balances. In US state
and local governments, individual fund statements are often combined by fund types
to save presentation space. Tables 11.1 and 11.2 present examples of statements for
the general fund.
PROPRIETARY FUNDS
In government, financial transactions incurred in providing business-type goods and
services are accounted for in proprietary funds, and reported as such in the financial
statements. Business-type activities are often funded through user charges that are
intended to cover all costs of the activities. As the purpose of most proprietary-type
activities is the determination of net income, proprietary funds use the income deter-
mination measurement focus. Proprietary fund statements are prepared on the accrual
basis, and therefore revenues are reported when earned and expenses are reported
when resources have been consumed in the process of generating revenues.
There are two types of proprietary funds. They are enterprise funds and internal ser-
vice funds. Enterprise funds are used when resources are provided primarily through
the use of service charges to those receiving the benefit, or when a matching of reve-
nues and expenses in a break-even fashion is desired. Internal service funds are used to
account for services provided within a government by one branch to another on a cost
reimbursement basis. For example, an internal service fund can be used for the financial
operations of a government-operated print shop that provides printing services to other
departments or units in the government. The financial statements of proprietary funds in
US state and local governments include the statement of net assets (before 2012) and the
statement of net position (after 2012); the statement of revenues, expenses, and changes
in fund net assets (before 2012) and the statement of revenues, expenses, and changes
in fund net position (after 2012); and the statement of cash flows. The last statement is
used to identify the sources of cash flows and how the cash is used.
FIDUCIARY FUNDS
The fiduciary funds account for resources that the government possesses in a trustee or
agency capacity on behalf of individuals, other governments, or private organizations.
The fiduciary funds cannot be used to support the government’s own programs and
operations. For example, a government can act as a trustee holding assets on behalf
of employees participating in governmental pension plans. A state government can
act as a trustee or agency to collect sales taxes on behalf of local governments. In
general, fiduciary funds use the income determination measurement focus and the
accrual basis of accounting (except for certain pension-related liabilities).
Among fiduciary funds, pension trust funds account for resources held in trust
for employees covered under the government’s retirement pension plans. Agency
funds account for assets held temporarily by a governmental unit as the agent for in-
dividuals, organizations, other funds, or other governmental units. Investment trust
funds account for the assets invested on behalf of other governmental organizations.
Private-purpose trust funds are used to account for all other trust arrangements under
which the principal and income are held for the benefit of individuals, other govern-
ments, and private agencies. The financial statements of fiduciary funds in US state
and local governments include the statement of fiduciary net assets (before 2012)
and the statement of fiduciary net position (after 2012), and the statement of changes
in fiduciary net assets (before 2012) and the statement of changes in fiduciary net
position (after 2012).
A CASE STUDY
In the preceding two chapters, Joe Klein of Evergreen analyzed two government-wide
financial statements—the statement of net position and the statement of activities. Now
Table 11.3
General Fund Revenues and Expenditures in 20x4: City of Evergreen
Amount ($) Percentage

Revenues
Property taxes 1,150,000 55.8
Sales taxes 320,000 15.5
Franchise taxes 230,000 11.2
Intergovernmental revenues 300,000 14.5
Investment earnings 38,000 1.8
Fees and fines 24,000 1.2
Total revenues 2,062,000 100.0
Expenditures
General government 255,150 11.7
Public safety 1,317,500 60.4
Transportation 311,850 14.3
Health and human services 296,900 13.6
Total expenditures 2,181,400 100.0
Joe feels that it is time to look into some specific areas of financial operations for improve-
ment. The city has a general fund, a Community Development and Improvement Project
Fund (a capital project fund), a Bond Note Redemption and Interest Fund (a debt service
fund), several special revenue funds, a water/sewer system fund (an enterprise fund), and
a parking system fund (an enterprise fund). Among these funds, the general fund is the
largest, with 66.7 percent of total revenues (i.e., General Fund Revenues/(General Revenues
+ Program Revenues) = $2,062,000/($2,158,000 + $932,000)). General fund expenditures
account for 69.5 percent of total expenses (i.e., $2,181,400/$3,140,000). (See Tables 10.3
and 11.2 for sources of these figures.) The general fund supports the basic services of the
city, which include policing, local road/street construction and maintenance, health and
human services, general administration, and other local services.
STEP 1: REVIEWING THE FUND STATEMENTS

Joe started with the balance sheet and the statement of revenues, expenditures, and
changes in fund balances. He created Table 11.3 for an overview of revenues and ex-
penditures. The table shows that taxes are the major revenue sources for the general
fund. About 83 percent of total general fund revenues are taxes, with the property taxes
representing the largest single revenue source for the general fund (55.8 percent). The
table also shows that, while the city has four major general fund functions and each
accounts for more than 10 percent of total expenditures, the most expensive one is
public safety, which accounts for 60.4 percent of total expenditures in the general fund.
Table 11.4
Revenue and Expenditure Comparison: General Fund in

the City of Evergreen ($)
20x4 20x3
amount amount Difference
(1) (2) (1) – (2)
Revenues
Property taxes 1,150,000 1,140,000 10,000
Sales taxes 320,000 330,000 (10,000)
Franchise taxes 230,000 230,000 0
Intergovernmental revenues 300,000 275,000 25,000
Investment earnings 38,000 60,000 (22,000)
Fees and fines 24,000 23,000 1,000
Total revenues 2,062,000 2,058,000 4,000
Expenditures
Public safety 1,317,500 1,145,000 172,500
Transportation 311,850 300,200 11,650
Health and human services 296,900 270,000 26,900
Total expenditures 2,181,400 1,975,300 206,100
Excess (deficiency) of revenues over expenditures (119,400) 82,700
Other financing sources (uses)

Transfer in 200,300 150,000
Transfer out (100,000) (225,000)
Total 100,300 (75,000)
Net change in fund balances (19,100) 7,700
STEP 2: COMPARING WITH LAST YEAR’S STATEMENTS

After the overview, Joe realized that the general fund was running a deficit of $19,100.
(See the net change in fund balances in Table 11.2.) The deficit seems to be caused
by the overspending of $119,400. This fund deficit caused Joe to further examine
individual revenue and expenditure items. He pulled out last year’s statement and
compared it with this year’s. The results are shown in Table 11.4.
The comparison shows several important findings. First, although the revenue
increased by $4,000 this year, the expenditure increased by $206,100. This is a 10.4
percent increase! Expenditure growth in public safety ($172,500) is the major cause
of this spending increase. In fact, about 84 percent (i.e., $172,500/$206,100) of the
total expenditure increase can be attributed to the increase in public safety spend-
ing. Second, revenue growth has slowed compared with the expenditure increase.
The major revenue source, the property tax, has only increased by $10,000, or less
than 1 percent (i.e., $10,000/$1,140,000 = 0.88 percent). Third, the major increase
in revenue came from intergovernmental revenues, which had a 9.1 percent increase
(i.e., $25,000/$275,000). However, this revenue source fluctuates over time and is
considered an unreliable revenue source.
STEP 3: ANALYZING THE ISSUES

The increase in public safety spending did not come as a surprise to Joe. The city has
experienced a steady increase in misdemeanors, traffic violations, and domestic violence
cases. The police chief requested three additional patrol officers, the related police equip-
ment, and some supplementary spending. The chief eventually got two patrol officers.
The increased cost of public safety appeared to be the result of this hiring.
Joe believes that the expenditure growth in the police department will continue
as the city becomes urbanized. The question is, how to pay for the increased ser-
vice costs? Among the general fund revenue sources, property taxes have been the
largest source of revenues. By analyzing the change in the property tax rate (the
millage), Joe realizes that the millage for city services has changed little during
the past decade, from 2.296 ten years ago to 2.304 now. In fact, in five of the ten
years during this period, the millage has declined from the previous year (see Table
11.5). This was probably the result of the city’s policy of rolling back the property
taxes. The rollback policy was an attempt to keep the property tax amount stable
when the property tax base (taxable property values) changes. In theory, it requires
the adjustment of the millage in response to the change of the taxable property
valuation to achieve an equalized effect on the actual property tax amount paid by
the taxpayer. More specifically, during the times of taxable value escalation, the
millage is lowered, and during the times of taxable value decline, the millage is
higher. However, in reality, since property values often increase, the rollback method
hurts the city more than helps it. The rollback method hurts Evergreen’s finances
by limiting its taxation capacity. It does not allow the city to gain financially at the
pace of a booming local property market. As the property taxes are the major reve-
nue sources for Evergreen, this rollback method limits the city’s revenue flexibility
and capacity significantly.
STEP 4: SEARCHING FOR SOLUTIONS

Joe believes that if the city does not increase the millage significantly, it will face
a revenue shortage in a few years. But he is not quite sure how much the revenue
shortage will be, and he doesn’t know the political and legal feasibility of rais-
ing the millage. He knows that a nearby city has levied a tax on the consumption
of public utilities such as water, power, phone, and cable services. Joe wants to
explore the feasibility of such a new tax in his city, and decides to conduct a re-
source development analysis to estimate the revenue shortage and develop possible
revenue options.
Table 11.5
Millage of Local Real Property Taxes for Citywide Services:

City of Evergreen
Year Rate
1 2.296
2 2.384
3 2.346
4 2.492
5 2.259
6 2.413
7 2.215
8 2.431
9 (20x3) 2.352
10 (the current year, 20x4) 2.304
Note: 1 millage or 1 mill = $1 in tax per $1,000 taxable values. For example, a millage of 2.304 is $2.304
in tax per $1,000 taxable values.
EXERCISES
1. KEY TERMS
Accounting equation for funds
Fund balance
Governmental funds
Measurement focus
Income determination (economic resource measurement) focus
Current financial resource measurement focus
General fund
Special revenue funds
Capital project funds
Debt service funds
Balance sheet for a fund
Statement of revenues, expenditures, and changes in fund balances
Proprietary funds
Enterprise funds
Internal service funds
Fiduciary funds
Pension trust funds
Agency funds
Investment trust funds
Private-purpose trust funds
Millage
2. DISCUSSION
1. Discuss the need for various funds in government. Use examples of funds in
your state or local governments in the discussion.
2. Discuss the importance of understanding the management focus and account-
ing basis in fund accounting. Use examples from your state or local govern-
ments in the discussion.
3. Discuss the different purposes of the general fund and special revenue funds.
Give examples of special revenue funds in your state or local governments.
4. Does your state or local government have a budget stabilization fund (some-
times known as rainy day funds) to address revenue shortages during economic
downturns and financial emergencies? Discuss the need for having such a
fund and treating it as a special revenue fund.
3. CAFR
Access a state or local government’s CAFR for the last two years.
1. Go to the General Fund Balance Sheet (likely included in the Governmental

Funds Balance Sheet). Compare key assets, liabilities, and the fund balances
for the past two years. Point out any change that causes concern.
2. Go to the Revenues, Expenditures, and Changes in Fund Balances—General
Fund (likely included in the Revenues, Expenditures, and Changes in Fund
Balances—Governmental Funds section). Compare key items of revenues and
expenditures and the fund balance for the past two years. Specify any change
that causes concern.
3. Go to the Statement of Net Assets (Net Position)—Proprietary Funds. Com-
pare key accounts of assets, liabilities, and net assets (net position) for the
past two years. Specify any change that causes concern. If a jurisdiction has
multiple enterprise funds, which is very likely, you could add up the items in
all of the funds or select one or two large funds for your analysis.
4. Go to the Revenues, Expenditures, and Changes in Fund Net Assets (Net Posi-
tion)—Proprietary Funds. Compare key items of revenues, expenditures, and
change in net assets (net position) for the past two years. Specify any change
that causes concern. If a jurisdiction has multiple enterprise (or internal ser-
vice) funds, you could add up the items in all the funds or select one or two
large funds for your analysis.
5. Go to the Statement of Cash Flows—Proprietary Funds. Compare the key
sources of cash flows for the past two years. Specify any change that causes
concern. Again, if a jurisdiction has multiple funds in this fund category, you
could add up the items in all of the funds or select one or two large funds for
your analysis.
6. Go to the Statement of Fiduciary Net Assets (Net Position). Compare key
accounts of assets, liabilities, and net assets (net position) for the past two
years. Specify any change that causes concern. If a jurisdiction has multiple
fiduciary funds, you could add up the items in all of the funds or select one
or two large funds for your analysis.
7. Go to the Statement of Changes in Fiduciary Net Assets (Net Position).
Compare key accounts of additions, deductions, and net assets (net position)
for the past two years. Specify any change that causes concern. Again, if a
jurisdiction has multiple fiduciary funds, you could add up the items in all of
the funds or select one or two large funds for your analysis.
12 Financial Condition Analysis
LEARNING OBJECTIVES
s 5NDERSTAND WHAT lNANCIAL CONDITION ANALYSIS IS

s $ETERMINE MEASURES TO ASSESS lNANCIAL CONDITION
s )DENTIFY ANY WARNING TREND OF A DETERIORATING lNANCIAL CONDITION
s 3PECIFY RELATIONSHIPS IN A lNANCIAL CONDITION ANALYSIS
s %XPLAIN RELATIONSHIPS IN A lNANCIAL CONDITION ANALYSIS
s 7RITE A lNANCIAL CONDITION ANALYSIS REPORT
Why do you see a doctor? You are either sick or go for a regular physical checkup.
If you are sick, the doctor often asks you a few questions about your symptoms, does
some lab tests, and then prescribes medicines or recommends further treatments. In
this process of diagnosis and treatment, the doctor identifies the causes of the problem
and, more important, develops a strategy to improve your health.
Doing a financial condition analysis is like seeing a doctor. Heads of an organiza-
tion have concerns or want to know about its health; they want to know what factors
influence its health and what to do to improve it.

WHAT IS FINANCIAL CONDITION ANALYSIS?
Financial condition analysis (FCA) is a thorough evaluation of the financial health of
an organization. You can use the analysis to determine the financial condition of your
organization, but more important, you can use it to improve the financial condition.
The ultimate purpose of FCA is to identify the factors that impact financial condition
and to provide recommendations to improve it.
What are the differences between FCA and the analysis of financial statements discussed
148
FINANCIAL CONDITION ANALYSIS 149
in the previous three chapters? Perhaps the most salient difference is that FCA stresses the
importance of socioeconomic and organizational factors in the analysis, while the analysis
of financial statements has a narrower focus on the financial information. FCA considers
socioeconomic and organizational factors the causes of financial condition.
What are the differences between FCA and the financial performance monitoring
discussed in Chapter 7? Financial monitoring is conducted more frequently than FCA.
Monitoring can be done daily or monthly on a very limited number of financial indicators.
FCA is a more thorough assessment that requires more time and resources for data col-
lection and analytical designs; it may not be conducted as often as financial monitoring.
When should FCA be conducted? An analysis may be performed at the beginning
of a fiscal period, when a budget is developed, or at the end of the period, when a
financial report is prepared. It can also be implemented during a financial crisis,
emergency, or distress. Finally, it can be part of an organization’s strategic planning
process in which the organization’s financial capabilities to support its mission and
goals are examined.
Who conducts FCA? An analysis can be performed by an organization’s internal
management team or outside consultants and independent auditors. The internal
approach has the advantage of ready accessibility to the information needed for the
analysis, while outside consultants or auditors may be more objective in analyses and
presenting critical recommendations.
How difficult is FCA? FCA can be rather complex. Measures and data for the analy-
sis may not be available. In general, the difficulty level of an analysis is determined by
three factors. First, the scope of the analysis determines analytical complexity. There
are four financial condition dimensions, defined as cash solvency, budget solvency,
long-run solvency, and service solvency. An analysis can focus on any single dimension
or combinations of dimensions. Obviously, an FCA that examines all four dimensions
is more complex than an FCA limited to one dimension. Second, the availability of
measures and data also affect the difficulty of the analysis. If measures or data are not
available or not accessible, surrogates or replacements must be found and used. Third,
an FCA requires the specification and testing of how a financial condition is affected
by socioeconomic/organizational factors. The process of specification is called FCA
modeling, which can be a rather complex process. The complexity is augmented by
the lack of quality theories in the FCA literature.
DETERMINING MEASURES IN FCA

After the scope of the FCA is determined, necessary measures need to be developed
and related data should be collected. Since the purpose of the analysis is to identify
socioeconomic/organizational factors that affect financial condition, measures of
financial condition and socioeconomic/organizational factors should be developed.
Measuring Financial Condition
Financial condition (also known as economic condition) is defined as the ability of an

organization to meet its financial obligations. During the process of providing goods
and services, an organization incurs financial obligations in the form of expenses,

expenditures, and debt that must be paid sooner or later. If the organization can pay
these obligations without incurring much financial hardship, we say that the orga-
nization’s ability to pay is high and the organization is in good financial condition.
The ability to pay is commonly called solvency in finance. There are four levels
of solvency. Cash solvency is the ability to generate sufficient cash to pay for current
liabilities. Budgetary solvency refers to the ability to collect sufficient revenues to
pay for expenditures or expenses. The ability to pay off long-term obligations is the
concept of long-run solvency. Finally, service solvency refers to the ability to finan-
cially support a desirable level of services.
How to measure financial condition? A good financial condition measure should satisfy
at least three criteria. First, a measure must assess a specified element of financial condition
(i.e., measurement validity). For example, a revenue/expenditure ratio is a valid measure
for budgetary solvency, which assesses the sufficiency of revenues to cover expenditures.
It is not a valid measure for cash solvency, because not all revenues are in the form of cash.
Second, the elements used in formulating a measure should be consistent and objective
(i.e., measurement reliability). If the unit of a measure is the general fund (i.e., general
fund revenues, general fund expenditures, the fund balance of the general fund), this unit
should be used consistently. Changing the unit will lead to measurement inaccuracy and,
worse, incorrect results for the FCA. Finally, the measure and supporting data should be
affordable to obtain (i.e., measurement affordability). The cost of obtaining measures and
data should be considered in selecting measures. Everything else being equal, the less
costly measure is always a better measure.
Based on these criteria, in this chapter a list of example measures is developed
to assess financial condition. Efforts are made to select only two measures for each
dimension of financial condition. Two ratios are used to measure cash solvency. The
cash ratio relates cash, cash equivalents, and marketable securities to current liabili-
ties. The ratio indicates the extent of assets available to pay off current liabilities. A
higher ratio indicates a better level of cash solvency.
Cash + Cash Equivalents + Marketable Securities

Cash Ratio =
Current Liabilities
Another ratio of cash solvency is the quick ratio. Compared with the cash ratio,
the quick ratio is a more lenient measure, because it includes noncash assets, such
as receivables, as assets to pay off current liabilities. A higher ratio indicates a better
level of cash solvency.
Cash + Cash Equivalents + Marketable Securities + Receivables

Quick Ratio =
Current Liabilities
Budgetary solvency can be measured by the operating ratio, which assesses the
sufficiency of revenues to cover expenditures. A higher value of the ratio indicates a
better level of budgetary solvency.
Total Revenues
Operating Ratio =
Total Expenditures (Expenses)
Another measure of budgetary solvency is the own-source ratio, which indicates

the level of revenue that comes from a government’s own sources, such as taxes,
charges, fees, and other revenues. Since these revenues are considered more stable
and controllable by the government than revenues from intergovernmental financial
assistance, a higher own-source ratio indicates a higher level of budgetary solvency.
Revenues of Own Sources

Own-Source Ratio =
Total Revenues
Two measures can be used for long-run solvency. The net asset ratio (or net
position ratio) assesses the extent of a government’s ability to withstand financial
emergencies during economic slowdowns, the loss of major taxpayers, and natural
disasters. A higher ratio indicates a better state of long-run solvency. Note that, after
2012, net position is reported in lieu of net assets in US state and local governments
(see Chapter 9 for this change).
Net Assets (or Net Position)

Net Asset Ratio (or Net Position Ratio) =
Total Assets
The numerator in the above equation, “Net Assets (or Net Position),” includes capi-
tal assets that may not be available to pay off long-term obligations. So a modified
net asset ratio can be used:
Net Assets (or Net Position) – Net Assets (or Net Position) Invested in Capital Assets
Total Assets
Another measure of long-run solvency is the long-term debt ratio, which assesses
an organization’s ability to pay off its long-term debt. A higher ratio of this measure
indicates a worse level of long-run solvency. The numerator in the equation “Total
Long-Term Debt,” is also known as the long-term debt outstanding.
Total Long-Term Debt

Long-Term Debt Ratio =
Total Assets (or Total Revenues)
Service solvency can be assessed by net assets (net position) per capita, which
indicates the level of net assets (net position) in relation to population. A higher ratio
indicates a better level of service solvency.
Net Assets (or Net Position)

Net Assets (or Net Position) Per Capita =
Population
Another measure of service solvency is the long-term debt per capita, which as-
sesses the level of long-term debt for each resident. A higher ratio indicates that a
government carries more long-term debt per capita and suggests a deteriorating state
of service solvency.
Total Long-Term Debt

Long-Term Debt Per Capita =
Population
Measuring Socioeconomic/Organizational Factors
There are a large number of socioeconomic/organizational factors that influence

financial condition. Including all of them in an FCA is impossible or very costly.
Selecting proper factors is critical. In addition to the above-mentioned principles of
measurement validity, reliability, and affordability, two other criteria should also be
considered in selecting socioeconomic/organizational factors in an FCA.
First, a theoretical cause-effect relationship must be developed to indicate how a
socioeconomic/organizational factor impacts financial condition. For example, because
population growth (a demographic factor) can bring more taxpayers and revenues,
it is justifiable to include population data in an analysis that uses revenues to mea-
sure financial condition. On the other hand, the relationship between the number of
school-age children and revenues is rather difficult to develop; therefore the number
of school-age children should not be included in the analysis. This criterion is called
the theoretical justification of measurement. It is the most important measurement
selection criterion in FCA.
The second criterion in measurement selection is that a measure is better if it is
more controllable. “Controllable” means that a measure is sensitive to policies or
managerial operations or other human actions of the organization. For example, a
city may find that its residents’ income level improves its financial condition (i.e.,
higher-income residents pay more taxes). However, it is rather difficult for the city
to improve residents’ incomes quickly and it often takes years, therefore the city
may not be able to use income growth to improve its financial condition quickly. On
the other hand, if the city finds that higher educational levels among city financial
employees also improve its financial condition (a higher educational level suggests a
higher level of professionalism), the city can relatively quickly improve its financial
condition by hiring people with higher-level degrees. This measurement selection
criterion is called measurement controllability, which should be considered for an
FCA to be more meaningful to decision or policy makers. In general, organizational
factors have higher measurement controllability than socioeconomic factors.
Table 12.1 presents a list of possible socioeconomic/organizational measures
that can be used in FCA. The list is by no means exhaustive. It serves only as an
example of possible measures in FCA. Other measures are available and should
also be considered.
Table 12.1
Socioeconomic/Organizational Factors in FCA
Measure Description or examples

Socioeconomic factors
Population The number of residents
Income Median or mean household income, or median or mean personal

income
Property values Total assessed property values, or total taxable property values
Education level The average number of school years completed by residents
Age Median or mean resident age
Employment rate Percentage of employed population to total employment-eligible

population
Commercial development The number of businesses, the value of commercial property, or the
or business activities number or value of new businesses during a certain period
Organizational factors
Budget management Budgetary systems and practices on budget formation, implementation,
and evaluation (e.g., tax rates)
Cash management Systems and practices in managing cash (e.g., availability of mandated
cash management policy)
Investment management Systems and practices in investment (e.g., availability of periodic review
of investment policies)
Fallback management Systems and practices in upholding and using financial reserves (e.g.,
availability of mandated “rainy day fund”)
Accounting and reporting Accounting and reporting systems and practices (e.g., use of cost
accounting)
Internal control Systems and practices in decentralizing budgeting and procurement

(e.g., availability of a decentralized procurement system)
Professionalism and Qualification or behaviors of financial personnel (e.g., mean years of

leadership education of financial personnel)
Note: This table is derived partly from the Ph.D. dissertation of Lynda M. Dennis, “Determinants of
Financial Condition: A Study of U.S. Cities,” University of Central Florida, 2005.
IDENTIFYING ANY WARNING TREND OF A DETERIORATING FINANCIAL CONDITION

After financial condition measures are developed and related data are collected, we
should examine the data to identify any possible warning trend of a deteriorating fi-
nancial condition. This step requires an examination of at least three periods of data
for a specified financial condition measure. A three-period continuing deterioration of

a measure constitutes a financial warning trend. For example, if the cash ratio at the
ends of the past three months was 0.75, 0.60, and 0.55 respectively, this downward
turn indicates a continuing deterioration of the measure and constitutes a financial
warning trend. Microsoft Excel provides good graphing functions that can be used
for the visual representation of a warning trend.
It is important to note that, although a warning trend provides a strong reason to
conduct an FCA, it is not the only one. The fluctuation (rather than continuation) of
a financial condition measure may also deserve a close look. At other times, manag-
ers may simply want an FCA to explore the possibilities of a continually improving
financial condition or to gain insight into the financial capacity of the organization.
SPECIFYING THE RELATIONSHIP

At the beginning of this chapter we said that the purpose of FCA is to find out the
factors that impact financial condition. In this section, we discuss how to identify
the impact. A basic principle in logic is that in order to say that Event A impacts
Event B, both events must first be related. In other words, to prove that a factor
impacts financial condition, this factor and financial condition must be related.
There is a relationship between the factor and the financial condition. Although a
relationship does not mean the impact actually occurs, it does serve as a necessary
condition for the impact to happen. In other words, without the relationship, the
impact cannot happen.
Statisticians have developed tools to assess relationships. They call these tools
measures of associations (association is a synonym for relationship). One measure
of association is the correlation coefficient. Let us look at an example of how to use
this statistic in an FCA. Table 12.2 shows a city’s population and revenues for the
last five years.
Table 12.2
Population and Revenues
Year Population Revenues ($)

Five years ago 173,122 198,837,119
Four years ago 176,373 265,927,499
Three years ago 180,462 249,374,988
Two years ago 184,639 265,884,544
One year ago 188,013 272,805,096
The Excel Insert Function (fx) can be used to obtain the correlation coefficient
easily. Select “Statistical” in the function category window and choose “CORREL”
(correlation) in the function window. Click the “OK” button. Select the population data
in the “Array 1” window (i.e., A2:A6) and the revenue data in the “Array 2” window
(i.e., B2:B6). The calculation process is shown in Excel Screen 12.1.
Excel Screen 12.1 Calculating Correlation Coefficients
Table 12.3
Interpretation of the Correlation Coefficient
Correlation coefficient value Interpretation

0 No relationship
Larger than 0 but smaller than 0.500 Weak positive relationship
From 0.500 to 0.699 Moderate positive relationship
From 0.700 to 0.999 Strong positive relationship
1.000 Perfect positive relationship
–1.000 Perfect negative relationship

From –0.700 to –0.999 Strong negative relationship
From –0.500 to –0.699 Moderate negative relationship
Smaller than 0 but larger than –0.500 Weak negative relationship
The “Formula Result” in the screen shows a correlation coefficient of 0.755. What does
that mean? Two pieces of information are needed to interpret a correlation coefficient—its
direction and magnitude. A positive value of a coefficient indicates that both factors move
in the same direction. In other words, when the value of one factor increases, the value of
the other increases too. A negative value of a coefficient indicates that the factors move in
opposite directions. The magnitude of a relationship is measured on a scale from –1.000
to 1.000. A zero (0) would mean no relationship between the two factors, while 1.000
indicates a perfectly positive relationship and –1.000 a perfectly negative relationship.
Table 12.3 can be used as the reference in explaining the correlation coefficient value.
In our example, since the correlation coefficient is 0.755, we say that the relation-
ship between population and revenues is a strong positive relationship, or that they
are strongly positively associated. The establishment of this relationship provides
some evidence that population may impact revenues.
Now, as an exercise, you can use the expenditure data in Table 2.1 in Chapter 2 of
this book to run a correlation analysis. The correlation coefficient between population
and total expenditures should be 0.953.
EXPLAINING THE RELATIONSHIP

With a correlation coefficient, we can tell if a relationship exists, and if it does, how
strong it is. Nevertheless, we still do not know the exact form of the relationship.
For example, we know that population and revenues are strongly associated, but we
cannot tell how much revenue will be brought in if the population increases by, say,
1,000. So, after a strong relationship is identified, the next step in FCA is to further
explore the exact form of the relationship. Realize that the exact form of a relation-
ship is important for making meaningful policy or management recommendations.
Many methods can be used to identify the exact form of a relationship. One method
uses per capita statistics. Let us use the data in Table 12.4 as an example.
Table 12.4
Population, Revenues, and Revenue Per Capita
Population Revenues ($) Revenue per capita ($)

Year (1) (2) (2)/(1)
Five years ago 173,122 198,837,119 1,149
Four years ago 176,373 265,927,499 1,508
Three years ago 180,462 249,374,988 1,382
Two years ago 184,639 265,884,544 1,440
One year ago 188,013 272,805,096 1,451
Average 1,386
The exact form of the relationship between population and revenues can be de-
scribed as one resident on average brings in about $1,386 in revenues. If an FCA
indicates the government needs to have $2,000,000 in revenues to improve its financial
condition to a certain degree in the next year, it will need to bring in an estimated
$2,000,000/$1,386 = 1,443 residents.
When per capita statistics are not available, the growth rate and percentages can
also be used in specifying the exact form of a relationship. For example, if we know
that a 1 percent increase in the tax rate will bring in $1,000,000 in tax revenues, and
if $2,000,000 in revenues is needed to improve financial condition to a certain degree,
then the tax rate should be increased by 2 percent.
Notice that, in our analysis, we examined the impact of one socioeconomic/orga-
nizational factor on financial condition at a time. For instance, in the above example,
we examined the impact of population trend on financial condition. In reality, it is
very likely that more than one factor impacts financial condition. For example, it is
possible that both population and household income affect financial condition jointly.
Advanced statistical tools are needed to analyze this joint impact, and a discussion
of these tools is beyond the scope of this book.
FCA REPORT WRITING

The purpose of an FCA report is to make recommendations to improve financial
condition. The report should first present the rationale of the analysis, describe the
existing financial condition, and discuss the process of the analysis. It should present
the key findings by specifying any important socioeconomic/organizational factors
that influence financial condition. It should also discuss possible policy/management
options that can improve financial condition in the near term and in the long term.
If needed, the cost and benefit of each option should be examined and presented to
specify the feasibility of each option.
A CASE STUDY
The city of Lucille (population 313,611) is located in a major metropolitan area in
the southeastern United States. The city provides a wide range of public services to
its citizens, such as policing, fire protection, parks and recreation, city road/street
construction and maintenance, library services, and many other municipal services.
Lucille is located within the boundaries of Osorio County. The county provides ser-
vices in the areas of correction, court services, property assessment, county road/street
construction and maintenance, and many other county-level services.
In a recent management meeting, City Manager Wendy Higgins told Finance Di-
rector Jeff Bolling that a recent issue of PA Times published the results of a survey
indicating that about 67 percent of US cities had experienced difficulty in collecting
sufficient revenues to pay for their services. In other words, three out of five cities said
they had a budget solvency problem. Wendy wants to know where Lucille stands in
budget solvency. Wendy knows that the city’s Finance Department conducts an annual
FCA; but the analysis has always focused on cash solvency—whether the city has
enough cash to meet its short-term financial obligations. Jeff explained that budget
solvency is different from cash solvency in that it reflects different aspects of financial
condition. Wendy then asked Jeff to prepare an FCA on the city’s budget solvency that
focuses on two specific questions: What is the city’s current budget solvency status?
And what can be done to improve the status, if needed? She wanted to see the analy-
sis in a week so she could present it to the city commission in a budget workshop.
STEP 1: DEFINING THE SCOPE OF THE ANALYSIS

Jeff knew the scope of the analysis would be limited by several factors, and he dis-
cussed these factors with Wendy to ensure that she understood these limitations.
First, the analysis would focus on budget solvency only. There would be no attempt
to address issues of long-term solvency and service solvency, which could be done
later if needed. Also, there would be no need to repeat the analysis on cash solvency,
which is always conducted at the end of a fiscal year. The main results of last year’s
cash solvency analysis can be seen in the CAFR. Second, the analysis would focus
on governmental funds only. No attempts would be made to address the issues in
other funds. This is because the data of governmental funds are readily available,
and the majority of the city’s expenditures are for governmental activities. The city’s
governmental-activity expenditures are 67 percent of the total primary government
expenses.
Third, the analysis would be limited by available measures and data. As the analy-
sis is needed in a short time, only measures and data available in the CAFR would be
used. There is no time or budget to collect data beyond the city’s possession, which
would be needed for a more comprehensive analysis. Fourth, the analysis would be
guided by the financial condition literature and experiences of city financial person-
nel. The latter is particularly important, as the current literature is often not specific
enough for the financial environment faced by the city. Last, any recommendation
made in the analysis would be valid for a time frame of no more than three years.
STEP 2: DETERMINING MEASURES AND COLLECTING DATA

Jeff decided to use two indicators to measure the budget solvency of the city. The first
was the operating ratio (Total Revenues/Total Expenditures), which assesses the extent
of revenues to cover expenses. The revenues include program revenues and general
revenues. A higher ratio indicates a higher budget solvency. More specifically, a ratio
of 1.000 indicates all revenues are used to cover all expenditures. A ratio greater than
1.000 indicates revenues exceed expenditures, and a ratio less than 1.000 suggests a
deficit of revenues over expenditures.
The second was the own-source ratio (Revenues from Own Sources/Total Reve-
nues), which measures the proportion of total revenues that comes from the city’s own
revenue sources. A higher ratio indicates less reliance on vulnerable intergovernmental
revenues and a higher level of budget solvency.
Jeff also collected information about the following socioeconomic/organizational
factors that could influence budget solvency. (1) Taxable property values can affect
the property tax revenues—one of the largest revenues of the city. Taxable value
increases should lead to an increase in tax revenues, and therefore improve the
operating ratio and the own-source ratio. (2) Population fluctuation may influence
Table 12.5
CAFR Data for the City of Lucille
Taxable Income per

Own-source property capita Unemployment
Year Expenditures ($) Revenues ($) revenues ($) values ($) Population ($) rate The millage
1 157,849,000 177,879,000 153,481,000 9,448,376,000 280,699 20,156 0.064 9.384
2 166,754,000 185,672,000 159,381,000 9,544,867,000 280,587 21,193 0.052 9.397
3 171,030,000 194,113,000 165,786,000 9,727,654,000 286,320 22,624 0.044 9.342
4 182,867,000 199,831,000 169,593,000 9,923,234,000 289,790 23,914 0.038 9.304
5 188,981,000 211,625,000 179,369,000 10,700,406,000 290,920 25,277 0.033 9.144
6 201,735,000 224,660,000 192,115,000 11,734,986,000 293,920 26,355 0.028 9.056
7 211,261,000 243,258,000 209,501,000 12,842,257,000 296,720 27,304 0.026 8.931
8 223,353,000 256,644,000 223,012,000 13,841,329,000 303,447 27,458 0.026 8.816
9 234,769,000 270,847,000 236,197,000 15,744,435,000 309,104 28,784 0.036 8.691
10 263,139,000 285,705,000 249,941,000 16,748,134,000 313,611 30,099 0.044 8.734

(this year)
159
both revenues and expenditures, and thus budget solvency. Population increase can
provide more revenues through increased taxes and fees; population increase may
also lead to increased spending to support more public services. (3) Income per
capita in the city may also affect budget solvency. Income growth may indicate an
increase in the tax base that results in improved budget solvency. But such increases
may also suggest a larger demand for a high quality of public services, which leads
to higher spending and potentially deteriorating budget solvency. (4) A higher
unemployment rate may suggest a greater need for public assistance and services,
which could negatively affect budget solvency. (5) As for the property tax rate, the
millage can influence the amount of revenues collected. Given the size of taxable
property values, a higher millage produces a larger amount of property taxes and a
higher level of budget solvency. Jeff collected the data for expenditures, revenues,
and all five socioeconomic/organizational factors for the last ten years from the
city’s CAFR, as shown in Table 12.5.
STEP 3: IDENTIFYING WARNING TRENDS

How is the city’s budget solvency? Is there a warning trend? To answer these questions,
Jeff used the data in Table 12.5 to compile data for the operating ratio and the own-
source ratio for the past ten years, as shown in Table 12.6. Notice that the operating
ratio for this year is 1.086, which is the ratio of this year’s revenues ($285,705,000)
to expenditures ($263,139,000). This year’s own-source ratio, 0.875, is calculated
from this year’s own-source revenues ($249,941,000) divided by total revenues
($285,705,000).
The operating ratio shows the city had sufficient revenue to pay its bills for the
past ten years. Jeff used a ratio value of 1.000 (Revenues = Expenditures) as the
benchmark to evaluate and explain the operating ratio. The ratio has been greater
than the benchmark, indicating a satisfactory status of budget solvency in that indi-
cator. The own-source ratio shows that more than 85 percent of the city’s revenues
came from its own sources, more than the national average of about 70 percent for
local governments. This measure shows that the city does not appear to over-rely
on intergovernmental revenues. As intergovernmental revenues can fluctuate over
time and are not considered a reliable source of revenue, the absence of overreliance
on intergovernmental revenues suggests a satisfactory status of budget solvency
for the city.
Nevertheless, two issues concern Jeff. First, the operating ratio has fluctuated over
the last five years. This year’s ratio (1.086) is particularly low in comparison with
those of previous years (the average of the past ten years is 1.124). Thus, there may
be a need to stabilize the ratio. Second, although the own-source ratio is higher than
the national average for local governments, it is still lower than that of cities with
populations greater than 100,000 in the state. It is also lower than several adjacent
cities that have socioeconomic characteristics that are similar to Lucille’s. These
concerns indicate there is still room for improvement in the city’s budget solvency.
Jeff then decided to continue the analysis to explore possible ways to improve the
budget solvency of the city.
Table 12.6
Operating Ratio and Own-Source Revenue Ratio
Year Operating ratio Own-source revenue ratio

1 1.127 0.863
2 1.113 0.858
3 1.135 0.854
4 1.093 0.849
5 1.120 0.848
6 1.114 0.855
7 1.152 0.861
8 1.149 0.869
9 1.154 0.872
10 1.086 0.875
(this year)
Table 12.7
What May Affect the Operating Ratio?
Correlation with operating ratio

Taxable property values 0.114
Population 0.072
Income per capita 0.086
Unemployment rate –0.307
The millage rate –0.266
Note: The figures are correlation coefficients.
Table 12.8
What May Affect Revenues?
Correlation
with revenues
Population 0.988
Unemployment rate –0.537
The millage –0.985
Note: The figures are correlation coefficients. Strong relationships are highlighted in bold.
STEP 4: SPECIFYING THE RELATIONSHIPS

In this step, Jeff wanted to specify the impact of socioeconomic/organizational factors
on the budget solvency of the city. The socioeconomic/organizational factors include
taxable property values, population, income per capita, the unemployment rate, and
the millage. Among them, the millage is considered an organizational factor, as it can
be determined by the city’s policy makers. All of the others are socioeconomic factors.
The Operating Ratio
Using the data in Table 12.5, Jeff first ran a correlation analysis of socioeconomic/
organizational factors with the operating ratio. Table 12.7 shows the result.
According to our rule of thumb to judge the relationship, none of these relation-
ships is strong (i.e., greater than 70 percent or less than –70 percent). None of these
factors appears to influence the ratio directly. However, since the operating ratio is
the division of revenues by expenditures (i.e., Revenues/Expenditures), one way to
improve the ratio is to increase revenues. So Jeff decided to examine factors that
could influence revenues. Table 12.8 shows the correlation between revenues and the
socioeconomic/organizational factors.
The results show that revenues are strongly and positively associated with taxable
property values, population, and income levels, which suggests that an increase in
these factors leads to the increase in revenues and, therefore, the improvement of
the operating ratio. The results also show that the millage is strongly and negatively
associated with revenues. Revenue increase is associated with millage decline. This
bewildering relationship is the subject of a later discussion in this analysis.
The Own-Source Ratio
Jeff then ran a correlation analysis to assess the possible influences of socioeconomic/
organizational factors on the own-source ratio. Table 12.9 presents the results.
Table 12.9
What May Affect the Own-Source Ratio?
Correlation with the

own-source ratio
Population 0.704
Unemployment rate 0.063
The millage rate –0.721
Note: The figures are correlation coefficients. Strong relationships are highlighted in bold.
The result shows that the own-source ratio is strongly and positively associated
with taxable property values and population. Increase in taxable property values
and population could lead to an improved own-source ratio. The millage is strongly
and negatively associated with the ratio. Increase in the millage is associated with a
decline in the own-source ratio.
Figure 12.1 Impact of Taxable Property Values on Budget Solvency
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In sum, the findings indicate that (1) increase in taxable property values and
population may result in the improvement of the city’s budget solvency through
more revenues, (2) increase in income may also lead to improved budget solvency
through the improvement of the operating ratio, (3) nevertheless, the increase in the
millage is associated with a decline in budget solvency. A further explanation of this
relationship is needed.
STEP 5: EXPLAINING THE RELATIONSHIPS

In order to make recommendations, Jeff wants to further explain the relationships
between budget solvency and taxable property values, population, income, and the
millage. He wants to know exactly how much these factors impact budget solvency
(i.e., the exact form of these relationships).
Taxable Property Values
First, the relationship between taxable property values and the budget solvency can
be simply specified in Figure 12.1.
In the current year, the city has taxable property values of $16,748,134,000 and
collected $285,705,000 in tax revenues. In other words, the city collected $0.0171
in revenue for every dollar of taxable value (i.e., $285,705,000/$16,748,134,000 =
0.0171). This revenue/taxable value ratio has been consistent for the past two years.
The city has experienced a real estate boom recently. It is expected that taxable
property values will continue to grow at an annual rate of about $700,000,000 in the
next year. This would bring the city an additional $11,970,000 (i.e., $700,000,000
× 0.0171) in revenues. As an example to illustrate exactly how taxable value affects
the budget solvency, this revenue increase would improve the operating ratio of the
year by 0.046 (i.e., Additional Revenues/Expenditures = $11,970,000/$263,139,000
= 0.046). Notice that this is the impact of increased taxable property values without
considering other factors that also influence budget solvency.
Population
Population growth can affect the city’s budget solvency in two simultaneous ways, as
shown in Figure 12.2. Population growth increases the city’s revenues because people
pay taxes, fees, charges, and other revenues. On the other hand, population growth
creates additional demand for city services, which increases expenditures.
Using the data for this year, Jeff calculated that the revenues from each resident
(revenues per capita) were $911.02 (i.e., $285,705,000/313,611) and the expenditures
Figure 12.2 Impact of Population on Budget Solvency
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for each resident (expenditures per capita) were $839.06 (i.e., $263,139,000/313,611).
The difference is $71.96 in net revenue. The positive figure indicates that the city may
gain the net revenue by bringing in more people. In other words, population growth may
bring more revenues than expenditures to the city. How much does the net revenue affect
budget solvency? Jeff predicts a population growth of 3,500 in the next year, which will
generate $251,860 (i.e., $71.96 × 3,500) in additional net revenue. In this example, the
revenue increase would improve the operating ratio for the current year by 0.000957
(i.e., $251,843/$263,139,000). Jeff notes that this is only the impact of the increased
population without considering other factors that also influence budget solvency.
Personal Income
Personal income affects the city’s budget solvency in several ways. Income growth can
prompt more personal consumption of fee- or charge-based city services and products.
Therefore, the growth increases the city’s revenues in fees or charges. Also likely is
that the increase in personal income leads to increased real estate consumption (i.e.,
upgrading homes, purchasing new homes or more expensive homes, purchasing land,
etc.). The correlation coefficient between income and taxable property value is 0.930.
So the increase in personal income may be reflected in the increase in taxable property
values. Because of this, the impact of increased personal income on budget solvency
is already reflected in the impact of taxable property values on budget solvency. Thus
Jeff decided not to further demonstrate this impact in his analysis in order to avoid
confusion or the possibility of overestimation.
The Millage
Finally, the millage appears to affect budget solvency negatively. A decrease in the
millage is associated with an increase in revenues and an improved own-source ratio.
The negative relationship between the millage and revenues is caused by a city policy
called the “property tax rollback” in which the millage is adjusted in assessing property
values. According to this policy, if a significant increase in taxable property values
occurs, the millage will be lowered to reduce the taxpayers’ burden, which results in
a direct negative relationship between taxable property values and the millage (the
correlation coefficient is –0.970 for the past ten years). This negative relationship
Figure 12.3 Impact of the Millage on Budget Solvency
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explains the negative relationship between the millage and the city’s revenues and
the own-source ratio. More specifically, during the past ten years, when the taxable
property values increased, the millage often declined. Figure 12.3 demonstrates the
impact of the millage on the budget solvency of the city.
Exactly how much of the millage change is associated with budget solvency?
During the past ten years, revenues had an annual 5.42 percent increase, while the
millage had a 0.80 percent annual decline. If the same percentage of millage de-
cline is expected for the next year, the revenue increase will be $15,485,211 (i.e.,
$285,705,000 × 5.42 percent). Then, the operating ratio will improve by 0.0589 (i.e.,
$15,485,211/$263,139,000). Again, this relationship is established without consider-
ing other factors that also influence revenues.
STEP 6: TAKING ACTION TO IMPROVE FINANCIAL CONDITION

A week later in a staff meeting, Jeff summarized the findings and recommended ac-
tions to improve the city’s budget solvency. He recommended that the operating ratio
should be stabilized at an average of 1.100 for the next five years. This ratio ensures
that revenues are sufficient to fund the existing level of services and the continual
accumulation of the city’s financial reserve. He also recommended an increase in the
own-source ratio from the current 0.875 to 0.900 for the next five years in order to
withstand the impact of any possible decline in intergovernmental assistance.
Jeff recommended several strategies to achieve these budget solvency goals. First, the
city should continue its efforts to provide a family-friendly environment in order to attract
more working people. Second, the city should maintain a quality of life environment that
ensures the healthy development of the local economy and the real estate market. Third,
the city should stress its existing economic development strategies that attract employers
that can bring high-paid jobs to the community. Fourth, the rollback policy related to the
property tax rate significantly limits the city’s capacity to increase revenues. A review of
this policy may be necessary. Jeff argued that any significant increase in taxable property
values would be offset by the rollback policy. The impact of the policy would be particu-
larly salient during economic downturns, when the city’s economy-sensitive revenue bases
would be in decline. As taxable property values may be less sensitive to cyclical changes
in the economy, property tax revenues might be one of a few revenue options the city has
to use to survive bad economic times. Any measure that eases the rollback policy to give
the city flexibility in property tax rates, assessment, and collection should be considered.
EXERCISES
1. KEY TERMS
Financial condition analysis (FCA)
Purpose of FCA
Scope of FCA
FCA modeling
Financial condition
Solvency
Cash solvency
Budgetary solvency
Long-run solvency
Service solvency
Measurement validity
Measurement reliability
Measurement affordability
Cash ratio
Quick ratio
Operating ratio
Own-source ratio
Net asset ratio
Long-term debt ratio
Net assets (net position) per capita
Long-term debt per capita
Socioeconomic/organizational factors
Theoretical justification of measurement
Measurement controllability
Warning trends
Correlation coefficient
Interpretation of correlation coefficient values
Exact form of relationship
2. DISCUSSION
1. Use examples from your state and local governments to discuss the need and
scope of financial condition analysis.
2. Use the measures listed in this chapter and in Chapter 7 (“Financial Perfor-
mance Monitoring”) as examples to develop new measures for an FCA, and
evaluate the measures using the criteria provided.
3. Review Management’s Discussion and Analysis (MD&A) of CAFRs in sev-
eral state or local governments of your choice. Discuss the key elements of
MD&A in relation to FCA.
4. Financial crises in government are often characterized by revenue shortage.
Cutting spending is the first thing that comes to mind in many governments
during crises. Estimating spending cuts and their impact can be part of an
FCA. Use examples in government to discuss situations in which spending
cuts are proposed or implemented and, importantly, the financial impact of
the cuts is estimated.
5. Discuss the statement that “theoretical justification of measurement . . . is the
most important measurement selection criterion in FCA.”
3. CALCULATION
Table 12.10 shows expenditure data for the past five years in an urban city.
Table 12.10
Expenditure Data (in thousands of dollars)
Public General
Year safety government Total
1 94,367 11,222 157,849
2 100,034 9,831 166,754
3 105,669 10,910 171,030
4 112,433 11,001 182,867
5 117,023 10,234 188,981
1. Compute the correlation coefficients for these factors.

2. Prepare a paragraph interpreting the results.
4. APPLICATION
In the case study, we examined the budgetary solvency in the city of Lucille. Now
the city manager wants an analysis of all four dimensions of FCA—cash solvency,
budgetary solvency, long-run solvency, and service solvency. Only data from the
past five years are available for analysis. Table 12.11 presents additional data from
the city’s CAFR.
Conduct an FCA to examine the cash solvency, budgetary solvency, long-run sol-
vency, and service solvency of Lucille.
5. APPLICATION
Conduct an FCA for a government of your choice.
168
Table 12.11
City of Lucille’s Additional Financial Data for the Past Five Years ($)
Net
Year Cash Marketable Current Assets (or Net Total
(December 31) Cash equivalents securities Receivables liabilities Position) assets
1 960,000 96,263,000 105,915,000 25,472,000 59,409,000 981,077,865 2,279,434,717
2 565,000 129,429,000 91,403,000 31,899,000 58,956,000 1,059,432,173 2,322,398,266
3 2,517,000 151,978,000 67,676,000 0 52,258,000 1,144,044,291 2,366,171,605
4 465,000 150,846,000 31,427,000 0 72,594,000 1,235,414,000 2,410,770,000
5 777,000 209,026,000 54,316,000 3,005,000 73,549,000 1,334,081,000 2,456,209,000

(this year)
13 Debt Capacity Analysis
LEARNING OBJECTIVES
s 5NDERSTAND WHY GOVERNMENTS BORROW

s 5NDERSTAND WHAT TYPES OF DEBT A GOVERNMENT HAS
s $ETERMINE AN AFFORDABLE DEBT LEVEL FOR A GOVERNMENT
s $ETERMINE ANY ADDITIONAL DEBT CAPACITY FOR A GOVERNMENT
s 0LAN AN AFFORDABLE DEBT LEVEL IN A GOVERNMENTS BUDGET
Everyone borrows nowadays. Individuals borrow to buy houses, cars, furniture,

and electronic appliances. Governments borrow to cover budget deficits, build infra-
structures, and sometimes pay for daily operations.
But borrowing has a limit. When you apply for a credit card, you are often required
to provide evidence of a good credit record and a stream of income. If you do not
have them, your application will probably be turned down. Even if you have a good
credit record and a reliable income source, you cannot keep borrowing beyond your
capacity—that is, your means to pay it back. During the economic boom in the 2000s,
many people and organizations borrowed beyond their capacities, causing themselves
financial and operational difficulties. For example, Jefferson County, Alabama, filed
for bankruptcy with $3.14 billion in debt in 2011. Many economists believe that
excessive borrowing was one of many causes of the great economic recession that
began in December 2007.
How much debt is too much? How should a government assess the level of debt to
ensure that it does not exceed its capacity to repay it? Debt capacity analysis (DCA)
answers these questions. The purpose of the analysis is to help a government avoid
the negative financial consequences of overborrowing, such as difficulty in paying
back debt on time, a deteriorating credit rating, a higher borrowing cost, an increase
in the tax burden for taxpayers, a reduced level of services to residents, debt default,
and worst of all, financial insolvency.
169
How is DCA related to the financial condition analysis (FCA) introduced in Chapter
12? Like the health of a human being, the financial health of an organization consists
of many aspects. FCA is a tool to examine the overall financial health of an organi-
zation, while DCA concerns a very specific but important aspect of that health—the
debt level. Clearly, too much debt causes a deteriorating overall financial condition
of an organization.
When should we conduct DCA? It can be done annually, at the beginning of a
fiscal period when a budget is developed or at the end of the period when a financial
report is prepared. It can also be conducted as part of a financial condition analysis
in a strategic planning session or anytime that it becomes necessary. Most important,
a DCA should be conducted prior to issuing a large amount of new debt.

TYPES OF DEBT
Why do governments borrow? The federal government borrows primarily to cover its
deficits as a result of revenue shortage (see Chapter 2). State and local governments
borrow mainly to finance the cost of capital projects such as land acquisitions, the
construction of infrastructures (roads, bridges, buildings), and the purchase of ex-
pensive equipment. This chapter focuses on state and local debt for financing capital
projects. The value of capital projects is often reported as fixed assets in accounting
(see Chapter 9).
There are two basic reasons governments borrow to finance capital projects. First,
capital projects are often expensive, so governments are unable to pay for them from
existing funds right away. Paying for capital projects directly from existing funds is
commonly known as the pay-as-you-go method. Second, and more important, bor-
rowing is fairer to taxpayers than the pay-as-you-go method. Imagine that a local
government is trying to build a fire station that has a lifetime of twenty years. If the
government pays for it from its existing financial reserve, which was collected from
taxpayers in the past, these taxpayers are essentially paying for a new fire station
that will serve future residents. These taxpayers may not stay or live to enjoy the
fire protection. However, if the government issues a debt and schedules a payment
scheme that fits the lifetime utility of the fire station so that the actual users of the
fire protection service will pay for the construction and operation of the fire station,
the government makes the debt a fair financing tool for the taxpayers. In other words,
the project users pay for the project.
What types of debt do governments have? State and local governments issue bonds
to pay for their debt. There are two types of bonds, based on sources of finance. A
general obligation bond is backed by the full faith and credit of a government includ-
ing its power to raise taxes to finance the debt. General obligation bonds are some-
times known as tax-supported debt and are often issued to finance capital projects
of governmental activities (see Chapters 2 and 10) when the projects cannot, or are
not allowed to, generate revenues sufficient to repay the debt. For example, a general
obligation bond can be issued to finance the cost of building a police substation in
DEBT CAPACITY ANALYSIS 171
a local government. Because policing cannot generate sufficient revenues to pay for
the bond (e.g., it does not make sense to charge a fee for patrolling a neighborhood),
the payment has to come from taxes or other government revenues.
If a bond is backed by the revenues generated from a project financed by the
bond, it is called a revenue bond, a nonguaranteed bond, or a self-supporting bond.
“Nonguaranteed” means it lacks the backing of government taxing power. Revenue
bonds are popular methods of financing capital projects of business-type activities,
which can generate sufficient revenues and possibly profits. For example, a revenue
bond can be issued to finance the construction of a water supply line to a residential
area in a city. The revenues generated from the water fee charged to water users can
be used to pay back the debt. This classification of general obligation and revenue
bonds is important because the issuance of different bonds may require different debt
capacities. A government may have enough debt capacity to issue revenue bonds but
not enough capacity to issue general obligation bonds.
DEBT CAPACITY ANALYSIS: A SIMPLE EXAMPLE

Debt capacity analysis (also known as debt affordability analysis in some literature)
answers three specific questions: Is your current debt level affordable? Can you borrow
more? How much more can you borrow? Let us work through a simple example of
personal finance to illustrate the process of debt capacity analysis. Assume that your
current debt includes a mortgage loan, a car loan, and several credit accounts for a total
amount of $100,000, and that your annual principal and interest payment for the debt
is $10,000. Is this an affordable level of debt for you? Let us say that you are making
$80,000 a year. Thus your payment in principal and interest is ($10,000/$80,000 =)
12.50 percent of your income. A financial planner tells you that any payment level
below 15 percent of your income is considered an affordable debt level and your debt
level of 12.5 percent is affordable. So you can borrow more.
How much more? Your debt level is affordable as long as your payment in principal
and interest does not exceed 15 percent of your annual income—you still have (15
percent – 12.5 percent =) 2.5 percent left to borrow. In other words, you can afford
an extra debt amount as long as its annual principal and interest payment is below
2.5 percent of your annual income. Realize that 2.5 percent of $80,000 is $2,000. So
you can afford an extra $2,000 in the principal and interest payment annually. But
into how much debt does that translate? For the convenience of our calculation, sup-
pose that the debt you will assume has 5 percent annual interest and a twenty-year
maturity (the length of the debt). The question becomes: what is the debt amount that
will cost you $2,000 annually in principal and interest payment for the next twenty
years with an annual interest rate of 5 percent?
This problem can be solved easily with Microsoft Excel Insert Function (fx). Select
“Financial” in the function category window and choose “PV” (present value) in the
function window. Then click the “OK” button. Notice that the debt amount is in its
present value form because it is the amount you want to borrow now. The calculation
process is shown in Excel Screen 13.1. Type in 0.05 in the “Rate” window for the
interest rate, 20 in the “Nper” window for the number of payment periods, and –2,000
Excel Screen 13.1 Calculating Debt with Excel
in the “Pmt” window for the annual payment in principal and interest (a negative value
is needed because this is a payment for a loan that should be paid back). The result is
$24,924, which is the additional amount of debt you can afford. This means that your
total debt level is affordable as long as it is below ($100,000 + $24,924 =) $124,924.
Now, you have just completed a DCA. Governments conduct DCA in a similar
way. The analysis consists of several steps: assessing the current debt level, determin-
ing the debt capacity, determining the additional debt capacity, and determining the
future debt capacity.
ASSESSING THE CURRENT DEBT LEVEL

There are two very important concepts involved in measuring the debt level. In the
earlier example of personal finance, the $100,000 of total debt is called the debt
outstanding and the $10,000 in annual principal and interest payment is known as
the debt service. Debt outstanding is the total dollar amount of principal that must
be repaid. It measures the total debt level that a government carries at a specific time
(say December 31 this year). Debt service is the annual payment in principal and
interest. Different from debt outstanding, which is a measure at a specific time, debt
service is a measure for a period (often a year).
In the assessment, you should calculate both the debt outstanding and the debt ser-
vice amounts in your government. You should identify and present the debt outstanding
for all types of debt including general obligation bonds and revenue bonds and their
proportions in the total debt. You also need to specify the service areas funded by the
debt. Is it issued in public safety, education, environmental protection, transporta-
tion, or some other service areas? You should also identify the maturity of the debt,
distinguishing the long-term debt (due in more than one year) from the short-term
borrowing (due within one year). If your jurisdiction is a primary government that
has component units (see Chapter 9), you may not be legally responsible for the debt
issued by a component unit and the debt may not be secured by the revenues of the
primary government. You may classify the debt of a component unit as “indirect” to
the primary government.
DETERMINING THE DEBT CAPACITY

Debt capacity is the level of debt a government can afford. A government has a higher
level of debt capacity if it can borrow more without causing difficulty in repaying
the debt. Two aspects considered in measuring debt capacity are whether (1) the
government can afford it and (2) the community can afford it. The following is a list
of possible measures of debt capacity.
s $EBT OUTSTANDING AS A PERCENTAGE OF TAXABLE PROPERTY VALUES $EBT /UTSTANDING

Taxable Property Values). This is a proper measure for many local governments
that use property taxes as a major source to pay off debt. It assesses whether the
community has sufficient financial resources to support the debt. Another simi-
lar measure is debt outstanding as a percentage of total personal income in the
community (= Debt Outstanding/Personal Income).
s $EBT OUTSTANDING PER CAPITA $EBT /UTSTANDING0OPULATION 4HIS MEASURE AS-
sesses the debt level per resident. Like the above measure, it is also a measure
of a community’s financial resources to support the debt. Both are measures of
a community’s debt capacity.
s $EBT SERVICE AS A PERCENTAGE OF REVENUES $EBT 3ERVICE2EVENUES OR THE Debt
Service Ratio. The revenues in the equation can be any revenue source available
to finance debt servicing. This measure assesses whether the government can
generate sufficient resources to pay for the debt. It is a measure of a government’s
debt capacity.
The first two measures mentioned assess the level of debt outstanding, so they
are also known as debt outstanding ratios. The last measure, the debt service ratio,
concerns the level of debt service. Among these measures, the debt service ratio is
the most popular measure of debt capacity for two reasons. First, although debt out-
standing indicates the amount a government owes, debt service is the amount that a
government has to pay on a regular basis. The capacity to pay off the debt is more
accurately measured by the debt service ratio. Second, a government has a little more
control over the debt service ratio than the debt outstanding ratios. For example,
because the taxable property values can go up and down quickly and a government
may have little control over the values, it is difficult to improve the debt outstanding
ratio (i.e., debt outstanding as a percentage of taxable property values). Even if the
government makes an effort to reduce the debt outstanding amount, the ratio still
goes up if the taxable property values decline. On the contrary, it is relatively easier
for a government to improve the debt service ratio because it has some control over
both the debt service amount (the numerator) and revenues (the denominator). If the
government makes an effort to reduce the debt service or to increase revenues, it will
see an improvement of the ratio right away.
What is an affordable debt level measured by the debt service ratio? Some experts
believe that debt service should not exceed 10 percent of the revenues available for the
debt service payment. Excluded in the revenues are one-time revenue sources such as
temporary grants or sales of an asset. This level of debt (10 percent in this example)
represents the maximum level of debt a government can carry, and any level higher
is considered unaffordable and unsustainable, so this specific measure is also known
as a benchmark debt ratio.
How is a benchmark debt ratio determined? There are several methods to gauge the
maximum amount of debt for your government. First, you may want to examine the
debt ratios of your government in the past. These historical ratios during different times
of tight or easy finance are empirical evidence of how much debt a government can
carry. Second, you can find a group of governments similar to yours in socioeconomic
characteristics (population, income, taxable property values, etc.) and use their average
debt ratio as the benchmark. This method is justifiable because similar socioeconomic
characteristics indicate similar capacities to pay off debt. Third, you can consult a bond
rating agency or an experienced analyst of government bonds. Some credit agencies
look for warning signs of overborrowing such as a large increase in debt outstanding
over the prior year’s level. You should consider their standards of such warning signs
in developing the benchmark. Finally, some governments have legal limitations on the
debt level, which should serve as the basis for a proper benchmark debt ratio.
Realize that benchmarks can be developed for both debt outstanding ratios and the
debt service ratio. It is also important to mention that benchmark debt ratios may differ
for various types of debt. For example, because general obligation bonds and revenue
bonds have different funding sources, their benchmark debt ratios should be different.
A government should develop benchmark debt ratios specific to each type of debt.
DETERMINING THE ADDITIONAL DEBT CAPACITY

Additional debt capacity is available if the current debt level of a government does
not exceed its benchmark debt ratio. For example, if the current debt service ratio in
your government is 6 percent and the benchmark is 10 percent, your additional debt
capacity is 4 percent. In the previous example of personal finance, your current debt
service ratio is 12.5 percent and the benchmark is 15 percent. So the additional debt
capacity is (15 percent – 12.5 percent =) 2.5 percent, which translates into $2,000 in
debt service and $24,924 in debt outstanding.
In another example, assume that a local government has 75,000 residents and
currently carries $30 million in debt for a debt per capita of ($30,000,000/75,000 =)
$400. If the benchmark is $500 of debt per person, the additional debt capacity for
the government is ($500 – $400) × 75,000 = $7.5 million.
DETERMINING THE FUTURE DEBT CAPACITY

For the purpose of financial planning, many governments forecast their future debt
capacity. They estimate the debt ratios for future years. This forecasting process helps
the governments detect any change in the debt capacity over time and, more important,
discover whether or not the capacity declines over time and what should be done to
avoid the decline. The forecast should estimate any additional debt capacity in the
future so financial planners or budgeters are aware of the availability of this additional
revenue resource in budgeting.
A CASE STUDY
Lakeview is a suburban city of 63,000 permanent residents with a large year-round
tourist population. The city provides policing, fire and emergency responses, parks
and recreation, local transportation, water supply, sewer treatment, storm water
management, and other municipal services. It contracts out residential solid waste
collection to private companies.
During this fiscal year, the city generated general revenues of $55.3 million. The
largest general revenue sources were property taxes ($19.2 million), sales taxes ($10.0
million), utility taxes ($6.3 million), and revenues from state and federal governments
($13.7 million). The city’s total assets at the end of this fiscal year were $191.2 mil-
lion, and its net position was $141.2 million.
The city has experienced a drastic revenue decline because of the recent economic
recession that started two years ago. The city’s general revenues have declined more
than 20 percent for the past two years due to a rapid deterioration of revenue bases.
The city’s investment in the municipal bond market and the stock market has lost 40
percent of its value over the past two years. The long-term financial forecast has the
city in a steep revenue decline over the next two years.
The city has long borrowed to finance its capital projects. The city’s debt in-
cludes general obligation bonds and revenue bonds. By the end of this fiscal year,
the city’s total long-term obligations in governmental activities amounted to $37
million, of which $36 million was long-term (due in more than one year) general
obligation bonds supported by tax revenues. The city manager, Leo McCravy, was
concerned that the decline in revenues would reduce the city’s capacity to borrow,
and he asked Jeff Liang, a financial analyst, to conduct a debt capacity analysis.
The questions Leo asked were: What is the city’s current debt level? Can the city
borrow more, and if it can, how much more? How much more can the city borrow in
the next five years? He asked Jeff to focus the analysis on general obligation bonds
because these bonds were supported by tax revenues that had recently experienced
a drastic decline.
STEP 1: CALCULATING THE CURRENT DEBT LEVEL

The city’s capital projects financed by general obligation bonds include construc-
tion and renovation projects for a fire station, the city hall, and a major road. Bonds
Table 13.1
General Obligation Bonds in Lakeview
Debt outstanding ($)

(December 31)
Five years ago 17,823,000
Four years ago 11,985,000
Three years ago 30,935,000
Two years ago 29,169,000
This year 36,449,000
were also issued to finance the acquisition of a ranch for the development of a future
city park. In addition, new bonds were issued to refinance the bonds issued twenty
years ago. The average maturity of these bonds is twenty years. The credit agencies
Standard & Poors and Fitch both gave an “A+” rating to the most recent bond issued
by the city, indicating an upper medium grade of bond ratings for the city. Table 13.1
shows debt outstanding for the past five years.
STEP 2: DETERMINING THE DEBT CAPACITY

In deciding on the measures of debt capacity, Jeff has choices of debt outstanding
ratios such as debt outstanding as a percentage of taxable property values (or personal
income or population) or the debt service ratio. Jeff believes that, although taxable
property values, residents’ personal income, and population are good indicators of a
city’s resource potential, they represent long-term perspectives of debt capacity. The
improvement of taxable property values, personal income, and population can take
a long time, and is often affected by factors that are out of the city’s control, such as
the housing market and the economy.
The city’s immediate concern is short term: what is the immediate impact of the
decline in revenues on debt capacity? And if the debt capacity of the city deteriorates
quickly, how should the city stop the deterioration and improve the capacity quickly?
Consequently, Jeff decides to focus on the debt service ratio (Debt Service/Revenues),
over which the city has more control.
To determine the revenues in calculating the debt service ratio, Jeff uses the general
fund revenues that are used in the city to support the general obligation bonds. These
revenues consist of sales taxes, an excise tax, property taxes, and intergovernmental
revenues. Table 13.2 shows the debt service ratios of the past five years in the city.
The city’s debt service ratio this year is ($3,783,000/$45,178,000 =) 8.37 per-
cent. To determine whether or not this ratio is too high, Jeff needs to decide on the
benchmark debt service ratio that the city should use in judging the affordability of
the city’s debt level. He believes that a benchmark debt service ratio should be low
enough that the debt service payment should not compete for funding with personnel
and operating expenses in the general fund and other prioritized general fund projects.
After carefully reviewing the relevant literature and consulting with several special-
Table 13.2
Debt Capacity in Lakeview
General fund Debt service

Debt service ($) revenues ($) ratio (%)
(1) (2) (1)/(2)
Five years ago 3,537,890 40,892,000 8.65
Four years ago 4,278,000 47,869,000 8.94
Three years ago 3,267,000 49,375,000 6.62
Two years ago 2,356,000 48,937,000 4.81
This year 3,783,000 45,178,000 8.37
ists from bond rating agencies, Jeff eventually determines that any debt service ratio
value above 10 percent should be considered too high. Any ratio value higher than
this benchmark indicates that the city needs to reduce the level of debt or to increase
the revenues available for debt payment.
The city’s debt service ratio is 8.37 percent this year, (10 percent – 8.37 percent
=) 1.63 percent less than the benchmark. This result indicates that the city should
generate sufficient revenues to pay off the principal and interest due this year. Also,
this surplus in the debt service ratio translates into an amount of ($45,178,000 × 1.63
percent =) $734,800 in the debt service, which is the additional amount of debt ser-
vice that the city can afford within the limit of the benchmark.
STEP 3: DETERMINING THE ADDITIONAL DEBT CAPACITY

How much does this additional debt service translate into the new debt amount? In
other words, assume that the city wants to reach the 10 percent limit in the debt ser-
vice ratio, how much more debt can the city take on? Or how much more debt can be
generated from an additional annual debt service of $734,800? Jeff assumes a maturity
of twenty years with an annual interest of 5 percent (which is a reasonable estimate
for a city with an A+ bond rating). The result in Excel Screen 13.2 shows that the
city can borrow an additional $9.1 million (i.e., $9,157,232) with an additional debt
service capacity of $734,800. Therefore, within the 10 percent benchmark, the city
can borrow up to (the existing debt outstanding $36.4 million + the possible new debt
$9.1 million =) $45.5 million this year.
Caution should be exercised about the interpretation of this additional debt capacity
of $9.1 million. First, it represents the maximum extra amount that the city can bor-
row within the limit of the benchmark. Any debt more than this level can cause the
debt service ratio to exceed the benchmark. Once it reaches the maximum, the city
does not want to borrow until it generates more revenues or reduces the debt service
amount. If the city borrows an additional $9.1 million with the terms specified (i.e.,
twenty years and 5 percent annual interest), its debt service will increase by $734,800
every year for the next twenty years.
Second, and perhaps most important, the calculation assumes that the city will
Excel Screen 13.2 Calculating Lakeview’s Debt with Excel
sustain the current level of revenues. Note that the debt service ratio is affected by
revenues. An increase in revenues will lead to an increase in additional debt capacity
and a decline in revenues will reduce it.
Third, the additional debt capacity is also affected by factors such as debt service
payments, the interest rate, and debt maturity. The debt capacity changes because
these factors change. This is particularly true for governments that borrow frequently;
their debt service amounts change frequently.
STEP 4: DETERMINING THE FUTURE DEBT CAPACITY

Though the analysis shows that the city can still borrow more this year, Jeff believes
that the revenue decline forecasted in the next few years will significantly affect the
city’s debt capacity. Considering several new debt issuances already in the city’s capi-
tal improvement plan and budget, Jeff believes that the city may not be able to issue
any new debt without exceeding the benchmark ratio. To understand the future debt
capacity of the city for the next five years, Jeff prepares Table 13.3.
The results show that the projected general fund revenues will decline for the
next four years and the decline over the next two years is drastic. The projected
debt service ratio will be 11.10 percent two years from now, exceeding the 10
percent benchmark by 1.10 percent mainly as a result of the revenue decline. This
will leave the city without any capacity to issue new debt (i.e., “the additional
debt capacity” is zero in Table 13.3 two years from now). In fact, the negative
Table 13.3
Future Debt Capacity in Lakeview
Projected debt Projected Projected Benchmark Additional

outstanding ($) Projected debt general fund debt service debt service debt service Additional Additional
(December 31) service ($) revenues ($) ratio(%) ratio (%) ratio (%) debt debt
(1) (2) (3) (4) = (2)/(3) (5) (5) – (4) service ($) capacity ($)
This year 36,449,000 3,783,000 45,178,000 8.37 10.00 1.63 734,800 9,157,232
Next year 34,626,550 3,568,000 38,401,300 9.29 10.00 0.71 272,130 3,391,341
Two years from now 32,895,223 3,409,000 30,721,040 11.10 10.00 –1.10 0 0
Three years from now 31,250,461 3,706,000 28,570,567 12.97 10.00 –2.97 0 0
Four years from now 29,687,938 2,967,000 27,142,039 10.93 10.00 –0.93 0 0
Five years from now 28,203,541 2,653,000 28,499,141 9.31 10.00 0.69 196,914 2,453,985
179
number in “additional debt service ratio” requires that the city reduce the debt
service and debt outstanding amounts in order to improve (reduce) the debt ser-
vice ratio. At the end of this chapter, you will work on an exercise problem on the
amounts of debt service and debt outstanding that should be reduced in order for
the city to meet the requirement of the 10 percent benchmark (Exercise Problem
4: Application).
In addition, the result indicates that due to the revenue decline, the city will not
have any additional debt capacity three years in a row starting two years from now.
The most severe shortfall in debt capacity will occur three years from now when the
debt service ratio rises to 12.97 percent, 2.97 percent higher than the benchmark.
STEP 5: PREPARING A DEBT CAPACITY REPORT

In preparing the debt capacity report, Jeff makes several recommendations for the
city’s debt management policies. First, because of the significant decline in general
fund revenues projected for the next four years, the city should consider curtailing or
eliminating the issuance of any new long-term debt that will mature within the next four
years. Second, the city’s debt capacity will deteriorate over the next four years. The city
should consider restructuring some of its existing debt to reduce its debt service during
this time. Options for refinancing the debt to a more favorable term in maturity should
be considered. Third, the city should make an effort to increase its revenues and should
consider revenue sources other than the general fund revenues to pay for the debt.
EXERCISES
1. KEY TERMS
Debt capacity analysis (DCA)
Pay-as-you-go
General obligation bonds and tax-supported bonds (full faith and credit debt)
Revenue bonds, nonguaranteed bonds, or self-supporting bonds
Debt outstanding
Debt service
Debt capacity
Debt outstanding ratios
Debt service ratio
Benchmark debt ratio
Steps in debt capacity analysis
Excel Insert Function (fx) PV procedure
2. DISCUSSION
1. Use examples in your state and local governments to discuss the need for
debt in local government. Some local governments carry little debt. Discuss
the implication of such practice in public service provision and financing.
2. Identify some projects funded by general obligation bonds or revenue bonds

in your state or local governments. Discuss the need to distinguish between
types of debt.
3. Discuss the need and value of debt capacity analysis in your state and local
governments.
4. Discuss the importance of examining both debt outstanding and debt service
in understanding the debt level of a government.
3. CALCULATIONS
The debt service and the revenues in a city government are $3.1 million and $30
million, respectively.
1. What is the debt service ratio? If the benchmark debt service ratio is 12 percent,
does the city have additional debt capacity? Assume an annual interest rate of
5 percent and a twenty-year maturity for the debt, how much additional debt
can the city carry?
2. Assume an annual interest rate of 4 percent and a twenty-year maturity for
the debt, how much additional debt can the city have?
3. Assume an annual interest rate of 5 percent and a thirty-year maturity for the
debt, how much additional debt can the city carry? Compare the results of the
additional debt capacity amounts in the above three different circumstances
in interest rate and maturity. Explain why they differ.
4. If the benchmark debt service ratio is 10 percent, does the city have additional
debt capacity? Why or why not?
4. APPLICATION
The case study indicates that the City of Lakeview will not have any additional debt
capacity two years from now. The additional debt service ratio is negative (–1.10
percent), indicating that the city must reduce its existing debt outstanding amount to
maintain the debt service ratio at the benchmark level (10 percent). Assume an an-
nual interest rate of 5 percent and a twenty-year maturity for the debt. How much of
the projected debt outstanding in that year ($32.90 million) should the city reduce in
order to keep its debt service ratio at the benchmark level?
Refer to the debt data three years from now in Table 13.3. Assume an annual interest
rate of 5 percent and a twenty-year maturity for the debt. How much of the existing
debt outstanding in that year ($31.25 million) should the city reduce in order to keep
its debt service ratio at the benchmark level?
Refer to the debt data four years from now in Table 13.3. Assume an annual interest
rate of 5 percent and a twenty-year maturity for the debt. How much of the existing
debt outstanding in that year ($29.69 million) should the city reduce in order to keep
its debt service ratio at the benchmark level?
Table 13.4
Debt Capacity Analysis in a Capital Planning Process
Forecast debt
outstanding ($) Forecast debt Forecast
(December 31) service ($) revenues ($)
Next year 12,382,937 1,538,000 20,382,765
Two years from now 13,002,084 1,410,000 17,325,350
Three years from now 15,602,501 1,706,000 17,498,604
Four years from now 12,482,000 2,200,000 17,673,590
Five years from now 11,857,900 2,054,000 17,850,326
5. APPLICATION
A county government is preparing its capital improvement plan and the capital budget.
The planning process involves a forecast of total debt needed to finance the projects in
the plan. As a financial analyst for the county, you are asked to prepare a debt capacity
analysis. Your forecast of the debt levels is based on the proposed capital projects
and their funding sources. Table 13.4 shows your forecast of the general obligation
bonds and the revenues that can be used to pay for the debt over the next five years.
The benchmark debt service ratio for the county is 12 percent. The county also uses
a target debt service ratio of 9 percent. The debt history of the county indicates that
the county’s funding for public services will be affected negatively if the debt ratio
exceeds 9 percent. In the debt capacity analysis, identify any additional debt capacity
in the next five years and discuss the debt affordability of the county. Prepare a debt
capacity report to make recommendations for the county’s debt management policies.
6. APPLICATION
Conduct a debt capacity analysis for a government of your choice. The debt information
should be found in the Comprehensive Annual Financial Report (CAFR). The CAFR
may include the debt information in a note to financial statements. You may also find
debt service figures in a summary of debt service requirements, various debt service
funds, and Statements of Revenues, Expenditures, and Changes in Fund Balances
for different fund types. Of course, you can always call and interview financial staff
to obtain the information necessary for the analysis.
14 Financial Risk Assessment
Analyzing the Risk of Revenue Loss
LEARNING OBJECTIVES
s 5NDERSTAND WHAT lNANCIAL RISK IS

s -EASURE AND EVALUATE THE RISK OF REVENUE LOSS
s $EVELOP STRATEGIES TO REDUCE THE RISK OF REVENUE LOSS

WHAT IS FINANCIAL RISK?
What is risk? Risk exists everywhere and anytime in our lives. When you eat, you
encounter a slight but real risk that the food will be contaminated. When you drive,
you increase the risk of auto accidents. When you exercise, you run the risk of sport-
related injury. Simply put, risk is a possible loss.
Risk occurs every day in a governmental organization too. Risk in an organiza-
tion can be political, legal, operational, or financial. Political risk occurs when an
organization faces the possible loss of political support from citizens, legislators, or
other stakeholders for its policies or practices. The failure to consult citizens before
implementing an important public policy puts an organization at political risk for
losing citizens’ support for the policy. Legal risk occurs when an organization is in
danger of violating the law. A local police department conducting racial profiling may
risk violating the state or the federal law. Operational risk refers to the possible loss
resulting from failures, interruptions, errors, or omissions in an organization’s internal
operations. An example is a communication breakdown among various agencies in
a hurricane rescue effort. Operational risk can also stem from job-related illness and
injuries of employees.
Financial risk refers to a possible revenue or income loss. Financial risk in an
organization often leads to difficulty in assuming financial obligations. This risk can
183
escalate and cause financial insolvency, particularly during economic downturns

when revenue sources shrink and demand for public services increases. In the great
economic recession that began in December 2007, many governments encountered a
severe risk of revenue loss and had difficulty providing public services at a desirable
level. Several commonly recognized financial risks are as follows.
s Investment risk is the possible loss of investment income as the market declines.
Many governments invest in bond and stock markets, exposing themselves to
market fluctuations. Investment loss was prevalent for many governments during
the economic recession in 2008 and 2009. For example, the Massachusetts state
pension fund reported its worst year in 2008–9 as a result of steep market declines
and a loss of $12.8 billion, or 23.6 percent of its value. Many other governments
had similar or even greater investment losses.
s Debt-related risk is the possible loss related to failure to pay off debt in a timely
fashion, which may cause financial insolvency and higher interest costs for a
government. The economic recession that began in December 2007 led to a de-
cline in revenues for repaying debts. Some governments had to restructure their
debt payments and risked paying more interest costs in the long run. A tool of
debt capacity analysis is discussed in Chapter 13.
s Revenue risk is the possible loss of revenues resulting mainly from a decline in
the revenue base. Revenue risk, also known as the risk of revenue loss in this
chapter, is often caused by an economic, financial, and operational environment
that is unfavorable for revenue growth. Revenue risk is greater for an organiza-
tion facing a likely drastic and persistent revenue decline, which was common
during the 2007–9 economic recession when revenue loss for many governments
was large and persisted over multiple years. A long, drastic, and unpredictable
revenue loss makes financial planning and management particularly difficult.
Of all the financial risks in government, revenue risk is perhaps the most important
because of its frequent and persistent occurrence and its large impact during economic
downturns. This chapter focuses on this risk also because the severity of revenue loss
experienced by many governments during the great economic recession in 2007–9
amplified the need to develop a tool to manage and reduce the risk of revenue loss.
How are financial risks in government managed or reduced? Public finance experts
have developed a risk management strategy that includes four steps: developing a risk
management goal, identifying the risk, measuring the risk, and controlling or reducing
the risk. This chapter introduces a simple tool to measure the risk of revenue loss.
The tool should also help a government develop strategies to control and reduce the
risk of revenue loss. The tool can be incorporated as part of a government’s financial
risk management strategy.
HOW TO MEASURE THE RISK OF REVENUE LOSS

Because revenue risk is a possible revenue loss, one method of measuring the risk
is to estimate the probability of the revenue loss by analyzing the probabilities of all
ANALYZING THE RISK OF REVENUE LOSS 185
Table 14.1
Revenues from Two Sources
Year Source A Source B

1 16 10
2 17 16
3 15 23
4 18 20
5 (last year) 15 12
Total of last 5 years 81 81
expected values of revenue loss and identifying the probability that a specific revenue
loss will occur. However, this process of estimation can be very time-consuming and
difficult; the requirement for data and statistical analysis tools exceeds the capacity
of many governments.
In this chapter, we introduce a much simpler method for measuring the risk. By
examining the historical data of a revenue source, we can measure changes in revenue
over time. The scope of revenue changes can be used as a measure of revenue risk. Let
us look at an example. The revenue amounts of two revenue sources (Sources A and B)
in the past five years are shown in Table 14.1. Note that these two sources have produced
the exact same amount of revenues for the past five years (= 81). If you are asked to
choose one reliable revenue source for the financial needs of your government in the
future, which one do you choose? Which source is more reliable or stable?
A quick examination of the data shows an up-and-down trend for Source A, but
the increments of changes have been small. For example, the increase from Year 1 to
Year 2 is (17 – 16 =) 1 and the rest of the increments from Year 2 to Year 5 are (15
– 17 =) –2, (18 – 15 =) 3, and (15 – 18 =) –3, respectively. In comparison, Source B
increased sharply until Year 3 and has drastically declined since then. The incremen-
tal changes for Source B over the past five years are 6, 7, –3, and –8, constituting a
range of changes significantly larger than seen for Source A. These results indicate
that Source B is a more unpredictable source of revenue than Source A. Therefore,
we say that Source B is riskier than Source A for our future financial needs.
A revenue source subject to large and quick changes is riskier than a revenue
source with a more stable pattern of change. Why is a more stable revenue source
less risky? Stability indicates that the changes in revenue are small and consistent
over time, providing a reliable source for governments. High stability and reliability
of revenue sources are necessary for public service provision. Public managers need
to have stable and reliable revenue streams to provide and sustain a desirable level
of public services. Moreover, a stable revenue source also indicates that the revenue
is more predictable, which is an essential requirement for financial planning and
implementation. Public managers require predictable revenue sources to implement
financial plans (i.e., budgets).
Financial experts describe the susceptibility to large and quick changes as “volatile.”
As you may have realized, this book equates risk to volatility in risk measurement.
Table 14.2
Growth Rates of Two Revenues
Growth rate of Growth rate of

Year Source A Source A (%) Source B Source B (%)
1 16 10
2 17 6.25 16 60.00
3 15 –11.76 23 43.75
4 18 20.00 20 –13.04
5 (last year) 15 –16.67 12 –40.00
Several steps are involved in measuring the volatility (i.e., the risk) of a revenue
source. First is to find a measure of the incremental changes. One such measure is
the revenue growth rate.
Revenue This Term – Revenue Last Term

Revenue Growth Rate This Term =
Revenue Last Term
In our example, the growth rate of Year 5 over Year 4 for Source A is (15 – 18) /
18 = –16.67 percent. Table 14.2 shows the growth rates of the two revenue sources.
The second step involves the development of a measurement of volatility for the
revenue growth rate. Statisticians have developed several measures that estimate
the variation of the growth rate data over time. One such measure is the standard
deviation, which calculates the distance between the individual growth rates and the
average growth rate.
A smaller standard deviation value indicates that the individual growth rates center
more closely on the average growth rate. In other words, a smaller standard deviation
indicates that the revenue source is more predictable and reliable around the average
growth rate. A larger standard deviation indicates that the individual growth rates
diverge from the average growth rate, making the revenue source less predictable and
less reliable, and therefore riskier.
How is the standard deviation calculated? Remember that we introduced the con-
cept of variance (V) in Chapter 8 (“Cash Management”). The equation of the standard
deviation is the square root of the variance.
Standard Deviation (or SD) = 3 Variance

Obtaining the values of standard deviation is easy with Excel. Screen 14.1 shows
the use of the Excel Insert Function (fx) STDEV procedure to calculate the standard
deviation for Source A in our example. Select “Statistical” in the function category
window and choose “STDEV” (standard deviation) in the function window. Click the
“OK” button. Select the numbers for the calculation. If you have a large database, you
may want to run the STDEV process from an Excel datasheet. An example of using
the datasheet in calculation is provided in Excel Screen 8.2 in Chapter 8 of this book.
Excel Screen 14.1 Calculating Standard Deviation with Excel
The standard deviation of the growth rate of Source A is 16.87 percent (0.1687).
It should be easy for you obtain the standard deviation of Source B with Excel in the
same way. Because the standard deviation of Source B (47.05 percent) is larger than
that of Source A, we say that Source B is riskier than Source A.
Now, we know the risks of individual revenue sources. Nevertheless, because
most governments have multiple revenue sources, it is also informative to know the
combined risk of all revenue sources. This is called the risk of a revenue portfolio. A
revenue portfolio should contain more than one revenue source.
A measure of this combined risk is the revenue portfolio risk ratio. To calculate the
ratio, you have to know the proportion of each revenue source in the total revenue.
In our example, the total revenue in the most recent year (last year or Year 5) was
(15 for Source A + 12 for Source B =) 27. The proportion of Source A in the total
revenue is (15/27 =) 55.56 percent. The proportional risk of this source, measured by
the standard deviation of the growth rate, is (55.56 percent × 16.87 percent =) 9.37
percent. Similarly, the proportion of Source B in the total revenue is (12/27 =) 44.44
percent. The proportional risk of Source B is (44.44 percent × 47.05 percent =) 20.91
percent. The combined risk is the total of the proportional risks of these two revenue
sources, which is (9.37 percent + 20.91 percent =) 30.28 percent. To generalize the
above calculation, the equation for the risk of a revenue portfolio that contains two
revenue sources (Source 1 and Source 2) is:
Revenue Portfolio Risk Ration = X1SD1 + X2SD2

In the equation, X1, X2 are the proportions of Sources 1 and 2 in the total revenue
respectively. SD1 and SD2 are the standard deviations for the growth rates of Sources
1 and 2, respectively. The following equation can be used to estimate the risk of a
revenue portfolio that includes k number of revenue sources.
Revenue Portfolio Risk Ration = X1SD1 + X2SD2 + . . . + XkSDk
X1, X2, . . . and Xk are the proportions of Sources 1, 2, . . . and k in the total revenue,
respectively. SD1, SD2, . . . and SDk are the standard deviations for the growth rates of
Sources 1, 2, . . . and k, respectively. “. . .” represents risk estimates for any possible
number of revenue sources.
Note that the risk of a revenue portfolio is determined by the risks of revenue
sources (i.e., the SDs) and the proportions of revenue sources in the total revenue
(i.e., the Xs). Therefore, a government has two strategies to reduce the risk of a reve-
nue portfolio: to reduce the risks of revenue sources or to reduce the proportion of a
riskier revenue source in the total revenue. The methods to reduce the risks of revenue
sources include the efforts to keep revenue bases and revenue rates stable. For example,
during an economic downturn when sales tax receipts are in decline, a government
should close sales tax loopholes and reduce sales tax exemptions to stabilize the tax
base. The methods used to reduce the proportion of a riskier revenue source will be
demonstrated later in the chapter with examples.
It is important to mention that a more stable revenue source does not necessarily
generate more revenues. The standard deviation of the revenue growth rate in Table
14.3 is 3.97 percent, a very stable revenue source compared with Sources A and B in
the above example. But the source has experienced a constant decline in revenue for
the past five years. Realize that a stable revenue source indicates a more predictable
or reliable pattern and it does not necessarily generate more revenue than a riskier
source for a given time. This is a limitation of using the standard deviation of reve-
nue growth rate as a measure of revenue risk. The measure is more appropriate for
revenues with an up-and-down pattern of growth than for revenues with a constant
(positive or negative) pattern of growth.
HOW TO REDUCE THE RISK OF REVENUE LOSS
To understand how to control or reduce the risk of revenue loss, you must first under-
stand two types of risk associated with revenue collection: systematic revenue risk and
unsystematic revenue risk. During major economic recessions, revenue loss occurs
in almost all revenues of governments, such as taxes, intergovernmental revenues,
user charges, and user fees. Systematic revenue risk is the risk of collapse of an entire
revenue system. It affects a great number of revenue sources, and it is virtually im-
possible for a government to escape from this risk if it occurs. Causes of systematic
revenue risk include natural or man-made disasters of immense magnitude. Examples
are the effect of Hurricane Katrina on the revenue system in the city of New Orleans
Table 14.3
A Revenue in Stable Decline
Year Revenue Growth rate (%)

1 22
2 19 –13.64
3 16 –15.79
4 14 –12.50
5 (last year) 11 –21.43
and the 2007–9 economic recession on the revenue systems of most state and local
governments.
On the other hand, unsystematic revenue risk affects one or only a few specific revenue
sources. For example, a price reduction for water consumption will result in a decline in
user charges from water consumption for a government. But the price decline will not
lead to a decline in revenues other than water-use charges. Compared with systematic
revenue risk, unsystematic revenue risk is more controllable and manageable. So we
focus on a method to reduce unsystematic revenue risk in this chapter.
As mentioned earlier, the risk of a revenue portfolio can be reduced by reducing
the proportion of a riskier revenue in the total revenue. Let us illustrate this point us-
ing our example in Table 14.2. The risk of Source A is 16.87 percent, and the risk of
Source B is 47.05 percent. With the revenue proportions last year (55.56 percent for
Source A and 44.44 percent for Source B), the portfolio risk is 30.28 percent. Now,
assume that we make more revenue collection efforts in the more stable Source A;
we increase the revenue proportion of Source A from 55.56 percent to 60.00 percent.
Consequently we reduce the revenue proportion for the riskier Source B from 44.44
percent to 40.00 percent. The portfolio risk is improved (reduced) from 30.28 percent
to (60.00 percent × 16.87 percent + 40.00 percent × 47.05 percent =) 28.94 percent.
The revenue portfolio of the organization has become less risky.
Another important way to reduce revenue portfolio risk is through revenue diver-
sification, defined as the inclusion of various types of revenue sources in a revenue
portfolio. A portfolio is more diversified if it consists of more revenue sources and/or
if the revenues come from these sources more evenly. The unsystematic revenue risk
of a revenue portfolio can be measurably reduced if there are more revenue sources
and these revenue sources do not move in the same direction (positive or negative) at
the same growth rate. The risk can be significantly reduced if these revenue sources
move in opposite directions. For example, if the revenues from public transit systems
(e.g., ticket sales from public bus routes and light rail) are negatively associated with
the revenues from privately owned vehicle use (e.g., motor vehicle license fees), a
revenue loss as a result of the decline in privately owned vehicle use (e.g., decline
in vehicle registration fees) will be offset by an increase in revenue growth from the
public transit systems.
Diversification is an important principle in finance to reduce unsystematic risk.
The mathematical proof of this principle is beyond the scope of this book. For those
who are interested in this proof, see the chapter “Introduction to Risk, Return, and
the Opportunity Cost of Capital” in Principles of Corporate Finance by Richard A.
Brealey, Stewart C. Myers, and Franklin Allen. Despite the importance of diversifying
revenue sources in risk management, it is often politically difficult and economically
costly to create new revenue programs for governments. As a result, they must focus
on the existing revenue programs in their risk management practices.
A CASE STUDY
Solivita County serves an urban and suburban population of 1.1 million and comprises
thirteen municipalities in its incorporated area and seventeen distinctive neighborhoods
in its unincorporated area. The county is a leading tourist destination and a premier
business center. The county government provides services in general government,
public safety, transportation, physical environment, human services, and culture and
recreation. The county’s major revenue sources are real property taxes, sales taxes,
intergovernmental revenues (IGR), and user charges, which account for more than
90 percent of the county’s total revenues. Of the $1,507 million in total revenues
collected last year, the above revenues contributed $1,373 million (or 91 percent of
the $1,507 million).
The county’s revenues have been struck hard by the recent economic recession.
Table 14.4 shows the major revenues and their growth rates for the past eleven years.
All of the major revenues have declined for the past two years, with the intergov-
ernmental revenues declining four years in a row. Judging by the growth rate, sales
taxes have had the largest decline for the past two years (–14.05 percent and –7.86
percent), followed closely by the decline in property taxes (–10.95 percent and –7.09
percent). By the size of the absolute dollar value, the decline in property taxes has
been the greatest. Property taxes had a ($646.23 million – $6000.43 million =) $45.80
million decline last year, compared with a ($252.39 million – 232.54 =) $19.85 mil-
lion decline in sales taxes, a ($200.32 million – $189.36 million =) $10.96 million
decline in the intergovernmental revenues, and a ($352.50 million – $350.38 million
=) $2.12 million decline in user charges.
The prospect of a long-term and constant deterioration of revenues greatly concerns
the county management. County Manager Tom Hawkins has long held a belief that
property taxes are one of the most reliable revenue sources for the county, which
stems from his observation that the property tax base has been relatively stable. An
analysis of the property tax base (i.e., taxable property values) supports his belief.
The base had steadily increased until two years ago when the economic recession
started. However, taxable values had held up relatively well during other economic
downturns in recent history, so Tom has always viewed property taxes as the last
resort for covering the county’s revenue shortages.
However, the across-the-board decline in all revenues in the past two years has
made Tom rethink the possibilities of continual revenue loss and how reliable these
revenue sources, including property taxes, are for generating revenues. Tom wants
an analysis on the financial risk associated with revenue loss.
Table 14.4
Major Revenues in Solivita (million $)
Property taxes Sales taxes IGR User charges

Property growth rate Sales growth rate growth rate User growth rate
Year taxes (%) taxes (%) IGR (%) charges (%) Total
1 393.44 186.56 167.65 212.46 960.11
2 461.87 17.39 206.66 10.77 187.49 11.83 246.25 15.90 1,102.27
3 459.82 –0.44 193.28 –6.47 202.61 8.06 242.51 –1.52 1,098.22
4 484.59 5.39 200.80 3.89 228.38 12.72 255.20 5.23 1,168.97
5 524.80 8.30 209.70 4.43 212.51 –6.95 270.22 5.89 1,217.23
6 587.20 11.89 226.31 7.92 238.32 12.15 289.11 6.99 1,340.94
7 722.74 23.08 263.74 16.54 244.93 2.77 324.08 12.10 1,555.49
8 724.05 0.18 282.82 7.23 237.24 –3.14 361.07 11.41 1,605.18
9 725.66 0.22 293.64 3.83 224.91 –5.20 368.73 2.12 1,612.94
10 646.23 –10.95 252.39 –14.05 200.32 –10.93 352.50 –4.40 1,451.44
11 (last year) 600.43 –7.09 232.54 –7.86 189.36 –5.47 350.38 –0.60 1,372.71
191
STEP 1: DEVELOPING THE PURPOSE OF THE ANALYSIS

The county has developed a mission for financial risk management agreed upon by
major stakeholders. The mission states that the county should provide public services
with a diversified revenue portfolio that can withstand severe economic declines and
provide stable revenues to sustain a desirable level of services to the citizens. The
underlying philosophy of this mission is that, as a public agency receiving taxpayers’
money, the county government should protect taxpayers and should not take unneces-
sary financial risk.
The purpose of Tom’s analysis is to supply information to assist in the decision-
making process concerning revenue risk management. More specifically, the analysis
should help the county determine reliable revenue sources for supporting and sustain-
ing a desirable level of county services to the public.
STEP 2: IDENTIFYING MAJOR REVENUE SOURCES AND ESTIMATING REVENUE RISKS

The major revenue sources in the county have been consistent for the past decade.
They are real property taxes, sales taxes, intergovernmental revenues from the federal
government and the state, and user charges mainly from the county’s utility services,
including water supply, sewer treatment, solid waste treatment, garbage collection,
and recycling.
Tom calculates the growth rates of these revenue sources and uses the standard
deviation to estimate the revenue risks of these sources. Table 14.5 shows the standard
deviations of growth rates for the major revenue sources based on the growth rate
data of past eleven years in Table 14.4.
Table 14.5
Risks of Major Revenue Sources in Solivita (%)
Revenue sources Standard deviation

Property taxes 10.62
Sales taxes 9.35
Intergovernmental revenues 9.02
User charges 6.54
The result surprises Tom. Property taxes, a revenue source believed to be very
stable, are most volatile. User charges from the consumption of utilities, a revenue
source deemed to fluctuate frequently in response to the economic trend, are least
volatile. To validate these results, Tom analyzes the historical trend of the risks for the
revenues, and constructs Table 14.6. The standard deviations are calculated from the
historical data of growth rates of the revenues. For example, the standard deviation
of property taxes in Year 3 (= 12.61 percent) is calculated from the growth rate data
of the previous two years (17.39 percent and –0.44 percent).
The results in Table 14.6 show that property taxes were the most volatile source of
all major revenues in seven of nine years, making them the riskiest revenues of all.
Sales taxes are not a stable source either, with a risk of around 9 percent in recent years.
Moreover, intergovernmental revenues have become more volatile in recent years with
a gradual increase in risk from 2.67 percent nine years ago to 9.02 percent last year.
Finally, the risk of user charges has gradually declined from 12.32 percent nine years ago
to 6.54 percent last year, making them the most stable revenues for the past six years.
To measure the risk of the revenue portfolio that consists of the four revenue sources,
Tom first calculates the proportion of each revenue source in the total revenues. He
uses the revenue data of last year in Table 14.4 to arrive at ($600.43 million/$1,372.71
million =) 44 percent for property taxes, ($232.54 million/$1,372.71 million =) 17
percent for sales taxes, ($189.36 million/$1,372.71 million =) 14 percent for inter-
governmental revenues, and ($350.38 million/$1,372.71 million =) 25 percent for
user charges. Therefore,
Risk of the revenue portfolio ratio =

(44% × 10.62%) + (17% × 9.35%) + (14% × 9.02%) + (25% × 6.54%) = 9.16%
STEP 3: ANALYZING THE RISKS

The results of the historical trend analysis again run counter to Tom’s long-held view
that property taxes are the most reliable revenue source and user charges are the most
volatile source against economic recessions. He carefully reviews the property taxes
growth rate data and concludes that the large variation of the rate mainly reflects the
large fluctuation of taxable values in recent years.
Moreover, Tom notices that legislative efforts to restrict tax rate change may also
contribute to the volatility of property taxes. These efforts have made it difficult to
increase property taxes during good economic times of tax base growth. For example,
the state legislature passed a law to restrict the property tax rate change in Year 7, which
was partly responsible for the significant decline in the revenue growth rate in Year 8
(i.e., from 23.08 percent in Year 7 to 0.18 percent in Year 8), leading to the increased
volatility (risk) of property taxes. Also, legislative efforts made it difficult to avoid
large and quick declines in property taxes during economic downturns of a shrinking
tax base. The sharp revenue growth rate decline in the past two years (–10.95 percent
and –7.09 percent) reflects the county’s inability to raise property tax rates during
the recent economic recession, which also contributes to volatility of this revenue.
After carefully reviewing the historical records of user charges, Tom realizes that
the reason for the steady user charges is a stabilized consumption level of the public
utilities provided by the county. As explained above, user charges are mainly from the
county’s utility services for water supply, sewer and wastewater treatment, garbage
collection, and recycling. Records show that residential consumption of these services
has been steady, suggesting that residents have developed the level of consumption
necessary and critical for their lives. This lifeline consumption level hardly changes
under varying economic conditions. For example, Tom notices that residential water
consumption is barely affected by the economic recession; people use water regardless.
It appears that this residential lifeline consumption consists of a significant propor-
194
Table 14.6
Historical Risks of Revenues in Solivita (%)
Property taxes Sales taxes User charges

Property tax standard Sales taxes standard IGR growth IGR standard User charges standard
Year growth rate deviation growth rate deviation rate deviation growth rate deviation
1
2 17.39 10.77 11.83 15.90
3 –0.44 12.61 –6.47 12.20 8.06 2.67 –1.52 12.32
4 5.39 9.09 3.89 8.68 12.72 2.47 5.23 8.78
5 8.30 7.44 4.43 7.14 –6.95 9.14 5.89 7.18
6 11.89 6.71 7.92 6.54 12.15 8.32 6.99 6.22
7 23.08 8.45 16.54 7.74 2.77 7.69 12.10 6.02
8 0.18 8.72 7.23 7.08 –3.14 7.96 11.41 5.70
9 0.22 8.70 3.83 6.62 –5.20 8.26 2.12 5.67
10 –10.95 10.35 –14.05 9.11 –10.93 9.19 –4.40 6.58
11 (last year) –7.09 10.62 –7.86 9.35 –5.47 9.02 –0.60 6.54
Note: The standard deviation of the most volatile revenue source in a year is highlighted. For example, highlighted in Year 3, is the standard deviation of
property taxes 12.61 percent, which is greater than 12.20 percent of sales taxes, 2.67 percent of intergovernmental revenues, and 12.32 percent of user charges.
tion of the overall consumption of the utility services. Consequently, the amount of
revenues collected from the user charges has been relatively stable.
Tom attributes the volatility of intergovernmental revenues to the significant
revenue base change and the county’s inability to secure large federal grants on
a regular basis. About 80 percent of intergovernmental revenues come from state
revenue-sharing programs in which a portion of a revenue source is shared between
the state and eligible local governments. Most of these programs distribute the local
share based on the population of a local jurisdiction and the revenue collected in the
jurisdiction. One of the largest revenues shared by local governments is a portion of
the state’s sales taxes and gasoline taxes. The revenues in these taxes have been rela-
tively unstable in recent years due to the tax rate change and significant fluctuations
in gasoline consumption. Moreover, the volatility of intergovernmental revenues also
reflects the unstable stream of revenues from federal grants. Despite the recent surge
in grants from federal programs, the county has encountered difficulty in hiring and
retaining high quality personnel who are skilled in applying federal grants.
Finally, revenues from sales taxes are closely associated with the economy as well
as with the tax base and exemptions. After reviewing sales tax receipt data and talking
to the financial staff in charge of the county’s sales tax program, Tom concludes that
the large volatility of sales taxes is a result of the narrowing sales tax base. Facing
pressure from the business sector, more and more items are exempted from the sales
tax base. The economics literature has shown that the volatility of a revenue increases
when its revenue base shrinks and becomes less diversified.
STEP 4: MAKING RECOMMENDATIONS TO REDUCE THE RISK

These analyses led to Tom’s conclusion that property taxes, sales taxes, and inter-
governmental revenues are no longer reliable sources for the county, which should
not rely on their growth for its financial needs. The county should strengthen its user
charge programs to reduce its revenue portfolio risk. The county needs to monitor
revenue risks closely and make swift and proper adjustments accordingly.
The county can reduce revenue risks by diversifying its revenue portfolio and by
increasing the exposure to less risky revenue sources. More specifically, the county
should consider a revenue risk management strategy that gradually reduces the
county’s overreliance on property taxes (44 percent of revenues come from property
taxes now) by developing more revenue programs. Particularly important are the
development of more user charge programs and enhanced collection of user charges.
The strategy should also include efforts to recruit and retain people who are highly
skilled in consistently obtaining federal grants.
If the county reduces the proportion of property taxes in the total revenues from
the current 44 percent to 40 percent and consequently increases the proportion of
user charges from 25 percent to 29 percent, its revenue portfolio risk will be reduced
from the current 9.16 percent to:
Risk of revenue portfolio ratio =

(40% × 10.62%) + (17% × 9.35%) + (14% × 9.02%) + (29% × 6.54%) = 8.99%
EXERCISES
1. KEY TERMS
Risk
Financial risk
Investment risk
Debt-related risk
Revenue risk (the risk of revenue loss)
Steps in measuring revenue risk
Stability and reliability of a revenue source
Volatility of a revenue source
Revenue growth rate
Standard deviation
Excel Insert Function (fx) STDEV procedure
Risk of a revenue portfolio
Revenue portfolio risk ratio
Systematic revenue risk
Unsystematic revenue risk
Revenue diversification
2. DISCUSSION
1. Use examples from your state or local governments to discuss the need for
and value of managing financial risk.
2. Use examples in local governments to discuss the value of a diversified reve-
nue portfolio in reducing revenue risk.
3. Discuss the role of risk measurement in managing revenue risk.
3. CALCULATIONS
Table 14.7
Data from Two Revenue Sources
Year Source A Source B

1 18 10
2 24 15
3 29 19
4 25 26
5 28 20
6 32 19
7 29 24
8 37 28
9 39 31
10 (last year) 41 30
Table 14.8
General Fund Revenues of a Suburban City ($)
Property Utility and Licenses and User

Year taxes franchise taxes permits IGR charges
1 5,959,942 6,999,214 1,529,097 5,817,858 2,683,038
2 6,404,029 6,884,535 1,741,884 5,603,067 2,489,606
3 6,854,967 8,865,372 1,436,497 5,437,853 2,549,963
4 8,226,736 8,115,696 1,813,857 5,461,688 3,383,324
5 9,608,919 8,313,949 2,281,556 5,946,434 3,226,640
6 13,121,630 8,147,617 2,509,545 6,820,539 3,546,082
7 14,626,118 7,199,201 3,144,780 6,928,813 3,820,138
8 17,315,192 7,190,208 2,501,672 6,692,469 3,524,221
9 16,260,916 7,238,824 2,363,710 6,646,488 3,811,202
10 16,529,608 7,499,549 2,595,700 6,013,806 3,714,765
11 (last year) 15,850,265 7,800,364 1,423,597 5,730,574 3,610,827
Table 14.7 shows two revenue sources. Calculate the risk of each source and the reve-
nue portfolio risk ratio. Discuss ways to reduce the risks.
4. APPLICATION
Table 14.8 shows general fund revenues of a suburban city of 29,000 residents for
the past eleven years. Conduct a revenue risk assessment. What is the revenue risk
of each revenue source? What are the risky sources in your judgment? What is the
risk of the revenue portfolio? Can you discuss possible revenue collection strategies
to improve the portfolio risk?
5. APPLICATION
Refer to the data of the past six years shown in Table 14.8. Conduct a revenue risk
assessment. What is the revenue risk of each revenue source? What are the risky
sources in your judgment? What is the risk of the revenue portfolio? Compared
with the revenue risk assessment in the previous question, what are the changes in
risk levels for these revenues? In other words, what sources become more volatile
and what sources become less volatile? Are your revenue collection strategies dif-
ferent from those developed in the previous question? (Note: the common wisdom
is that you always want more data in an analysis to increase the reliability of the
analysis.)
6. APPLICATION
Conduct a revenue risk assessment for a government of your choice. The historical
revenue information should be available in the budgets and Comprehensive Annual
Financial Reports of the government. You can also call and interview financial per-
sonnel to obtain the information necessary for the analysis.
Appendix A
Introduction to Microsoft Office Excel
This book uses Microsoft Office Excel in calculations. The book assumes that you
have basic knowledge of Excel, which is very popular and easy to use. If you are not
comfortable with it, go to the Microsoft Office website to take a tutorial or read an
introductory guide to the software. A list of useful Excel websites is shown at the end
of this appendix. You should be ready in no time. All Excel calculations in this book are
conducted with either Data Analysis ToolPak or the Insert Function (fx) (also known
as the Paste Function in some literature). Although Excel examples in this book are
prepared with Excel 2007 or Excel 2010, this version differs very little from Excel
2003 regarding the Data Analysis and the Insert Function so the instructions in this
book apply to Excel 2003 users too.
LOCATING THE INSERT FUNCTION (BT )

You should be able to easily locate the “Insert Function” button, labeled with the
symbol fx, next to the “Formula Bar” (or on the “Formulas” tab) in an Excel sheet.
If your Excel sheet does not show it, click the “View” tab, and check the “Formula
Bar” button in the Show/Hide group. You should also find it in the “Function Library”
group on the “Formulas” tab. For Excel 2003 users who cannot find it in an Excel
sheet, click the “Function” button on the “Insert” tab.
If you are an Excel for Mac user and you could not find the “Formula Bar,” click the
“View” button and choose the “Formula Bar” on the drop-down menu. The formula
functions work the same on a Mac as on a Windows PC.
LOADING THE DATA ANALYSIS TOOLPAK

MICROSOFT EXCEL 2007 OR 2010
To use the Data Analysis ToolPak, you need to load it first. To load it in Excel 2007 or
2010, click “Microsoft Office Button,” often located at the upper left corner of your
Excel sheet, and then click “Excel Options.” (Note that some versions of Excel 2010
199
200 APPENDIX A: INTRODUCTION TO MICROSOFT OFFICE EXCEL
have “Customize Quick Access Toolbar” button instead of “Microsoft Office Button.”
In that case, select “More Commands” on the toolbar.) Click “Add-Ins,” and then in the
“Manage Box,” select “Excel Add-Ins.” Click “Go.” In the “Add-Ins” box, select the
“Analysis ToolPak” check box, and click “OK.” If “Analysis ToolPak” is not listed in
the “Add-Ins” box, click “Browse” to locate it. After you load the “Analysis ToolPak,”
the “Data Analysis” command is available in the “Analysis” group on the “Data” tab.
MICROSOFT EXCEL 2003

To load the Analysis ToolPak in Excel 2003, on the “Tools” menu, click “Add-Ins.”
In the “Add-Ins” box, select the check box next to the “Analysis ToolPak,” and then
click “OK.” If the Toolpak is not listed, click “Browse” to locate it. You may see a mes-
sage that says that the “Analysis ToolPak” is not currently installed on your computer
and asks you to install it (see next section for more information). After you load the
“Analysis ToolPak,” the “Data Analysis” command is available on the “Tools” menu.
MICROSOFT EXCEL 2008 FOR MAC

If you use 2008 Excel for Mac, you can install the Analysis ToolPak by clicking
“Add-Ins” on the “Tools” menu. Click to select the “Analysis ToolPak” and then click
“OK.” To use the ToolPak, click “Data Analysis” on the “Tools” menu. In the “Analy-
sis Tools” box, click the tool you want to use. For 2011 Excel for Mac, please read
this Microsoft webpage to find the Data Analysis Toolpak: http://support.microsoft.
com/kb/2431349.
USEFUL EXCEL WEBSITES

These sites provide useful information that familiarizes you with Excel programming
and procedures.
For a useful introduction to Excel 2010:
s HTTPWWWGCmEARNFREEORGEXCEL
For loading Excel 2010 ToolPak:

s HTTPOFFICEMICROSOFTCOMEN USEXCEL HELPLOAD THE ANALYSIS TOOLPAK
HP010021569.aspx
For a useful Excel 2007 tutorial (largely applied to Excel 2010):

s WWWFGCUEDUSUPPORTOFlCE%XCELINDEXASP
For a demonstration of Excel Insert Function for Mac users

s HTTPWWWYOUTUBECOMWATCHV"M3-"O
For a learning roadmap of Excel for Mac:

s http://office.microsoft.com/en-001/mac-excel-help/learning-roadmap-for-excel-
for-mac-2011-HA103526326.aspx
Appendix B
Exercise Answers
CHAPTER 1. REVENUE FORECASTING

2. DISCUSSION
1. You should know the forecast subject, the forecast horizon, and a forecast
technique. You can use examples of revenue sources in your local government.
2. Besides the trial and error method introduced in the book, consider the shape
of the data trend. Data with sharp ups and downs over time require consid-
eration of weighting more on the most recent data and thus a greater _. Also
look into socioeconomic or organizational factors that may influence revenue
collection. If a factor that influences the revenue collection in the recent years
is expected to continue to exert influence on the revenue collection next year,
assign a larger _.
3. For example, you can apply growth rate (i.e., growth percentage). If revenues
were 10 two years ago and 12 last year, the growth rate is (12 – 10) / 10 =
0.20 or 20 percent. You can average growth rates for the past years to arrive
at a measure of incremental change.
4. The relationship between the revenue being forecast and the predictors of the
revenue must be very strong. Moreover the shape of the relationship should
be established. For example, in a study of the water/sewer rate structure in a
Florida local government, I discovered a strong relationship between revenues
from water charge and revenues from sewer charge: Sewer Charge = _+ 2
× Water Charge while _ is a constant. I can use this formula to forecast the
revenues from the sewer charge.
5. In this chapter, we focus on mechanics of forecast techniques (the science of
forecast). However, forecasting is done by humans. Forecasting is limited by
a forecaster’s extent of knowledge, information, and subjective judgments.
6. Attacks on your forecast could come from many political stakeholders for
many reasons. One popular attack strategy is to challenge the validity of the
201
202 APPENDIX B: EXERCISE ANSWERS
results by pointing out the shortcomings and limitations of the forecasting

process. Thorough use of forecast tools and effective communication skills
place the forecaster in a good position to defend the forecast results.
3. PRACTICING FORECAST TOOLS

1. Forecast for Year 6 = (15 + 13 + 16)/3 = 14.67.
2. Using the average of the data of the first four years, we have (10 + 12 + 15 +
13)/4 = 12.50. Forecast for Year 6 = (0.8 × 16.00) + (0.2 × 12.50) = 12.80 +
2.50 = 15.30. The result from Excel should be 15.45.
3. The average of the last three increments is [3 + (–2) + 3]/3 = 1.33. Forecast
for Year 6 = 16.00 + 1.33 = 17.33.
4. FORECASTING A WATER/SEWER CHARGE

1. Total revenue = 568,790 × $10.50 = $5,972,295.
2. Forecast for Year 10 = 10.40 + 5.50(10) = 65.4. Forecast for Year 11 = 10.40
+ 5.50(11) = 70.9. The forecast revenue difference between Year 10 and Year
11 = 70.90 – 65.40 = 5.50. Note that this is b (or revenue increment) in the
regression model.
3. APE (for the first forecast) = 35.00 – 40.00 /40.00 = 0.125, or 12.5 percent.
APE (for the second forecast) = 46.00 – 42.00 /42.00 = 0.0952, or 9.52
percent. MAPE = (12.5 percent + 9.5 percent)/2 = 11.0 percent.
5. FORECASTING LICENSES, PERMITS, AND FEES IN THE CITY OF SUN LAKE,

CALIFORNIA
1. Forecast with SMA = $18,749,757. Forecast with EXS (_ = 0.8) = $19,847,140.
Forecast with TMA = $20,289,136 + ($1,990,388 + $591,938 + $2,013,099)/3
= $21,820,944.
2. APE 1 (forecast for Year 8): SMA = $18,749,757 – $23,210,218 /$23,210,218
= 19.2 percent. EXS = $19,847,140 – $23,210,218 = 14.5 percent. TMA = |
$21,820,944 – $23,210,219 | /$23,210,218 = 6.0 percent. APE 2 (forecast for
Year 7): SMA = | $17,217,949 – $20,289,136 | /$20,289,136 = 15.1 percent.
EXS = $18,079,157 – $20, 289, 136 | /$20,289,136 = 10.9 percent. TMA =
| $18,957,127 – $20,289,136 | /$20,289,136 = 6.6 percent. MAPE for: SMA
= (19.2 percent + 15.1 percent)/2 = 17.2 percent, EXS = (14.5 percent + 10.9
percent)/2 = 12.7 percent, TMA = (6.0 percent + 6.6 percent)/2 = 6.3 percent.
So, TMA is the most accurate method.
3. Forecast for Year 9 = $23,210,218 + [($23,210,218 – $20,289,136)
+ ($20,289,136 – $18,276,037) + ($18,276,037 – $17,684,099)]/3 =
$23,210,218 + ($2,921,082 + $2,013,099 + $591,938)/3 = $23,210,218 +
$1,842,040 = $25,052,257. Similarly, forecast for Year 10 = $25,052,257
+ $2,258,740 = $27,310,997. Forecast for Year 11 = $27,310,997 +
$2,340,620 = $29,651,617. Realize that the increment increases from
APPENDIX B: EXERCISE ANSWERS 203
$1,842,040 to $2,340,620, which may not be accurate. So, a simple remedy

is to use $1,842,040 for all three forecasts, which yields: Forecast for
Year 9 = $23,210,218 + $1,842,040 = $25,052,257, forecast for Year 10 =
$25,052,257 + $1,842,040 = $26,894,297, forecast for Year 11 = $26,894,297
+ $1,842,040 = $28,736,337.
4. Using Excel, forecast = $12,469,511 + $1,034,895(Year). Forecast for Year
8 = $12,469,511 + $1,034,895(8) = $20,748,671. APE 1 for the regression
= | $20,748,671 – $23,210,218 | /$23,210,218 = 10.6 percent. You can also
compute the MAPE for the regression. To do that, you need to formulate a
regression equation by using data of the first six years to forecast the reve-
nue in Year 7, resulting in forecast = $12,776,367 + $919,823(Year). So, the
forecast for Year 7 = $12,776,367 + $919,823(7) = $19,215,128. APE 2 for
the regression = | $19,215,128 – $20,289,136 | /$20,289,136 = 5.3 percent.
MAPE = (10.6 percent + 5.3 percent)/2 = 8.0 percent. The regression is more
accurate than SMA and EXS, but less accurate than TMA.
6. FORECASTING FRANCHISE TAX IN SUNBELT

First, let us forecast revenues for Year 10 and Year 11. Since this is trend data, TMA is a
proper tool. Using TMA, we have: forecast for Year 10 = $17,655,000 + [($15,257,000
– $15,089,000) + ($16,749,000 – $15,257,000) + ($17,655,000 – $16,749,000)]/3 =
$17,655,000 + ($168,000 + $1,492,000 + $906,000)/3 = $17,655,000 + $855,333 =
$18,510,333. Forecast for Year 11 = $18,510,333 + $855,333 = $19,365,666.
Now, let us forecast the revenue for Year 12, temporarily assuming that there is
no 10 percent contract increase of revenue from BellSouth. Forecast for Year 12 =
$19,365,666 + $855,333 = $20,220,999.
Let us also forecast the revenue from BellSouth with an assumption that there is
no 10 percent contract increase. Using TMA, we have: Forecast for Year 10 from
BellSouth = $7,062,000 + [($7,062,000 – $6,700,000) + ($6,700,000 – $5,950,000)
+ ($5,950,000 – $6,036,000)]/3 = $7,062,000 + $342,000 = $7,404,000. Forecast for
Year 11 from BellSouth = $7,404,000 + $342,000 = $7,746,000. Forecast for Year 12
from BellSouth = $7,746,000 + $342,000 = $8,088,000.
Now, a 10 percent contract increase of the revenue from BellSouth for Year 12 will
bring an additional 10 percent × $8,088,000 = $808,800, which should be added to
the forecast for Year 12. So, the forecast for Year 12 (with the 10 percent BellSouth
contract increase) = $20,220,999 + $808,800 = $21,029,799.
7. FORECASTING MISCELLANEOUS REVENUE

Since the city reclassified this revenue in Year 5, we should use the data after that time.
A quick review of the data from Year 6 to Year 10 does not indicate a clear trend, with
two years of increase (Years 7 and 9) and two years of decline (Years 8 and 10). An
application of SMA on the latest three years’ data yields a forecast of ($8,249,782
+ $10,783,255 + $7,556,219)/3 = $8,863,085. Your response to the finance director
might go something like this:
I have decided to use this figure as a forecast basis, and take it to the financial officials of the
city for their input on any significant socioeconomic or organizational changes in the city
that could influence this revenue. I will make the adjustment for the forecast based on these
inputs. In regard to the 95 percent underestimation, it is the finance director’s right to take
whatever percentage he or she wants. But, it is my obligation as a forecasting professional
to give the most accurate figure I can come up with.
8. PROBABILITY FORECASTING AND SCENARIO FORECASTING

What is the chance of positive economic growth, personal income growth, or prop-
erty value increase? Events in economy, population, income, legislations, and other
socioeconomic or organizational factors may be assessed with probabilities. The
relationship between such a factor and a revenue source can be used in forecasting
the revenue. For example, in many US states, the retail sales taxes are often linked
to states’ economic growth in the way that a growing state economy is highly associ-
ated with an increase in sales tax receipts. Therefore if we know the probabilities of
economic growth (e.g., “the chance of a 4 percent Gross State Product growth is 70
percent”), we can forecast the sales taxes based on the probabilities.
CHAPTER 2. RESOURCE DEVELOPMENT ANALYSIS

2. DISCUSSION
1. RDA is used to identify the size and duration of revenue shortage, and to
develop fiscal options to cover the shortage. RDA is essentially a fiscal policy
analysis. It is needed when a revenue shortage occurs or is predicted to occur.
There is no need for RDA if there is no revenue shortage. Revenue forecasting
should be done on a regular basis with or without revenue shortage.
2. Revenue loss was the major reason for revenue shortages in many US local
governments during the 2007–9 recession. Sharp decline in housing value
led to revenue loss in property taxes—the major revenues for many local
governments.
3. Tax increase often faces strong resistance from taxpayers. Moreover, tax
increase may not be appropriate to cover the revenue shortage in providing
business-type activities such as public utility supply (e.g., water, electricity,
waste water treatment). Tax increase may not be the best option when a large
financial reserve exists. Moreover, large and persistent shortages may call
for institutional reforms and new fiscal policies; tax increase may not be
enough.
4. Many local governments have policies on financial reserve such as setting
aside a percentage of revenue or surplus as financial reserve. You may want to
find out these policies and comment on their clarity and adequacy in building
a sufficient reserve.
3. REVENUE SHORTAGE IN SALES TAX

1. Revenue this year = ($23,902,346 – $12,345,670) × 0.075 = $866,751. Reve-
nue next year = ($24,567,390 – $16,345,670) × 0.075 = $616,629. Estimated
revenue shortage = $866,751 – $616,629 = $250,122.
2. Estimation error = ($250,122 – $345,291)/$345,291 = –27.56 percent.
3. Revenue this year = ($23,902,346 – $12,345,670) × 0.075 = $866,751. Reve-
nue next year = ($24,567,390 – $16,345,670) × 0.080 = $657,738. Estimated
revenue shortage = $866,751 – $657,738 = $209,013.
4. Estimation error = ($209,013 – $345,291)/$345,291 = –39.47 percent.
4. REVENUE SHORTAGE IN USER CHARGE

1. Revenue this year = ($243,578,500 × 7.08/1,000) + ($124,760,340 ×
9.54/1,000) = $2,914,749.
2. Revenue next year = ($231,349,400 × 7.08/1,000) + ($100,760,350 ×
9.54/1,000) = $2,599,207. So, the revenue shortage = $2,914,749 – $2,599,207
= $315,542.
3. Estimation error = ($315,542 – $275,654)/$275,654 = 14.47 percent.
5. EXPENDITURE AND POPULATION GROWTH

You need to first calculate the police expenditure per capita for the past ten years, then
use these figures to compute police expenditure per capita growth rate (use the example
in Table 2.1 for reference). You should arrive at an average growth rate of 4.0 percent.
The police expenditure per capita last year was $356.20 ($211,635,000/594,176). The
estimated police expenditure per capita for the next year is $356.20 × 1.040 = $370.40.
CHAPTER 3. COST ESTIMATION

2. DISCUSSION
1. Costing is important for business-type activities in government. Sometimes
costing provides useful information for governmental activities as well. In
2012, officials from the General Services Administration in the US federal
government were put in the hot seat at Congressional inquiries about the
agency’s profligate spending at a conference held in Las Vegas. In this case,
costing is needed to hold public officials accountable for wasteful spending.
2. Examples from your personal finances may help you think through this ques-
tion. Are your household expenditures this month equal to your costs? Did
you purchase any expensive and durable products (i.e., computers, electronic
appliances), pay property taxes, or pay credit bills this month? Should you
count all of these expenditures as costs this month?
3. Quantity is also known as output of a production (or service delivery) process.
For example, the output of a public library can be measured by the number
of users and the number of library items loaned. The output of a public park
can be the number of visitors.
4. If your local government (city or county) spends $10 million on governance
and administration (e.g., legislation, executive management, human resource
management, budget management), what could be examples of cost base for
distributing this spending among functional departments or programs (e.g.,
police, public works, health, education)?
5. The key difference is that, while the straight-line method needs the lifetime
of usage of the capital item, the usage rate method requires the availability
of usage units.
3. CALCULATIONS
1. Overhead rate = $53,340/(175 + 134) = $172.62 per student. Cost allocation
to the MPA program = $172.62 × 175 students = $30,208.74.
2. Overhead rate = $124,200/1,920 = $64.69 per hour. Cost allocation to the
economic development program = $64.69 × 200 hours = $12,937.50.
3. Annual network cost = ($12,000 – $2,000)/3 = $3,333.33.
4. The total of network working hours is 2,920 + 2,190 + 1,460 = 6,570, and
the total of work hours in the first year is 2,920. The network cost in the first
year = ($12,000 – $2,000)/6,570 × 2,920 = $4,444.44.
4. DETERMINING THE COST BASE

Here are examples of three administrative or office cost items and the related
measures. You can come up with your own. The first cost item is a manager’s
salary and benefit. The measure of time spent is “the number of hours spent by
the manager.” The measure of output is “the number of reports produced by the
manager” or “the number of directives issued by the manager.” The second cost
item is the electricity bill. The measure of time spent is “the number of work
hours.” The measure of output is “the number of products or services provided by
an agency.” The third cost item is office expenses. The measure of manpower used
is “the number of workers.” The measure of output is “the number of products
produced by an agency.”
5. COST OF OPERATIONS
The following information was obtained from a city’s CAFR in a certain year.
1. In the last year, the three most expensive functions were police, wastewater,
and fire protection.
2. In the last year, police expenses were $82,247,630 (20.2 percent of total).
Wastewater expenses were $60,340,070 (14.8 percent of total). Fire protection
expenses were $46,395,168 (11.4 percent of total). The total expenses were
$407,204,348.
3. Two years ago, police expenses were $73,354,220 (20.1 percent). Wastewater
expenses were $60,673,007 (16.7 percent). Fire protection expenses were
$36,513,281 (10.0 percent). The total expenses were $364,196,770.
4. There was an increase in total expenses by $43,007,578 (i.e., $407,204,348
– $364,196,770) during this period. This was an 11.8 percent
($43,007,578/$364,196,770) increase, which means that city services were
11.8 percent more expensive. The police expenses increased by $8,893,410
(i.e., $82,247,630 – $73,354,220). The fire expenses grew by $9,881,887.
The wastewater expenses declined by $332,937. Of the total increase of
$43,007,578, 20.0 percent (i.e., $8,893,410/$43,007,578) was attributable to the
increase in the police expenses, and 23 percent (i.e., $9,881,887/$43,007,578)
was due to the increase in the fire protection expenses.
5. The expenses per capita were $2,089 last year and $1,895 two years ago. The
increase was $194, or 10.3 percent. This suggests that the city’s residents may
eventually have to pay more for city services.
6. USING INFLATIONARY INDEX IN COST ESTIMATION

Suppose that the US city average of CPI from the last five years for all urban con-
sumers is 2.2 percent (e.g., [2.8% + 3.8% + (–0.4%) + 1.6% + 3.2%]/5). If the cost
of the function or program is $1 million this year, the estimated cost will be $1.022
million next year.
CHAPTER 4. COST COMPARISON

2. DISCUSSION
1. The conversion makes it possible to compare costs of competing options.
Inaccurate cost estimations would occur without conversion and could lead
to a bad decision.
2. Management should compare costs (expenses) of different decision-making
or service delivery options. For example, a 2012 Government Accountability
Office (GAO) report finds that the federal workforce is ill-prepared in a flu
pandemic. Should your government require all workers to get flu shots?
What is the cost of mandating the shots, compared to the cost of risking a flu
outbreak?
3. Selecting different discount rates can lead to different outcomes in cost com-
parison. A greater rate indicates a larger discount of the cost that occurs in the
future. Determining a proper discount rate can be difficult. Our book gives
examples that use the interest rate or borrowing cost as substitute. Chapter 6
(Cost-Benefit Analysis) gives more coverage on the discount rate.
4. The present value is approximately equal to the future value if the discount
rate is close to zero. The interest rate was very low for several years after the
2007–9 recession. For example, the annual return on federal treasury bills in
2011 was 0.03 percent.
3. CALCULATIONS
1. PV = $1,000/(1 + 0.05) = $952.38.
2. PV = $1,000/(1 + 0.05)2 = $907.03.
3. PV = $200 + $500/(1 + 10 percent) + $500/(1 + 10 percent)2 + $500/(1 + 10
percent)3 = $200.00 + $454.55 + $413.22 + $375.66 = $1,443.43. (Your Excel
calculation should confirm this result.)
4. You need to solve for C in the following equation: $12,000 = C/(1 + 5 per-
cent) + C/(1 + 5 percent)2 + C/(1 + 5 percent)3 + C/(1 + 5 percent)4 + C/(1 +
5 percent)5, and C = $2,771.70. You should use Excel to solve this problem.
5. The question actually asks how much you have to pay monthly for the next
ten years to make up $100,000 in today’s value (PV). You should use Excel
to solve for C in the following equation: $100,000 = C/(1 + 7 percent/12) +
C/(1 + 7 percent/12)2 + C/(1 + 7 percent/12)3 + . . . + C/(1 + 7 percent/12)119
+ C/(1 + 7 percent/12)120. Refer to the example of annualized cost in the text
for the calculation process and Excel programming. In Excel’s Insert Func-
tion (fx), choose the “PMT” (payment) function, and make sure to convert
the annual interest rate (7 percent) to a monthly rate by dividing it by twelve.
C = $1,161.06.
6. You need to solve for C in the following equation: $100,000 = C/(1 + 7
percent/12) + C/(1 + 7 percent/12)2 + C/(1 + 7 percent/12)3 + . . . + C/(1 +
7 percent/12)239 + C/(1 + 7 percent/12)240. With the use of Excel, you should
get C = $775.27.
4. PRESENT VALUE ANALYSIS

1. When the discount rate is 5 percent, the PVC for EOP is $1,854,595, and the
PVC for PMS is $1,813,785. So, PMS is less costly and should be recom-
mended for purchase.
2. When the discount rate is 10 percent, the PVC for EOP is $1,816,987, and
the PVC for PMS is $1,700,960. Again, PMS is less costly and should be
recommended for purchase.
3. When the discount rate is 5 percent, the annualized cost of each option is: EOP
(for six years’ use) = $365,388, and PMS (for five years’ use) = $418,939. So,
EOP is less costly and should be recommended for purchase. This conclusion
is based on the assumption that there is no cost for EOP in the sixth year, and
that there is no salvage value for both systems after their lifetimes.
5. PRESENT VALUE ANALYSIS: LEASE OR BUY DECISIONS

The PVC for the buy option is $20,673. The PVC for the lease option is $19,243.
So, the printer should be leased. The same conclusion should be reached with the
annualized cost analysis.
CHAPTER 5. INCREMENTAL COST ANALYSIS

2. DISCUSSION
1. The incremental cost is more accurate than the average cost to estimate the
cost changes of decision-making options when there are fixed costs. When all
cost items are variable, the results of incremental cost analysis and average
cost analysis should be the same.
2. Despite its advantages, incremental costing analysis is not very popular in
the public sector. One possible reason is the difficulty in obtaining data of
incremental costs. The financial reporting system in the public sector does
not generate incremental costs or expenses directly. You will have to acquire
them yourselves. Carefully observing cost patterns and the quantity level over
time is the key to obtaining incremental cost data.
3. The incremental cost is negative when the total cost is reduced. For example,
during a fiscal downturn, a public university reduces the number of courses
offered (the quantity) to cut the total cost. Let us say that the university reduces
the total cost by $5 million (the incremental cost) by cutting 100 courses. The
marginal cost is –$5 million/–100 = $50,000, which indicates the cost saving
from each course reduced. The negative sign of the production quantity (i.e.,
–100) indicates a reduction in the number of courses offered.
4. The marginal cost is a very important concept in the private sector. It is often
discussed along with the marginal revenue (the change in revenue for a unit
change in quantity). There is profit when the marginal cost is less than the
marginal revenue. Although profit motive is largely absent in the public sec-
tor, business-types activities in government should break even. Incremental
costing is useful for decision making in these activities.
3. CALCULATIONS
1. TC (quantity = 15,000) = $3.0 million + $1.5 million = $4.5 million. FC
(quantity = 20,000) = $3.0 million. VC (quantity = 20,000) = ($1.5 mil-
lion/15,000) × 20,000 = $2.0 million. TC (quantity = 20,000) = $3.0 million
+ $2.0 million = $5.0 million. IC (quantity = 20,000) = $5.0 million – $4.5
million = $500,000. MC (quantity = 20,000) = $500,000/(20,000 – 15,000)
= $100.
2. Similarly, FC (quantity = 30,000) = $4.5 million. VC (quantity = 30,000) =
$3.0 million. TC (quantity = 30,000) = $7.5 million. IC (quantity = 30,000)
= $7.5 million – $5.0 million = $2.5 million. MC (quantity = 30,000) = $250.

FC (quantity = 46,280) = $1,500,000 personnel cost + $15,000 office expenses +
$150,000 miscellaneous + $50,000 vehicle maintenance = $1,715,000. VC (quantity =
46,280) = $69,000 gasoline + $189,000 overhead = $258,000. TC (quantity = 46,280)
= $1,715,000 + $258,000 = $1,973,000. VC (quantity = 49,780) = $258,000/46,280 ×

49,780 = $277,512. TC (quantity = 49,780) = $1,715,000 + $277,512 = $1,992,512.
IC = $1,992,512 – $1,973,000 = $19,512. MC = $19,512/3,500 = $5.57. Because
the city is willing to pay $6 per ton, higher than $5.57, the county should accept the
offer. The $6 is called the marginal revenue in economics. If the marginal revenue is
larger than the marginal cost, there is profit.

The recyclable materials increase from 3,500 to 5,000 tons. That is a 1,500-ton in-
crease. The total quantity for the second year is 49,780 + 1,500 = 51,280. Because
the depreciation of the vehicle is $30,000 and the maintenance cost is $10,000 per
year, FC (quantity = 51,280) = $1,715,000 + $30,000 + $10,000 = $1,755,000. VC
(quantity = 51,280) = $258,000/46,280 × 51,280 = $285,874. TC (quantity = 51,280)
= $1,755,000 + $285,874 = $2,040,874. IC = $2,040,874 – $1,992,512 = $48,362.
MC = $48,362/1,500 = $32.24. Because the county’s marginal cost, $32.24, is larger
than what the city is willing to pay, $6.00, the county should reject the city’s demand
for the additional service unless the city is willing to pay a fee equal to or higher than
the marginal cost.
6. INCREMENTAL COST ANALYSIS AND ZERO-BASED BUDGETING (ZBB)

It would be surprising if you were to find any use of incremental costing in ZBB.
This is precisely one of several reasons that ZBB fails. Many governments simply
do not have capable individuals or the technical capacities required to warrant the
success of ZBB.
CHAPTER 6. COST-BENEFIT ANALYSIS

2. DISCUSSION
1. For one, thinking in cost-benefit terms helps the decision maker spend money
more wisely. The Chicago Tribune reported that the federal government spent
about $400,000 to print more than 350 commemorative resolutions passed
by the 112th US Senate, including proclamations of National Registered
Apprenticeship Month, National Safe Digging Month, and World Plumbing
Day (“More holidays than Hallmark,” August 15, 2012). If the senators were
asked if benefits of these resolutions outweigh $400,000, some of them might
think twice before proposing such resolutions.
2. The cost of a project reflects the resources consumed, which is also referred to
as an input of the project in the literature. The relationship between input and
output is more direct and clear than the relationship between input and outcome.
For example, the number of arrests made is a measure of output of a police
patrol program while the crime rate is an outcome measure. Change in budget
(the cost) would have a greater effect on the arrests than on the crime rate.
3. CBA requires monetary conversion of benefits, which is impossible or dif-

ficult for some public programs. For example, how to gauge financial gains
of a public school reading class? What is the monetary benefit of improving
the reading skills of school-age children?
4. The opportunity cost of holding cash is the interest forgone. The opportunity
cost of taking an unpaid vacation is the income you sacrifice at work. The
opportunity cost of changing jobs is the money you lose in your current posi-
tion.
5. The funding decision for a project in the public sector is largely driven by the
support of key political stakeholders. Economic value, legal and regulatory
requirements, technical requirements, and administrative execution capaci-
ties are also considered. CBA, which assesses economic value of the project,
helps the decision-making process. But even a project with great economic
value has little chance of receiving funding if it lacks political support.
3. CALCULATIONS
1. When the discount rate is 5 percent, the NPV for Project A = $158,650, and
the NPV for Project B = $522,639.
2. When the discount rate is 10 percent, the NPV for Project A = –$73,454, and
the NPV for Project B = $271,219.
3. The above analysis shows that, at the 5 percent discount rate level, both proj-
ects are economically feasible. However, Project B has a higher economic
value than Project A does. At the 10 percent level, Project B is economically
feasible, and Project A is not. The results indicate that Project B is a better
choice than Project A economically.
4. THE SENSITIVITY ANALYSIS IN CBA

1. When the discount rate is 5 percent, the NPV is –$1,692, less than that at the
10 percent level, but still negative. Sometimes, it is informative to calculate
the discount rate when the NPV is zero, also known as the internal rate of
return.
2. When the cost of ineffective replacement increases to $65, the NPV is posi-
tive and the purchase becomes economically feasible. In reality, the cost of
ineffective replacement changes quite often, so a sensitivity analysis should
be applied. In fact, when the discount rate is 10 percent, the NPV (if the cost
of ineffective replacement = $20) = –$11,088; the NPV (if the cost of inef-
fective replacement = $50) = –$3,614; the NPV (if the cost of ineffective
replacement = $65) = $122; the NPV (if the cost of ineffective replacement
= $100) = $8,838. So if the cost of ineffective replacement increases to $65,
the NPV becomes positive.
3. An extended life increases the benefit. When the discount rate is 10 percent,
the NPV (if the estimated project life = five years) = –$3,614; the NPV (if
the estimated project life = six years) = –$1,600; the NPV (if the estimated
project life = seven years) = $231. So, if the lifetime of the new system is
extended to seven years, the NPV becomes positive.
5. COST-EFFECTIVENESS ANALYSIS
With a seven-year term and a 5 percent discount rate, the PVC per student for
Option A is $22,689,230/1,600 = $14,181. The PVC per student for Option B is
$22,227,076/1,500 = $14,818. Option A is more cost effective (i.e., it is less expensive
to educate each student).
CHAPTER 7. FINANCIAL PERFORMANCE MONITORING

2. DISCUSSION
1. Monitoring financial performance can serve many purposes. In a 2010 guber-
natorial election campaign, Texas Governor Rick Perry said his competitor Bill
White was a poor financial manager because Houston suffered $1.7 billion in
operating losses during White’s tenure as mayor. Clearly, the governor used
results of financial monitoring for political gain. In this exercise, you may
want to identify the cases in which financial monitoring is used for manage-
rial, not political, purposes.
2. If you are familiar with the literature on performance measurement in govern-
ment, you know that many measures of organizational performance are not
financial. For example, the performance of a local police patrol unit can be
measured by crime rate, response time, patrol miles, and so on. The performance
of an environmental protection agency can be measured by air or water pollu-
tion levels. You can find numerous such nonfinancial measures in government
documents. In this exercise, you may want to limit your search to one or two
governmental services and focus on so-called outcome measures of the services.
3. You may want to start with reports that use financial indicators. One example is
a state or local government’s Management Discussion and Analysis (MD&A)
in its Comprehensive Annual Financial Report (CAFR), which is a narrative
explanation of the government’s financial performance and condition. Another
place to search is through publications of the Government Finance Officers
Association (GFOA) (www.gfoa.org). For example, GFOA recommends that a
government should closely monitor the level of unrestricted fund balance (fund
balance with no restriction on the purpose or the time of use) in the general
fund (“GFOA Best Budgeting Practices: Appropriate Level of Unrestricted
Fund Balance in the General Fund”).
4. There are two related aspects in this statement. One concerns the fact that you
should have enough liquidity (i.e., cash, cash equivalents) to pay your bills
and run your daily operations. Another is that financial results are not the goal
of many public services. Nonetheless, you also should know that financial
results and liquidity are related (e.g., more revenues or earnings can lead to
more cash in hand).
5. Required in financial performance monitoring are financial data, indica-

tors, skills and tools of monitoring, and monitoring infrastructure (e.g.,
computer systems). In terms of monitoring tools used, this chapter intro-
duces a budget-to-actual comparison. For more sophisticated discussions
of monitoring, see XiaoHu Wang’s Performance Analysis for Public and
Nonprofit Organizations (Sudbury, MA: Jones & Bartlett, 2010), Section
III Monitoring Performance.
6. Our criteria focus on practical use of indicators in monitoring. Other criteria
include measurement validity and reliability, which should be discussed in
any research methodology book. Chapter 12 of this book also reviews criteria
to select financial condition measures.
3. OBTAINING INFORMATION FROM THE CAFR

The following information was found in a city’s CAFR in a certain year:
1. Total assets for the primary entity: $1,563,967,486.

2. Total net assets for the primary entity: $928,959,123.
3. Total revenues for the primary entity (General Revenues + Program Reve-
nues): $395,973,195.
4. Total expenses for the primary entity: $407,204,348.
5. Change in net assets for the primary entity: –$11,232,153.
6. Current assets for the primary entity (Total Assets – Noncurrent Assets):
$576,876,178.
7. Total liabilities for the primary entity: $635,008,363.
8. Current liabilities for the primary entity (Total Liabilities – Noncurrent
Liabilities): $149,320,759.
9. Population: 194,913
4. CALCULATION OF FINANCIAL INDICATORS

1. Total revenues per resident: $395,973,195/194,913 = $2,032.
2. Total expenditures per resident: $407,204,348/194,913 = $2,089.
3. Current ratio: Current Assets/Current Liabilities = $576,876,178/$149,320,759
= 3.86 (Note: Using the rule of thumb of 2, the liquidity of the city appears
to be in good shape by this measure.)
4. Change in Net Assets/Total Net Assets = –$11,232,153/$928,959,123 =
–0.012.
5. Total asset turnover: Total Revenue/Total Assets = $395,973,195/$1,563,967,486
= 0.25.
6. Fixed asset turnover: Total Revenues/Fixed Assets = $395,973,195/
($248,284,554 + $738,806,754) = $395,973,195/$987,091,308 = 0.40.
7. Return on assets: Change in Net Assets/Total Assets = – $11,232,153/
$1,563,967,486 = –0.007.
The city’s negative change of net assets should cause concern. Financial monitor-
ing of this indicator should be performed. The current ratio shows the city is in good
standing in liquidity. The total asset turnover indicates that every dollar of the city’s
assets brings a quarter in revenues.
5. HISTORICAL COMPARISON OF THE INDICATORS

An examination of CAFRs for the past three years shows that the city had net asset
increases two years in a row prior to this year’s decline. The concern over the net asset
decline of this year is alleviated a little. Nevertheless, the net asset change should be
closely monitored. The analysis also shows that the change in the current ratio is in the
territory of a normal change. The measure of the expenditures per resident indicates
that city services have become more expensive for the past three years.
CHAPTER 8. CASH MANAGEMENT: DETERMINING THE OPTIMAL CASH BALANCE

2. DISCUSSION
1. If you manage to find the record of your local governments’ cash account
or you go online to check their CAFRs, I would not be surprised if you see
many of them keeping a large amount of cash. Some do that for good reasons.
However, holding too much cash is a waste of financial resources. Unfortu-
nately, it often does not get enough exposure from the media and the public.
People generally pay less attention to a budget surplus or financial reserve
than a budget deficit.
2. They are related in the sense that cash balances can be invested and invest-
ment incomes can become a source of cash. Safety of the investment, return
of the investment, maturity of the investment, and liquidity of the investment
(how easy it is to convert the investment into cash) are some considerations
for developing an investment strategy.
3. Electronic payment methods may have advantage of speed, convenience,
safety, and environmental benefits. But you always arrive at a better decision
after considering various points of view.
4. Having a cash budget is necessary for achieving the optimal cash balance.
You can use your personal finance to understand this. A cash budget helps
you find out your monthly cash balances, the pattern of cash balances over
time, and the amount you can invest.
3. CALCULATIONS
1. Using Excel, you should easily have: the variance of net daily cash flows =
$1,410.
2. Spread = 3 × (0.75 × 10 × $1,410/0.000274)1/3 = $1,014. Lower limit = $200.
Upper limit = $1,214. Return point = $200 + ($1,014/3) = $538.
4. CASH MANAGEMENT IN BRIDGETOWN

1. To create a cash budget, you need to forecast monthly cash receipts and dis-
bursements for the next year. A scan of the monthly cash flow data of the last
three years does not show a clear trend for most of the months. For example,
the January receipt data of the past three years are $865,000, $873,650, and
$871,903—the cash flow increases and then declines. Because there is no trend
discovered in cash flows, you can use SMA in forecasting the cash receipts
and disbursements for the next twelve months. You can then calculate net
cash flows for every month by using forecast receipts minus disbursements:
–$99,196 in January; $10,007 in February; $20,120 in March; $246,468 in
April; $531,753 in May; –$187,115 in June; –$229,366 in July; $45,270 in
August; –$30,180 in September; –$65,390 in October; $575,428 in November;
and –$341,032 in December. The foundation also has a forecast average cash
balance of $2,302,777.
2. The variance of monthly net cash flow with the above data is $79,744,304,424.
Dividing it by thirty (the number of days in a month), we have the “variance
of daily net cash flow”: $2,658,143,481. From other information given, the
spread = 3 × (0.75 × 200 × $2,658,143,481/0.000137)1/3 = $428,323. Lower
limit = $1,000,000. Upper limit = $1,428,323. Return point = $1,142,774.
3. The foundation has a forecast average cash balance of $2,302,776. The Miller-
Orr results indicate that the foundation can invest some of this money. One
possible investment strategy suggested by the model is that the foundation
always keep a minimum cash balance of $1,000,000, and, if the cash bal-
ance falls below it, replenish cash by an amount of $1,142,774 – $1,000,000
= $142,774. If the cash balance exceeds $1,428,323, the foundation should
invest by the amount of $1,428,323 – $1,142,774 = $285,549.
CHAPTER 9. FINANCIAL REPORTING AND ANALYSIS: THE STATEMENT OF

NET ASSETS AND THE STATEMENT OF NET POSITION
2. DISCUSSION
1. Realize that a balance sheet is a report of finances at a specific time (say
December 31, 20x1). So you need to select the time for the reporting first.
In theory you can choose any time, but you may want to select the end of a
fiscal period (e.g., the end of a calendar year or a month).
2. Note that, though some accounts may have somewhat different names, they
essentially report same or similar financial transactions. Some governments
list different “receivables” (or “payable”) accounts separately while others
group them together.
3. You may want to conduct a literature search to find out various definitions of
financial accountability in government. It is also a good idea to compare it
with financial accountability in business.
4. The differences are significant. Here is a clue: budgets are financial plans
while financial reports demonstrate the results of the plans.
5. Maybe you want to start by comparing presentation formats and terminologies
used in these two documents.
CHAPTER 10. FINANCIAL REPORTING AND ANALYSIS: STATEMENT OF

ACTIVITIES
2. DISCUSSION
1. The two statements reflect two different, but equally important, aspects of finance
of an entity. Realize net assets (net position) are reported in both statements.
2. Realize that the statement of activities reports financial information of a fis-
cal period (often a year), which is different from the statement of net assets
(net position), which presents financial information at a specific time (say
December 31, 20x1). The most difficult aspects of preparation may be how
to classify and track expenses and revenues, as well as how to use a proper
accounting basis to report them.
3. It is tempting to report detailed program expenses in the statement for better
accountability and tracking of program costs. However, such preparation can
be costly because it requires collection of additional information. It could also
make the statement looks “messy” in presentation.
4. In personal finance, cash basis is perhaps the better choice if you do not have
a lot of financial transactions and, importantly, you do not owe (or are not
owed) a lot of money. Otherwise, the accrual basis would be a better choice.
CHAPTER 11. FINANCIAL REPORTING AND ANALYSIS: FUND-LEVEL STATEMENTS

2. DISCUSSION
1. They are used to account for different types of activities.
2. These two concepts are essential for understanding the differences between
funds.
3. In your personal finance, perhaps you set aside revenues for investment, child
education, or emergencies. Similarly, a government wants to use special reve-
nue funds for revenues that are restricted or earmarked for specific purposes.
4. Having a special revenue fund, in lieu of using unrestricted revenues, ensures
revenues are set aside, earmarked, and protected for “rainy day” spending.
CHAPTER 12. FINANCIAL CONDITION ANALYSIS

2. DISCUSSION
1. You can find news stories on government finance easily. There should be
plenty of reasons for FCAs in many governments facing revenue shortages
during financial downturns. But it would be much more interesting if you

could find the need for an FCA in your own state or local government through
investigation of their financial records.
2. Many financial measures are available for financial analysis in government.
This book only introduces a very limited number of them, but it provides ex-
amples on developing the measures systematically. You should articulate the
objective, need, and scope of the analysis and develop measures accordingly.
You may also want a classification scheme, such as the input-process-result
system in Chapter 7 or the four-solvency scheme in Chapter 12, so that the
measures selected are comprehensive.
3. MD&A is a specific form of financial condition analysis. It provides an annual
overview of financial condition. MD&A often focuses on describing financial
conditions in the past, present, and future, though analysis of socioeconomic
and organizational factors that influence financial condition may also be
performed.
4. For example, the Pentagon notified Congress that it would be furloughing most
of its civilian workforce of 800,000 one day per week for 2013 for an estimated
savings between $4 billion and $5 billion in 2013 (Jeremy Herb, “Pentagon
informs Congress of plans to furlough 800K civilian workers,” TheHill.com,
February 20, 2013, http://thehill.com/blogs/defcon-hill/operations/283981-
pentagon-tells-congress-it-will-furlough-800k-civilian-workforce [accessed
May 1, 2013]).
5. A relationship means little if it is not theoretically justified. You may find
a positive relationship between resident age and property tax revenues in a
city. But it does not make sense unless you realize that older residents tend
to have higher income and live in residences of higher property values. It is
their income, not age, which leads to high property tax revenues. Financial
indicators tend to be correlated one way or another. Their relationships are
relatively easy to establish, which calls for particular attention to theoretical
justification for the relationships. Misrepresented relationships can lead to
confusion and mistakes in conclusions drawn and recommendations made
in an FCA.
3. CALCULATION
1. The correlation coefficients are: –0.196 between public safety expenditures and
general government expenditures, 0.995 between public safety expenditures
and total expenditures, and –0.248 between general government expenditures
and total expenditures.
2. First, the data show that public safety expenditures are strongly positively
associated with total expenditures. An increase in public safety expenditures
leads to the increase in total expenditures. Second, there is a weak negative
relationship between public safety expenditures and general government ex-
penditures. In other words, the increase in public safety expenditures appears
associated with the decrease in general government expenditures. This result
suggests that general government activities compete for resources with public
safety activities.
4. APPLICATION
Analysis on Cash Solvency
Is there any warning trend in the cash ratio or the quick ratio? The values of the
cash ratio for the past five years have been 3.42, 3.76, 4.25, 2.52, and 3.59. The
values of the quick ratio have been 3.85, 4.30, 4.25, 2.52, and 3.63. Both indica-
tors show that the city appears to have high liquidity. No clear trends are identi-
fied from this data, except that the ratios in Year 4 (2.52 for both the cash ratio
and the quick ratio) appeared to be significantly lower than those of other years.
Cash and cash-related assets were particularly low in that year, which deserves
a close examination.
A correlation analysis has been conducted to specify the relationships between
the cash ratio and taxable values (the correlation coefficient = –0.33), population
(–0.27), income per capita (–0.28), the unemployment rate (–0.43), and the millage
(0.33), and between the quick ratio and taxable values (–0.57), population (–0.54),
income per capita (–0.48), unemployment rate (–0.57), and the millage (0.60). No
strong relationship has been discovered. The cash solvency appears to be impacted
by factors other than those included in this study. Further identification and examina-
tion of these factors are needed. The status of cash solvency in the city appears good
now. However, the need for a good model to predict cash solvency will become more
urgent when cash solvency deteriorates.
Budgetary Solvency
Budgetary solvency was discussed in the case study in this chapter.
Long-Run Solvency
The values of the net asset (position) ratio have increased for the past five years:
0.43, 0.46, 0.48, 0.51, and 0.54, which indicates that the city’s long-run solvency
by this measure has improved during that time. However, until information about
other long-run solvency measures (such as the long-term debt ratio) becomes
available for analysis, it is difficult to develop a complete picture of the long-run
solvency for the city.
The net asset (position) ratio is strongly associated with taxable values (the cor-
relation coefficient = 0.99), population (0.99), and income per capita (0.98), which
suggests that the increased values of these factors may improve the city’s long-run
solvency. Nevertheless, the positive relationship between the net asset (position)
ratio and the unemployment rate (0.86) is puzzling. Since only five years of data are
analyzed, this relationship could be spurious. This finding needs to be reexamined
when more data become available.
Service Solvency
The values of net assets (position) per capita have increased for the past five years:
$3,337.90, $3,570.50, $3,770.20, $3,996.80, and $4,253.90. The city’s service sol-
vency by this measure has improved during this time. The net assets (position) per
capita appear to be associated with all of the socioeconomic/organizational factors in
this study. But again, since only five years of data are used for analysis, these findings
need to be reexamined when more data become available.
CHAPTER 13. DEBT CAPACITY ANALYSIS

2. DISCUSSION
1. This may mean that the government is either not engaged in large capital
spending or, more likely, it adopts a pay-as-you-go approach to financing.
Both approaches significantly limit public service provision and financing.
2. This distinction is one of several important classifications in debt manage-
ment. It concerns financing sources of debt.
3. To carry debt is to borrow from the future. Debt capacity analysis helps achieve
a viable financial future.
4. They assess different aspects of debt. While debt outstanding is a measure of
debt level, debt service is concerned with debt-paying ability.
3. CALCULATIONS
1. The city’s debt service ratio is 10.33 percent. Because the benchmark ratio
is set at 12 percent, the city has additional debt capacity. The additional debt
service is $500,000, and the additional debt capacity is $6,231,105 with speci-
fied terms.
2. The additional debt capacity is $6,795,163.
3. The additional debt capacity is $7,686,226. Lower interest rates and/or longer
maturity terms increase additional debt capacity. The city can borrow more
when the interest rate is lower and the maturity is longer.
4. No. Because its debt service ratio exceeds the benchmark ratio.
4. APPLICATION
Two years from now, to maintain a debt service ratio at 10 percent, the city’s debt
service must be reduced by ($30,721,040 × –1.10% =) –$336,896 (a negative sign
indicates a reduction). To reduce the debt service by this amount, the city must re-
duce its debt outstanding by $4,198,469. (Hint: Using Excel Insert Function (fx) PV
procedure for a 5 percent annual interest rate and a twenty-year maturity.)
Three years from now, the city’s debt service must be reduced by ($28,570,567
× –2.97% =) –$848,943, which results in a reduction of the debt outstanding by
$10,579,710.
Four years from now, the city’s debt service must be reduced by ($27,142,039
× –0.93% =) –$252,796, which results in a reduction of the debt outstanding by
$3,150,398.
5. APPLICATION
The county’s debt capacity is in decline. The debt service ratio values will increase
from 7.55 percent in Year 1 (next year) to 12.45 percent in Year 4 (four years from
now). The ratio will exceed the 9 percent target ratio in Year 3 (9.75 percent), Year
4 (12.45 percent), and Year 5 (11.51 percent). The ratio will exceed the 12 percent
benchmark in Year 4. The decline is caused by two factors: a sharp revenue decline
from Year 1 to Year 2 and a slow recovery thereafter, and more important, a rapid
increase in debt service.
By the target ratio, the county has additional debt capacity in Year 1 and Year 2.
By the benchmark ratio, the county has additional debt capacity every year except
Year 4. For example, the county can borrow an additional debt up to $11,314,837 in
Year 1 within the benchmark ratio of 12 percent.
To improve the debt capacity over the next five years and particularly in Year 4,
the county needs to adopt strategies to improve its revenue collection potential, for
example, by diversifying its revenue bases and increasing revenues rates. Moreover,
the county should consider strategies to reduce debt service, such as refinancing the
existing debt to more favorable terms, delaying or eliminating new capital projects
in the capital improvement plan, and reducing or eliminating new debt in the capital
budget.
CHAPTER 14. FINANCIAL RISK ASSESSMENT: ANALYZING THE RISK OF

REVENUE LOSS
2. DISCUSSION
1. You may want to start with the government’s risk management strategy or
policy if it exists, finding out if the strategy includes management of financial
risk.
2. Do you know any government that relies on a few major revenue sources? In
general, special purpose governments (e.g., schools or special districts) have
fewer revenue sources than general purpose governments (e.g., cities or coun-
ties). Governments with less diversified revenue sources are more vulnerable
during economic downturns when these revenues are in decline.
3. Measuring risk properly should be a prerequisite for risk management.
3. CALCULATIONS
The standard deviations of Sources A and B are 15.72 percent and 22.83 percent,
respectively. Thus Source A is less risky than Source B. The risk ratio for the revenue
portfolio based on the revenue proportions of the most recent year (Year 10) is about
18.70 percent. The ratio can be reduced if more revenue is collected from Source A.
For example, an increase from the current (41/70 =) 58 percent to 66 percent of the
revenues from Source A will lead to a portfolio risk ratio reduction to 18.21 percent.
The addition of more revenue sources should also increase the revenue diversification
of the portfolio and therefore reduce the portfolio risk.
4. APPLICATION
The standard deviations of property taxes, utility/franchise taxes, licenses/permits
fees, intergovernmental revenues, and user charges are 12.73 percent, 10.81 percent,
23.88 percent, 7.03 percent, and 12.09 percent, respectively. The risk of the portfolio
is about 11.70 percent, based on the proportions of the most recent year (Year 11).
The largest revenue source is property taxes (46 percent of the total), followed by
utility/franchise taxes (23 percent), and intergovernmental revenues (17 percent).
Although intergovernmental revenues are the least risky source (SD = 7.03 percent),
these revenues have also experienced continual declines for the past four years. The
city may want to focus its revenue risk management strategy on increasing the reve-
nues from utility/franchise taxes, which is the second least risky source (SD = 10.81
percent) and has seen growth in the past three years. For example, if the utility taxes
increase in total revenue from the current 23 percent to 30 percent and property taxes
decline proportionately from the current 46 percent to 39 percent, the risk of the reve-
nue portfolio will be reduced from 11.70 percent to 11.57 percent.
5. APPLICATION
The use of the data of the past six years reduces the risks for all revenue sources
except license/permit fees. The most stable source is still the intergovernmental reve-
nues (SD = 4.22 percent), followed by utility/franchise taxes (SD = 6.38 percent),
and user charges (SD = 7.05 percent). The risk of the portfolio is about 8.82 percent.
This analysis shows little need to adjust the revenue collection strategies specified in
the answer to the previous question, reaffirming the applicability of these strategies.
Glossary
This section provides brief definitions of the key terms in the book. The in-depth
explanations and applications of these terms are in the text of the book. The section
can be used as a quick reference guide for readers and students.
A
Absolute percentage error (APE): a measure of forecast accuracy. A smaller value
in APE indicates a more accurate forecast.
Accounting cycle: a cycle of four sequential phases: the evidence of transactions, the
accounting journal, the account ledger, and financial statements and reports. A
financial transaction should go through all four phases to complete an account-
ing cycle.
Accounting equation for funds: Assets = Liabilities + Fund Balance.
Accounting journal: a chronological listing of every financial event (transaction)
that has occurred in an organization.
Accounting ledger: an accounting instrument used to summarize and accumulate
transaction information.
Accounts payable: a liability category that shows the amount an organization owes
others.
Accounts receivable: the asset category that represents the amount owed by residents,
customers, or service users.
Accrual basis accounting: in accrual basis accounting, the revenue is reported in
the period during which it occurs, regardless of the payment status, and the
expense is reported when a resource has been used in the process of producing
goods or services.
Achievable project objectives: objectives of projects whose designated results can
be empirically observed. Having achievable project objectives is necessary to
measure the benefits of a project in a cost-benefit analysis.
223
224 GLOSSARY
Activity-based costing (ABC): a method of cost allocation that emphasizes alloca-

tion precision through a careful examination of the cause-effect relationship
between activities and costs.
Agency funds: the funds that account for assets held temporarily by a governmental
unit as the agent for individuals, organizations, other funds, or other govern-
mental units.
Annualized cost: a method used to compare costs of options with different lifetimes.
The present value of cost for an option can be translated into a periodic payment
for each year of the option’s life to find the cost per year.
Asset reserves: positive net asset amounts. The reserves can be in forms of investment
in capital assets, restricted net assets, or unrestricted net assets.
Assets: economic resources of an organization. Examples are cash, investments,
inventories, land, and infrastructures.
Average cost (or unit cost) (AC): the result of the total cost divided by the quantity
of output. It represents the cost of each unit in quantity.
B
Balance sheet: the financial statement that discloses information on assets, liabilities,
and net assets. In US state and local governments, the balance sheet information
for a government as a whole is reported in the statement of net assets or in the
statement of net position (after 2012). Some nonprofit organizations may use the
name the statement of financial position to disclose their balance sheet information.
Balance sheet for a fund: the financial statement that contains current assets, current
liabilities, and the fund balance.
Benchmark debt ratio: the maximum level of debt that an entity can afford; any
level higher is considered unaffordable and unsustainable.
Benefit/cost ratio: The ratio (= Present Value of Benefit/Present Value of Cost) is
a decision-making criterion in cost-benefit analysis. A project is considered
economically feasible if its benefit/cost ratio is greater than 1.
Block rate: a rate structure in which different rates apply for different amounts in
the base. For example, in a block-rate water-charge design, water users pay a
higher rate for a higher level of water consumption.
Borrowing as a revenue option: a revenue option that is often preferred in US state
and local governments to cover revenue shortages as a result of acquiring du-
rable capital assets.
Break-even production: a level of a production where total cost is equal to total
revenue.
Budgetary solvency: the ability to generate sufficient revenues to pay expenditures
or expenses.
Business-type activities: a category used in the Comprehensive Annual Financial
Report. As opposed to governmental activities, the provision of business-type
activities may generate sufficient revenues to cover the related expenses. Popu-
lar business-type activities include water supply, wastewater treatment, parking
facilities, and toll roads.
GLOSSARY 225
C
Capital assets: see “Long-term or fixed assets.”
Capital cost: the cost associated with the acquisition of capital assets.
Capital project funds: the funds that account for receipts and disbursements of
resources in financing construction or purchase of major capital assets.
Cash (or cash equivalents): the asset category that often includes bank savings and
checking accounts, short-term certificates of deposit, and other assets that can
be converted to cash quickly and easily.
Cash balance: the amount of cash left at the end of a fiscal period.
Cash basis accounting: In cash basis accounting, the revenue is reported when the
cash payment is received and the expense is reported when the cash payment
is made.
Cash budget: a budget that includes projected cash receipts, disbursements, and
balances.
Cash disbursements: the amount of cash distributed during a fiscal period.
Cash ratio: a measure of cash solvency that relates cash, cash equivalents, and
marketable securities to current liabilities.
Cash receipts: the amount of cash received during a fiscal period.
Cash safety: an objective of cash management that emphasizes the prevention of cash
loss as a result of poor decision making or criminal behavior.
Cash solvency: the ability to generate sufficient cash to pay for current liabilities.
Change in net assets: the difference between annual total revenues and annual total
expenses in an organization. Change in net assets should be replaced by change
in net position in US state and local governments after 2012.
Change in net position: See “Change in net assets.”
Comparable scenarios estimation of expenditure growth: a method that uses
spending scenarios in comparable entities to estimate expenditure growth.
Component units: the entities that are legally separate from the primary government
but have a close financial or governing relationship with the primary govern-
ment. For example, a state university can be a component unit to the state (the
primary government).
Comprehensive Annual Financial Report (CAFR): a financial report prepared by
US state and local governments at the end of a fiscal period. A CAFR often con-
sists of key financial statements as well as important financial and demographic
data of a government. Also included in a CAFR is a Management’s Discussion
and Analysis (MD&A), which provides an analytical overview of the govern-
ment’s financial activities, conditions, and performances. Two government-wide
financial statements in the CAFR are the statement of net assets and the state-
ment of activities.
Conservatism: a principle that governs accounting practices. It means that financial
managers should always consider the fact that less than 100 percent of revenues
can be collected.
Correlation coefficient: a statistical measure of association. A larger value indicates
a stronger relationship.
226 GLOSSARY
Cost: the resource consumed in producing a product, service, program, or process.

Cost allocation: the process of distributing indirect cost items to a cost objective.
Cost base: a basis used to calculate the overhead rate. An example is the number
of telephone calls made as a cost base to distribute the cost of telephone calls.
Cost-benefit analysis (CBA): a tool to assess the economic feasibility of a program,
a policy, or an activity through cost and benefit estimations. In this book, CBA
is used to judge the economic feasibility of capital projects.
Cost convention: a principle that governs accounting practices. Assets should be
valued at their cost at the time of acquisition in financial reporting.
Cost depreciation: the effort to distribute capital costs or the method of doing so.
Cost-effectiveness analysis (CEA): a tool to estimate the cost and effectiveness of
a project.
Cost items (or cost elements): individual components that constitute the cost. For
example, cost items of an education program could consist of instructors’ salaries,
operating expenses to offer classes, and the depreciation of capital expenses in
classroom buildings, instructional equipment, and other educational infrastruc-
ture.
Cost objective: concerns the subject of what is being targeted in costing. Cost ob-
jective can be a program, a project, a process, or a function. For example, in
calculating the cost of providing police patrols in a community, the police patrol
program can be the cost objective.
Cost pool: the cost that should be allocated.
Cost time frame: the time period in which a cost estimation is made.
Current assets: cash, cash equivalents, or assets convertible to cash within one year.
Current financial resource measurement focus: the measurement focus of a fund
that stresses the availability of financial resources to support its financial obli-
gations.
Current liabilities: financial obligations that are expected to be paid within one year.
Current ratio: a measure of liquidity (= Current Assets/Current Liabilities). It is a
financial process indicator in financial performance monitoring.
D
Daily interest rate: the daily rate of return on an investment.
Data outlier: a data point that indicates an obvious deviation from the mainstream
trend.
Debit and credit: the accounting practice that uses signs “debits” and “credits” to
ensure the proper reporting of a financial transaction. In double entry bookkeep-
ing, debits and credits are entries made in account ledgers to record changes in
value due to financial transactions.
Debt capacity: the level of debts an entity can afford.
Debt capacity analysis (DCA): a tool to establish an affordable level of debt for an
entity. The analysis can also be used as a budgeting tool to plan the debt level
in the future.
Debt outstanding: total dollar amount of the debt principal that must be repaid.
GLOSSARY 227
Debt outstanding ratios: measures of debt capacity. Debt Outstanding Ratio = Debt
Outstanding/Taxable Property Values (or Personal Income or Population).
Debt ratio: a measure of debt capacity. Debt outstanding ratios and the debt service
ratio are all debt ratios. However, sometimes, the debt ratio is specifically referred
to as the ratio of the debt (i.e., the debt outstanding) divided by total assets (i.e.,
Total Debt/Total Assets). Debt ratio is a financial process indicator in financial
performance monitoring.
Debt-related risk: the possible loss related to failure to pay off debts on time.
Debt service: debt payment in principal and interest for a period, often a year.
Debt service funds: the funds that account for the accumulated resources needed to
pay off principal and interest on a debt.
Debt service ratio: a measure of debt capacity. Debt Service Ratio = Debt Service/
Revenues.
Decision-making matrix: a decision-making tool used in a resource development
analysis to assess revenue options.
Decision rules (in the Miller-Orr model): No transaction is needed if the cash bal-
ance falls between the lower limit and the upper limit. If the cash balance rises
to the upper limit, invest cash by the amount of (Upper Limit – Return Point).
If the cash balance falls to the lower limit, sell investments by the amount of
(Return Point – Lower Limit) to replenish cash.
Deferred inflows of resources: an acquisition of net assets by a government that
is applicable to a future reporting period instead of the current period. It has
a negative effect on net position, similar to liabilities. In the example given in
Chapter 9, the government is paid $5 million in cash now to enter into an agree-
ment with a private company to collect solid waste. So the cash account (an asset
account) increases by $5 million, but $4 million of the cash should be reported
as revenues for the government for a future reporting period. In accounting
practice, this $4 million should be reported as deferred inflows of resources (on
the liability side) that offset the $5 million cash already reported, so that the
total revenue this reporting period is ($5 million – $4 million =) $1 million. For
more information about deferred inflows (or outflows) of resources, see GASB
Statement No. 63 and Statement No. 65.
Deferred outflows of resources: a consumption of net assets by the government that
is applicable to a future reporting period instead of the current period. It has a
positive effect on net position, similar to assets. One example is debt issuance
costs—costs associated with issuing debt (bonds), such as various fees and
commissions paid to investment banks, law firms, auditors, and so on. These
payments generate future benefits.
Delphi technique: a systematic, interactive forecasting method. It relies on a panel
of experts who answer questionnaires in two or more rounds about their forecast
figures and the rationales of their forecasts. A facilitator provides a summary of
these forecasts and rationales.
Demographics estimation of expenditure growth: a method that uses demographic
changes in estimating expenditure growth. Population and income are popular
demographic variables used in the estimation.
228 GLOSSARY
Direct cost: the cost items that can be directly assigned to a cost objective. For ex-
ample, a police patrol officer’s salary is a direct cost item for a police patrol
program in a local government.
Direct services: a category used in the Comprehensive Annual Financial Report. They
are services provided to residents, customers, or clients outside a government.
Discount rate: the rate used to discount the future value.
Double-entry accounting: an accounting practice in which every accounting transac-
tion must be recorded in at least two accounts.
Downward trend (in revenue forecast): a trend in revenue forecast indicating that
the revenue has declined over time.
E
Enterprise funds: the funds that account for financial transactions incurred in providing
business-type goods and services. Enterprise funds are used when resources are
provided primarily through the use of service charges to those receiving the benefit,
or when the matching of revenues and expenses in a break-even fashion is desired.
Estimation error in revenue shortage estimation: the difference between the esti-
mated shortage and the actual shortage in the proportion of the actual shortage.
Expenditure: a budget concept that represents the amount of spending during a fis-
cal period.
Expenditures per capita: the average amount of expenditure by each resident or
citizen (= Total Expenditure/Population). It can be used to reflect the govern-
ment’s spending for each resident. It is a financial input indicator in financial
Expenses: a category used in the Comprehensive Annual Financial Report that reflects
resources consumed during a fiscal period. Expenses figures are prepared on an
accrual basis in the statement of activities.
Exponential smoothing (EXS): a forecasting technique that assigns different weights
to data of different periods. A common practice of EXS in revenue forecasting is
to assign larger weights to the more recent revenue data, resulting in a forecast
outcome that reflects more on the revenue in the most recent year.
F
Fiduciary funds: the funds that account for resources in the possession of the gov-
ernment in a trustee or agency capacity for individuals, other governments, or
private organizations.
Financial condition: the ability of an organization to meet its financial obligations.
Financial condition analysis (FCA): an evaluation of an organization’s financial health.
The ultimate purpose of the analysis is to identify the factors that impact financial
condition and to provide recommendations to improve financial condition.
Financial indicators: indicators used to assess an organization’s financial operation
and condition.
GLOSSARY 229
Financial input indicators: indicators used to assess the availability of financial

resources and the level of financial resource consumption.
Financial merits of a revenue option: financial costs of revenue options used to
cover revenue shortages.
Financial process indicators: indicators used to address issues in financial opera-
tions such as cash liquidity, debt capacity, operating deficits, pension liability,
and capital outlays.
Financial reserves as a revenue option: the use of accumulated savings to cover
revenue shortages.
Financial results indicators: financial indicators employed to evaluate the efficiency
or the effectiveness of resource uses.
Financial risk: a possible revenue or income loss.
Fixed assets: an asset category that accounts for assets and properties that cannot
easily be converted into cash. Fixed assets are often compared with current as-
sets (also called liquid assets).
Fixed asset turnover: a financial results indicator (= Total Revenues/Total Fixed
Assets) that reflects the revenue per dollar of assets invested in long-term assets
such as equipment and properties.
Fixed cost (FC): cost that does not change with variation in the production quantity
of goods or services.
Flat rate: a rate structure in which the same fixed rate applies regardless of the base.
For example, in a flat-rate sales tax design, customers pay the same tax rate
regardless of the values of sales.
Forecast horizon: the length of the forecast.
Forecast subject: the subject of the matter that is being forecast. In revenue forecast-
ing, it can be a tax, a fee, a charge, or other types of revenues.
Forecasting techniques: tools used to forecast. Introduced in this book are simple
moving average (SMA), exponential smoothing (EXS), transformation moving
average (TMA), regression against time, and a quasi-causal technique.
Full faith and credit debts: See “General obligation bonds.”
Fund balance: the difference between assets and liabilities in a fund. Also known
as fund equity.
Fund equity: See “Fund balance.”
Fund operating surplus (or deficit): the difference between revenues and expen-
ditures in a fund. It can be used as a financial process indicator in financial
Fundamental accounting equation: Assets = Liabilities + Net Assets.
Funds: fiscal and accounting entities that report their financial assets, liabilities, and
fund balances with the double-entry mechanism.
Future value: value realized sometime in the future.
G
General fund: the fund that accounts for most basic services provided by a govern-
ment and most of its daily operations.
230 GLOSSARY
General obligation bonds: bonds backed by the full faith and credit of a government
including its power to raise taxes in financing the debt. They are also known as
tax-supported bonds.
General revenues: the revenues not associated with specific programs or functions in
the statement of activities of the Comprehensive Annual Financial Report. Taxes
are typical general revenues that are not associated with any specific function
or program of services.
Going concern: a principle that governs accounting practices. It is assumed that the
reporting entity is going to continue in business for the foreseeable future.
Governmental Accounting Standards Board (GASB): the authority to issue the
generally accepted accounting principles (GAAP) used by State and Local
governments in the United States. It is a private, nongovernmental organiza-
tion subject to oversight by the Financial Accounting Foundation (FAF), which
funds GASB.
Governmental activities: a category used in the Comprehensive Annual Financial
Report. As opposed to business-type activities, the provision of governmental
activities does not or cannot generate sufficient revenues to pay for the related
expenses. Popular governmental activities include public safety, education,
transportation, health and human services, and general government.
Governmental funds: funds that account for the financial transactions incurred in
supporting governmental activities. Governmental funds include the general
fund, special revenue funds, capital project funds, and debt service funds.
I
Income determination (economic resource measurement) focus: the measurement
focus of a fund that stresses net assets or incomes.
Increasing taxes as a revenue option: a revenue option that commonly applies to the
revenue shortages caused by providing governmental activities such as public
safety, public education, and health and human services.
Increasing user charges as a revenue option: a revenue option that commonly
applies to the revenue shortages caused by providing business-type services
(activities) such as water and electricity provision.
Incremental changes: the differences between two consecutive terms. Incremental
changes are needed in the transformation moving average (TMA) of revenue
forecasting.
Incremental cost (IC): the change in total cost due to a change of production quantity
or of decision options.
Indirect cost: cost items that cannot be directly assigned to a cost objective. An
indirect cost item has to be distributed to the cost objective through the method
of cost allocation.
Indirect expenses: a category used in the Comprehensive Annual Financial Report.
Indirect expenses cannot be directly assigned to functions or programs; they have
to be distributed to direct services through a certain expense allocation method.
Institutional/policy changes as a revenue option: efforts to address revenue short-
GLOSSARY 231
ages by developing institutional arrangements that favor revenue growth or

expenditure reduction.
Intergovernmental assistance as a revenue option: a revenue option that uses the
revenues coming from other governments to cover revenue shortages.
Internal service funds: funds used to account for services provided within a govern-
ment by one branch to another on a cost reimbursement basis.
Inventory: an asset category that represents the materials and supplies that will be
used in producing goods or services.
Investment plans: financial strategies that include investment types, amounts, and
durations.
Investment returns: financial earnings from investments. Making a large investment
return at a time of maintaining a cash balance sufficient to pay for financial
obligations (liquidity) are two somewhat contradicting cash management goals.
Investment risk: possible loss of investment income as the market declines.
Investment trust funds: funds that account for the assets invested on behalf of other
governmental organizations.
Investments: an asset category that often includes marketable securities such as
stocks and bonds, real estate, and other investment vehicles.
L
Legal or regulatory merits (or feasibilities) of a revenue option: the level of legal
and regulatory compliance required for a revenue option.
Liabilities: an organization’s financial obligations expected to be paid to others.
Liabilities are the amounts that the organization owes to outside entities and
employees. Examples include various accounts payable and loans that an orga-
nization takes.
Liquidity: a concept that concerns whether an organization has enough cash and cash
equivalents to meet its short-term financial obligations.
Long-run solvency: the ability to pay for long-term financial obligations.
Long-term or fixed assets: long-lived and expensive assets often in forms of land,
plant, buildings, infrastructure, and equipment. Although many long-term assets
are also fixed assets, some intangible long-term assets such as trademarks and
patents are not categorized as fixed assets.
Long-term debt: a liability category that reflects an organization’s long-term loans
or leases.
Long-term debt per capita: a measure of service solvency. Long-Term Debt Per
Capita = Total Long-Term Debt Outstanding/Population.
Long-term debt ratio: a measure of long-term solvency. Long-Term Debt Ratio =
Total Long-Term Debt Outstanding/Total Assets (or Total Revenues).
Lower limit (in the Miller-Orr model): the minimum cash balance in the Miller-
Orr model.
Low-risk investments: investments with a low probability of financial loss. They
include government-issued bonds, bank savings accounts, bank certificates of
deposit, and other guaranteed securities.
232 GLOSSARY
M
Marginal cost (MC): change in the total cost of producing one more unit of goods
or services.
Materiality: a principle that governs accounting practices. It should be indicated, in
an auditor’s report, whether or not the financial statements are free of significant
(material) reporting errors.
Mean absolute percentage error (MAPE): a measure of forecast accuracy. Com-
pared with absolute percentage error (APE), MAPE is a more reliable measure
of forecast accuracy because its calculation involves the data of multiple terms,
while APE uses only the data of one term.
Measurable and quantifiable project objectives: A necessary condition to assess
project benefit in a cost-benefit analysis is that the project objectives can be
quantified and measures can be developed to estimate the achievement of the
objectives.
Measurement affordability: a criterion to judge whether the data of a measure are
inexpensive to obtain. The data of a good measure must be affordable to obtain.
Measurement controllability: a measurement selection criterion in a financial
condition analysis that stresses the sensitivity of a measure to the policies or
managerial operations of an organization.
Measurement focus: the subject of the financial reporting for a fund. It concerns
what information is expressed in the reporting.
Measurement reliability: a criterion to judge whether a measure is an objective and
consistent assessment of what it measures. A reliable measure of a financial con-
dition must be an objective and consistent assessment of the financial condition.
Measurement validity: a criterion to judge whether a measure assesses what it is
supposed to assess. A valid measure of a financial condition must assess a speci-
fied element of the financial condition.
Millage: the property tax rate. A millage of 1.00 (or 1.00 mill) is equal to $1 per
$1,000 taxable value.
Miller-Orr model: a cash management model that determines a cash balance in-
terval in which cash management goals of liquidity and investment returns can
be achieved. The Miller-Orr model can also help investment decision making.
Mixed cost: the cost that can be classified as the fixed cost on some occasions and
the variable cost for others.
Modified accrual basis accounting: In modified accrual basis accounting, revenue is
reported when it is measurable and available and expense is reported when the
organization becomes legally obligated to pay and the payment will be made.
Monetary denominator: a principle that governs accounting practices. It refers to
the fact that all actions that have a financial element must be monetized.
Mutually exclusive project objectives: a consideration in measuring and calculat-
ing the benefit in a cost-benefit analysis, which requires that the completion of
a project objective does not affect another objective.
Mutually inclusive project objectives: a consideration in measuring and calculating
the benefit in a cost-benefit analysis. There are cases of cost-benefit analysis in
GLOSSARY 233
which the completion of a project objective affects another objective. Caution

should be exercised to avoid double counting of benefits in these cases.
N
Net asset ratio (also net position ratio): a measure of long-term solvency. Net As-
set (or Net Position) Ratio = Total Net Assets or Net Position/Total Assets. A
modified form of the Net Asset Ratio = (Total Net Assets or Net Position – Net
Assets or Net Position Invested in Capital Assets)/Total Assets.
Net assets: the difference between (total) assets and (total) liabilities. GASB State-
ment No. 63 called for the use of net position to replace net assets in US state
and local governments. Also see “Net Position.”
Net assets per capita: a measure of service solvency. Net Assets Per Capita = Total
Net Assets/Population.
Net cash flows: the difference between cash receipts and cash disbursements.
Net (expenses) revenues: the difference between program expenses and program
revenues in the statement of activities of the Comprehensive Annual Financial
Report.
Net investment in capital assets: a net position item in the statement of net position
of US state and local governments that reports the net value of capital items.
Net position: the measure to replace net assets in US state and local government
financial reporting after 2012. Net Position= (Assets + Deferred Outflows of
Resources) – (Liabilities + Deferred Inflows of Resources)
Net present value (NPV): the difference between costs and benefits in the present
value form. NPV is a decision-making criterion in cost-benefit analysis. A project
is economically feasible if its NPV is positive.
Net worth: the difference between total assets (plus deferred outflows) and liabilities
(plus deferred inflows). It is also known as net position or net assets (before
GASB Statement 63).
Noncurrent assets: These generally include long-term assets such as land, plant,
equipment, and long-term investments over a year. Noncurrent assets may also
include assets designated for specific purposes so they are not available for im-
mediate and general use.
Noncurrent liabilities: financial obligations due beyond a year.
Nonfinancial indicators: indicators used to assess an organization’s performance
that is not characterized by financial transactions, financial operations, or the
monetary success.
Nonguaranteed bonds: See “Revenue bonds.”
O
Objective evidence: a principle that governs accounting practices. There is a preference
to use objective evidence rather than subjective estimation in financial reporting.
Operating cost: the cost of sustaining daily operations (i.e., not part of personnel
and capital costs).
234 GLOSSARY
Operating ratio: a measure of budgetary solvency. Operating Ratio = Total Reve-

nues/Total Expenditures (or Expenses).
Opportunity cost: the value of the best alternative forgone. It is a useful concept in
estimating the cost of a project in a cost-benefit analysis.
Opportunity rate of return: the return of the best alternative to a project. Also see
“Discount rate.”
Optimal cash balance: a cash balance that meets the daily demand for cash and
earns a large investment return.
Outcomes of a project: a project’s intermediate or long-term impact and achievement.
Outputs of a project: a project’s direct products or immediate effects.
Overforecast: a forecast outcome greater than the actual revenue amount.
Overhead rate: the rate used in the cost allocation to distribute an indirect cost item
to a cost objective. It is equal to the cost pool divided by the cost base.
Own-source ratio: a measure of budgetary solvency. Own-Source Ratio = Revenues
of Own Sources/Total Revenues.
P
Pay-as-you-go: the method of paying for capital projects directly from existing funds.
Pension trust funds: the funds that account for resources held in trust for employees
covered under a governments’ retirement pension plans.
Personnel cost: the cost of providing personnel services.
Political merits of a revenue option: political support available for a revenue option
in covering revenue shortages.
Present value: the value of the present day.
Present value of benefit (PVB): benefit in its value of the present day.
Present value of cost (PVC): cost in its value of the present day.
Primary government: a state or a local government that has a separate elected
governing body and is fiscally independent of other state or local governments.
Private-purpose trust funds: funds that account for all other trust arrangements
under which the principal and income are held for the benefit of individuals,
other governments, and private agencies.
Program revenues: revenues generated in functions or programs of services specified
in the statement of activities of the Comprehensive Annual Financial Report.
Project (accounting) cost: the summation of all resources consumed by a project
during its lifetime. Project cost is different from the opportunity cost that con-
cerns the value forgone by doing the project.
Project outcomes: a project’s intermediate or long-term impact and achievement.
Some cost-benefit analyses call for an estimation of project outcomes. Project
outcomes are more difficult to observe than project outputs.
Project outputs: a project’s direct products or immediate effect. Outputs are important
estimates of project benefits in cost-benefit analysis. Project outputs are easier
to estimate than project outcomes.
Proprietary funds: funds that account for financial transactions incurred in providing
GLOSSARY 235
business-type goods and services. Proprietary funds consist of enterprise and

internal service funds.
Public service agencies: organizations that mainly provide public services.
Purchase price estimation of expenditure growth: an estimate based on the price
or the cost of obtaining service capacities or providing a service. The estima-
tion focuses on the increase in personnel, operating, and capital expenditures.
Q
Quantity range: the range of the production quantity. Quantity range is a useful con-
cept in cost analysis. The fixed cost can be different in different quantity ranges.
Quasi-causal forecasting model: a forecasting technique that uses predictors to
generate the forecast result.
Quick ratio: a measure of cash solvency that relates cash, cash equivalents, market-
able securities, and account receivables to current liabilities.
R
Regression against time: a revenue forecasting technique that takes the revenue
trend into consideration. The forecast combines a baseline revenue and a reve-
nue increment of the forecast period.
Resource development analysis (RDA): a tool to assess and tackle revenue shortages.
Restricted cash and cash equivalents: monies that may be reported as noncurrent
assets. They are designated for specific purposes and therefore not available for
immediate and general use by the government. Restricted cash can be used for
a range of purposes such as loan repayment, equipment purchase, or investment.
Restricted net assets: net assets with restrictions on the purposes or the time of use.
Return on assets: a financial results indicator (= Change in Net Assets/Total Assets)
that represents the earning (or change in net assets) per dollar of assets.
Return on net assets: a financial results indicator (= Change in Net Assets/Net Assets)
that assesses the change in net assets (or profitability) per dollar of net assets.
Return on net assets should be called return on net position (= Change in Net
Position/Net Position) in US state and local governments after 2012.
Return on net position: See “Return on net assets.”
Return point (in the Miller-Orr model): a cash balance in the Miller-Orr model to
make investment or cash replenishment decisions.
Revenue: a category used in the Comprehensive Annual Financial Report. It is the
financial resources collected during a fiscal period. Also see “Total revenues.”
Revenue base: the source from which the revenue is collected. For example, the
revenue base of a local real property tax can be taxable real property values.
Revenue bonds: bonds backed by the revenues generated from a project financed by
the bonds. They are sometimes called nonguaranteed bonds or self-supporting
bonds.
Revenue/cost ratio: a measure to assess the financial merits of revenue options in
236 GLOSSARY
resource development analysis. It reflects the amount of revenues generated for

each dollar of cost.
Revenue diversification: the inclusion of various types of revenue sources in a reve-
nue portfolio.
Revenue growth rate: Revenue Growth Rate This Term = (Revenue This Term –
Revenue Last Term)/Revenue Last Term.
Revenue loss: the amount of revenue decline from one fiscal period to another.
Revenue per capita: the average amount of revenue for each individual citizen or
resident (Total revenues/Population). It can be used to demonstrate the revenue
burden carried by each resident or the resource available for each resident served.
It is a financial input indicator of financial performance monitoring.
Revenue portfolio risk ratio: a measure of the risk for a revenue portfolio. For a
revenue portfolio with two revenue sources, Revenue Portfolio Risk Ratio =
X1SD1 + X2SD2. In the formula, X1, X2 are the proportions of Revenue Sources
1 and 2 in total revenues, respectively. SD1 and SD2 are the standard deviations
of the growth rates of Revenue Sources 1 and 2, respectively.
Revenue predictors: factors highly associated with a revenue source. They are used
to formulate the equation in a quasi-causal revenue forecasting model.
Revenue rate: the rate that applies to a revenue base. The revenue amount is equal
to the product of the revenue base and the revenue rate.
Revenue risk (the risk of revenue loss): the possible loss of revenues mainly result-
ing from the decline in the revenue base.
Revenue shortage: a fiscal condition in which the amount of revenue generated is
insufficient to support services. A revenue shortage can be the result of a sig-
nificant expenditure increase, a significant revenue loss, or both.
Revenue trend: an indication that revenue continues in a distinctive direction over
time.
Risk: a possible loss.
Risk of a revenue portfolio: the combined risk of multiple revenue sources. It can
be measured by the Revenue Portfolio Risk Ratio.
S
Self-supporting bonds: See “Revenue bonds.”
Service solvency: the ability to pay for a desirable level of services.
Simple moving average (SMA): a forecasting technique that uses the arithmetic
average as the forecast result. In SMA revenue forecasting, the average of reve-
nues in previous years is used as the forecast result.
Smoothing constant (alpha or Greek letter ): the weight assigned to the most
recent revenue data in exponential smoothing. Alpha is a proportional term
(i.e., it cannot be larger than 1.00). A larger alpha value indicates more weight
assigned on the most recent revenue data.
Solvency: the ability to pay for financial obligations.
Special items: a category used in the statement of activities in the Comprehensive
Annual Financial Report. It refers to the revenues collected from a special source.
GLOSSARY 237
Special revenue funds: funds that account for resources legally restricted for specific
identifiable purposes.
Spread (in the Miller-Orr model): the cash interval in the Miller-Orr model to
calculate the upper limit of the cash balance. Spread = Upper Limit – Lower
Limit. There is no need to invest or replenish cash if the cash balance is within
the spread.
Stability and reliability of a revenue source: A stable revenue that fluctuates slowly
and consistently over time, providing a reliable source for an entity.
Standard deviation: a statistic that can be used to measure the volatility of a reve-
nue source.
Statement of activities: a financial statement in the Comprehensive Annual Fi-
nancial Report of US state and local governments. The statement reports the
government-wide information of annual revenues and expenses as well as the
change in net assets.
Statement of net assets: a financial statement in the Comprehensive Annual Financial
Report of US state and local governments before 2012. The statement reports
the government-wide information of assets, liabilities, and net assets.
Statement of net position: a financial statement in the Comprehensive Annual
Financial Report of US state and local governments after 2012. The statement
reports the government-wide information of assets, deferred outflows, liabilities,
deferred inflows, and net position.
Statement of revenues, expenditures, and changes in fund balances: the financial
statement in US state and local governments that reports revenues, expenditures,
and changes in fund balances of a fund.
Straight-line depreciation: a cost depreciation method that distributes capital costs
equally among periods over the lifetime of a capital project.
Sunk cost: past cost that has already been incurred and cannot be recovered.
Systematic revenue risk: the risk of collapse of an entire revenue system.
T
Tax-supported bonds: See “General obligation bonds.”
Theoretical justification of measurement: a measurement selection criterion in a
financial condition analysis that stresses the development of a cause-effect rela-
tionship between socioeconomic/organizational factors and a financial condition.
Time-series forecasting: a group of forecasting tools that use historical data in
forecasting. All forecasting techniques introduced in this book, except the quasi-
causal, are time-series tools.
Time value of money (TVM): the notion that time plays a role in valuation.
Total asset turnover: a financial results indicator (= Total Revenues/Total Assets)
that reflects the revenue per dollar of assets. It is an indicator of asset allocation
efficiency.
Total cost (or full cost) (TC): the dollar value of all related cost items that should
be assigned to a cost objective.
Total expenditures: the total amount of resources consumed in a fiscal period.
238 GLOSSARY
Total revenues: the amount of financial resources collected in a fiscal period.

Transaction cost: the cost per transaction to convert cash to securities or vice versa
in cash management. The concept has other definitions in economics.
Transfers: a category used in the statement of activities of the Comprehensive Annual
Financial Report. Transfers occur when resources are moved from business-type
activities to governmental activities (or vice versa) without receiving anything
in return.
Transformation moving average (TMA): a revenue forecasting technique that
considers the trend of a revenue source by incorporating incremental changes
in forecasting.
U
Underforecast: a forecast outcome smaller than the actual revenue amount.
Unrestricted net assets: net assets with no restriction on the purposes or the time
of use.
Unsystematic revenue risk: the risk that affects one or only a few revenue sources.
Upper limit (in the Miller-Orr model): the cash balance in the Miller-Orr model
indicating that the cash is more than sufficient and some of it should be invested.
Upward trend (in revenue forecast): a trend in revenue forecast indicating that the
revenue has increased over time.
Usage rate depreciation: a cost depreciation method that relies on the usage rate in
depreciating the capital cost.
User charge design (a revenue design for user charges): a revenue design in which
the amount of a user charge depends on the user charge base and the user charge
rate. For example, if the water charge rate is $10 per 1,000 gallons, the amount
of the water user charge for a user who consumes 3,000 gallons of water is ($10
× 3 =) $30. In this example, the total water consumption is the user charge base.
V
Variable cost (VC): the cost that changes to reflect the variation in the production
quantity of goods or services.
Variance of daily net cash flows: a measure of the cash balance fluctuation in the
Miller-Orr model.
Volatility of a revenue source: A volatile revenue source fluctuates sharply and
quickly over time, providing an unreliable source of revenue for an entity. A
volatile revenue source is said to be a riskier source.
Index
A Assets (continued)
Absolute percentage error (APE) statement of net assets, 116–17
defined, 223 statement of net position, 118
exponential smoothing (EXS), 14 Average cost
regression against time, 12, 15 classification of, 42–43
revenue forecasting accuracy, 11–12, 14–15 defined, 224
transformation moving average (TMA), 11, estimation of, 46
15 Averages, 8
Accounting cycle, 120–21, 223
Accounting equation for funds, 138, 223 B
Accounting journal, 120, 223 Balance sheet
Accounting ledger, 120, 121, 223 defined, 224
Accounts payable, 117, 223 governmental fund statements, 139t, 140
Accounts receivable, 117, 223 statement of net assets, 116
Accrual basis accounting Benchmark debt ratio, 174, 224
defined, 223 Benefit/cost ratio, 71, 224
proprietary fund statements, 141 Block rate, 25, 224
regulatory principles, 122 Bonds
statement of activities, 132, 133 debt capacity analysis (DCA), 170–71
Achievable project objective, 72, 223 resource development analysis (RDA), 29
Activity-based costing (ABC), 43–44, 224 Borrowing
Agency funds, 141, 224 debt capacity analysis (DCA), 169, 170
Allen, F., 190 defined, 224
Annualized cost, 56–58, 224 resource development analysis (RDA), 29, 31t
Asset allocation efficiency, 88–89 Borrowing capacity, 88
Asset reserve, 87–88, 224 Break-even production, 41, 224
Assets Brealey, R.A., 190
defined, 224 Budgetary solvency, 149, 150–51, 224
financial performance monitoring, 87–88 Business-type activity
fund-level statements, 138 defined, 224
239
240 INDEX
Business-type activity (continued) Cash management

financial performance monitoring, 88 Miller-Orr Model (continued)
proprietary fund statements, 140–41 liquidity, 102
resource development analysis (RDA), 28, 29, lower cash limit, 102–3, 104–6
31t Microsoft Excel calculation, 103–4
statement of activities, 129 model illustration, 102f
net cash flow, 103
C return point, 102, 104–6
Capital, 117 spread, 102–3, 104–6
Capital costs transaction cost, 103
classification of, 44 upper cash limit, 102–3, 104–6
cost depreciation, 45–46 variance of daily net cash flow, 103–4
defined, 225 optimal cash balance, 99, 102–6
straight-line depreciation, 45–46 study exercises
total cost estimation, 45–46 answer key, 214–15
usage rate depreciation, 46 Bridgetown Foundation, 110–11, 215
Capital project funds, 139, 225 calculations, 109, 214
Cash balance, 101, 225 discussion, 109, 214
Cash basis accounting, 132–33, 225 GFOA recommendations, 112
Cash budget, 100–2, 225 key terms, 108–9
Cash/cash equivalents, 117, 225 Cash ratio, 150, 225
Cash disbursements, 100–1, 102, 225 Cash receipts, 100–1, 102, 225
Cash management Cash safety, 99, 225
cash budget development, 100–2 Cash solvency, 149, 150, 225
cash balance, 101 Change in fund equity (balance), 88
cash disbursements, 100–1, 102 Change in net assets
cash receipts, 100–1, 102 defined, 225
investment plan, 101–2 financial performance monitoring, 88, 89
long-term investment, 102 statement of activities, 131
low-risk investment, 101 Change in net position
short-term investment, 101–2 financial performance monitoring, 88
cash safety, 99 statement of activities, 131
case study, 106–8 Claims payable, 117
data analysis, 107–8 Comparable scenario estimation of expenditure
data collection, 106, 107t growth, 27, 225
data review, 106, 107t Component units, 122, 225
decision-making, 108 Comprehensive Annual Financial Report
Miller-Orr Model, 107 (CAFR)
concepts, 100–6 debt capacity analysis (DCA), 182
investment return, 99 defined, 225
learning objectives, 99 financial performance monitoring, 90, 96–97,
liquidity, 99 213
Miller-Orr Model, 102–6 fund-level statements, 146–47
daily interest rate, 103 operating costs, 52
decision rules, 104–5 statement of activities, 136
INDEX 241
Conservatism, 122, 225 Cost-benefit analysis (CBA) (continued)

Consumer Price Index (CPI), 52–53, 207 sensitivity analysis, 79–80, 211–12
Correlation coefficient, 154, 155t, 225 sustainability analysis, 81
Cost, 226 Cost comparison
Cost allocation, 43, 226 annualized cost, 56–58
Cost base, 43, 51–52, 206, 226 case study, 58–60
Cost-benefit analysis (CBA) decision-making, 59–60
achievable project objective, 72 present value of cost (PVC), 59
benefit/cost ratio, 71 project-cost estimation, 58–59
benefit determination, 72–73 concepts, 54–58
case study, 74–78 discount rate, 55–58
benefit determination, 76–77 future value (FV) of cost, 54–58
cost determination, 77 learning objectives, 54
decision-making, 78 Microsoft Excel calculation, 55–57
discount rate, 78 present value of cost (PVC), 54–58
net present value (NPV), 78 study exercises
question formulation, 76 answer key, 207–8
concepts, 70–74 calculations, 60, 208
cost determination, 73–74 full-cost comparison, 61–62
cost-effectiveness analysis (CEA), 73, 80, 212 key terms, 60
defined, 226 lease/buy decisions, 61, 208
discount rate, 74 present value of cost (PVC), 61, 208
example of, 70–72 time value of money (TVM), 54–58
future value (FV) of cost, 70 Cost convention, 122, 226
learning objectives, 70 Cost depreciation, 45–46, 226
measurable/quantifiable project objectives, 73 Cost-effectiveness analysis (CEA), 73, 80, 212,
mutually exclusive project objectives, 73 226
mutually inclusive project objectives, 72–73 Cost estimation
net present value (NPV), 70–71, 72t average cost estimation, 46
opportunity cost, 73–74 break-even production, 41
opportunity rate of return, 74 case study, 46–50
present value of benefit (PVB), 70–71, 72t average cost estimation, 49–50
present value of cost (PVC), 70–71, 72t capital costs, 48–49
process steps, 72–74 operating costs, 47–48
project cost, 73–74 personnel costs, 47
project outcomes, 73 total cost estimation, 49
project outputs, 73 concepts, 42–46
study exercises cost classification, 42–44
answer key, 210–12 activity-based costing (ABC), 43–44
calculations, 79, 211 average cost, 42–43
cost-effectiveness analysis (CEA), 80, 212 capital costs, 44
discussion, 78–79, 210–11 cost allocation, 43
educational analysis, 80 cost base, 43
key terms, 78 cost items, 42
probability analysis, 80 cost pool, 43
242 INDEX
Cost estimation Current liabilities (continued)

cost classification (continued) governmental fund statements, 138–39
direct costs, 43 statement of net assets, 117
indirect costs, 43–44 Current ratio, 87, 226
operating costs, 44
overhead rate, 43 D
personnel costs, 44 Daily interest rate, 103, 226
total cost, 42 Data outlier, 13–14, 226
cost defined, 41, 42 Debit and credit balance, 120–21, 226
cost objective, 42 Debt capacity, 226
cost time frame, 42 Debt capacity analysis (DCA)
cost versus expenditure, 42 additional debt capacity, 174
fiscal year, 42 borrowing, 169, 170
learning objectives, 41 case study, 175–80
public service agencies, 41 additional debt capacity, 177–78
study exercises CAFR data, 182
answer key, 205–7 current debt level, 175–76
calculations, 51, 206 debt capacity determination, 176–77
Consumer Price Index (CPI), 52–53, 207 future debt capacity, 178–80
cost base, 51–52, 206 written report, 180
discussion, 50–51, 205–6 concepts, 170–80
key terms, 50 current debt level
operating costs, 52, 206–7 debt outstanding, 172–73
total cost estimation, 44–46 debt service, 172–73
capital costs, 45–46 debt capacity determination
cost depreciation, 45–46 benchmark debt ratio, 174
operating costs, 45 debt outstanding per capita, 173
personnel costs, 44–45 debt outstanding ratio, 173–74
straight-line depreciation, 45–46 debt outstanding/taxable property values,
usage rate depreciation, 46 173
utilization rate, 45 debt service ratio, 173–74
Cost items, 42, 226 debt service/revenues, 173
Cost objective, 42, 226 defined, 226
Cost pool, 43, 226 distinction of, 170
Cost time frame, 42, 226 example, 171–72
Current assets future debt capacity, 175
defined, 226 learning objectives, 169–70
financial performance monitoring, 87 Microsoft Excel calculations, 171–72, 177–78
governmental fund statements, 138–39 study exercises
statement of net assets, 116, 117 answer key, 219–20
Current financial resource measurement focus, application, 181, 182, 219–20
138–39, 226 calculations, 181, 219
Current liabilities discussion, 180–81, 219
defined, 226 key terms, 180
financial performance monitoring, 87 self-selective activity, 182
INDEX 243
Debt capacity analysis (DCA) (continued) Expenditure by function, 87

types of debt, 170–71 Expenditure per capita, 87, 228
bonds, 170–71 Expenses, 228
full-faith-and-credit debt, 170 Exponential smoothing (EXS), 6–8, 14, 15t, 228
general obligation bond, 170–71
nonguaranteed bond, 171 F
pay-as-you-go method, 170 FCA modeling, 149
revenue bond, 171 Fiduciary fund, 228
self-supporting bond, 171 Fiduciary fund statements, 141
tax-supported debt, 170 Financial Accounting Standards Board (FASB),
Debt outstanding, 172–73, 226 122
Debt outstanding ratio, 173–74, 227 Financial condition, 149–50, 228
Debt ratio, 88, 227 Financial condition analysis (FCA)
Debt-related risk, 184, 227 budgetary solvency, 149, 150–51
Debt service, 172–73, 227 operating ratio, 150–51
Debt service funds, 139, 227 own-source ratio, 151
Debt service ratio, 173–74, 227 cash solvency, 149, 150
Decision-making matrix, 31–32, 227 cash ratio, 150
Decision rules (Miller-Orr Model), 104–5, 227 quick ratio, 150
Deferred inflows of resources, 118, 227 case study, 157–65
Deferred outflows of resources, 118, 227 data collection, 158–60
Delphi technique, 3, 227 measure determination, 158–60
Demographic estimation of expenditure growth, millage, 164–65
26–27, 227 operating ratio, 161t, 162
Direct cost, 43, 228 own-source ratio, 161t, 162–63
Direct services, 129, 228 personal income, 164
Discount rate population growth, 163–64
cost-benefit analysis (CBA), 74 relationship explanation, 163–65
cost comparison, 55–58 relationship specification, 161–63
defined, 228 scope of analysis, 158
Double-entry accounting, 120, 228 solutions/action, 165
Downward trend (revenue forecasting, 8, 228 taxable property values, 163
warning trends, 160, 161t
E complexity dimensions, 149
Earnings/profits, 89 concepts, 148–57
Economic incentive package, 30 defined, 148, 228
Economic Ordering Quantity (EOQ), 102 distinction of, 148–49
Enterprise funds, 141, 228 FCA modeling, 149
Estimation error (revenue shortage estimation), financial condition, 149–50
24, 228 financial condition measures, 149–52
Evidence of transactions, 120 implementation management, 149
Expenditure implementation period, 149
defined, 228 learning objectives, 148
resource development analysis (RDA), 26–27 long-run solvency, 149, 150, 151
statement of activities, 129, 130t, 131t, 132t, 133 long-term debt ratio, 151
244 INDEX
Financial condition analysis (FCA) Financial performance monitoring

long-run solvency (continued) case study (continued)
net asset ratio, 151 report presentation, 94
net position ratio, 151 underperformance analysis, 94
measure availability, 149 concepts, 86–92
measure criteria, 150 data resources, 90, 96–97, 213
measure determination, 149–53 essential elements, 86
measurement affordability, 150 indicator availability, 86–89
measurement reliability, 150 asset, 87–88
measurement validity, 150 asset allocation efficiency, 88–89
purpose of, 148, 154 asset reserve, 87–88
relationship explanation, 156–57 borrowing capacity, 88
exact form of relationship, 156 business-type activity, 88
relationship specification, 154–56 change in fund equity (balance), 88
correlation coefficient, 154, 155t change in net assets, 88, 89
measures of association, 154 change in net position, 88
Microsoft Excel calculations, 154, 155f, 156 current assets, 87
scope of analysis, 149 current liabilities, 87
service solvency, 149, 150, 151–52 current ratio, 87
long-term debt per capita, 152 debt ratio, 88
net assets per capita, 151–52 earnings/profits, 89
net position per capita, 151–52 expenditures by function, 87
socioeconomic/organizational factors expenditures per capita, 87
list of measures, 153t financial indicators, 86
measurement controllability, 152 financial input indicators, 86–87
theoretical justification of measurement, 1 financial process indicators, 86, 87–88
52 financial results indicators, 86, 88–89
solvency, 150 fixed asset turnover, 89
study exercises fund, 88
answer key, 216–19 fund equity (balance), 88
application, 167, 168t, 218–19 fund operating deficit, 88
calculation, 167, 217–18 fund operating surplus, 88
discussion, 166–67, 216–17 governmental activity, 88
key terms, 166 liabilities, 87–88
self-selective activity, 167 liquidity, 87
warning trends, 153–54 net assets, 87–88
written report, 157 net position, 87–88, 89
Financial indicators, 86, 228 noncurrent assets, 87–88
Financial input indicators, 86–87, 229 nonfinancial indicators, 86
Financial merit of revenue option, 30, 229 return on assets, 89
Financial performance monitoring return on net assets, 89
case study, 93–94 return on net position, 89
indicator determination, 93 revenues by source, 86–87
indicator evaluation, 93 revenues per capita, 87
performance evaluation, 93–94 total asset turnover, 88–89
INDEX 245
Financial performance monitoring Financial risk assessment (continued)

indicator availability (continued) revenue loss measurement, 184–88
total expenditures, 87 examples, 185t, 186t
total revenues, 86–87 Microsoft Excel calculations, 186–87
total revenues by fund, 86–87 reliability of revenue source, 185
indicator determination, 86–90 revenue growth rate, 186
indicator selection, 89–90 revenue portfolio risk ratio, 187–88
learning objectives, 85–86 risk of a revenue portfolio, 187
monitoring frequency, 89–90 stability of revenue source, 185
performance evaluation standard deviation, 186–87
indicator examination, 90 volatility of revenue source, 185–86
overall performance, 91, 92t revenue loss reduction, 188–90
performance trend, 91 revenue diversification, 189–90
purpose of, 85–86 systematic revenue risk, 188–89
study exercises unsystematic revenue risk, 189
answer key, 212–14 risk, 183
calculation of financial indicators, 97, 213–- study exercises
14 answer key, 220–21
discussion, 95–96, 212–13 applications, 197, 221
financial/organizational performance, 97–98 calculations, 196–97, 220–21
historical comparison of indicators, 97, 214 discussion, 196, 220
key terms, 95 key terms, 196
obtaining CAFR information, 96, 213 self-selective activity, 197
underperformance analysis Financial statement/report, 120, 121
action plan for, 92 Fiscal year
causation factors, 91–92 cost estimation, 42
Financial process indicators, 86, 87–88, 229 statement of net assets, 116, 117
Financial reserves as revenue option, 30, 31t, statement of net position, 118
229 Fixed assets, 116, 117, 229
Financial results indicators, 86, 88–89, 229 Fixed asset turnover, 89, 229
Financial risk, 183–84, 229 Fixed cost (FC), 64–65, 229
Financial risk assessment Flat rate, 25, 229
case study, 190–95 Forecast horizon, 4, 229
analytical purpose, 192 Forecast subject, 4, 229
revenue risk assessment, 192–93, 194t Forecasting accuracy measures
revenue source identification, 191t, 192–93 absolute percentage error (APE), 11–12, 14–15
risk analysis, 193, 195 mean absolute percentage error (MAPE), 11,
risk recommendations, 195 12, 14, 15t
concepts, 183–90 Forecasting cost, 14
financial risk, 183–84 Forecasting techniques, 4, 229
debt-related risk, 184 Forecast period, 4
investment risk, 184 Full-faith-and-credit debt
revenue risk, 184 debt capacity analysis (DCA), 170
risk of revenue loss, 184 resource development analysis (RDA), 29
learning objectives, 183 Full-time equivalent (FTE), 45
246 INDEX
Fund Fund-level statements

defined, 229 governmental fund statements (continued)
financial performance monitoring, 88 statement of revenues, expenditures, and
fund-level statements, 138 changes in fund balances, 140
Fund balance, 138, 229 income determination focus, 138, 140–41
Fund equity (balance), 88 learning objectives, 137–38
Fund operating deficit, 88, 229 liabilities, 138
Fund operating surplus, 88, 229 measurement focus, 138
Fundamental accounting equation, 116, proprietary fund statements, 140–41
229 accrual basis accounting, 141
Fund-level statements business-type activity, 140–41
accounting equation for funds, 138 enterprise funds, 141
assets, 138 income determination focus, 140–41
case study, 141–45 internal service funds, 141
data analysis, 144, 145t statement of cash flows, 141
millage, 144 statement of net assets, 141
previous year comparison, 143–44 statement of net position, 141
solutions/actions, 144 statement of revenues, expenses, and
statement review, 142 changes in fund net assets, 141
concepts, 138–45 study exercises
fiduciary fund statements answer key, 216
agency funds, 141 CAFR data, 146–47
investment trust funds, 141 discussion, 146, 216
pension trust funds, 141 key terms, 145
private-purpose trust funds, 141 Future value (FV)
statement of changes in fiduciary net assets, cost-benefit analysis (CBA), 70
141 cost comparison, 54–58
statement of changes in fiduciary net defined, 229
position, 141
statement of fiduciary net assets, 141 G
statement of fiduciary net position, 141 General fund, 139, 140t, 229
fund, 138 General obligation bond
fund balance, 138 debt capacity analysis (DCA), 170–71
governmental fund statements, 138–40 defined, 230
balance sheet, 139t, 140 resource development analysis (RDA), 29
capital project funds, 139 General revenue, 129, 130–31, 132t, 230
current assets, 138–39 Generally Accepted Accounting Principles
current financial resource measurement (GAAP), 122
focus, 138–39 Going-concern, 122, 230
current liabilities, 138–39 Government Finance Officers Association (GFOA)
debt service funds, 139 cash flow forecasting, 112
general fund, 139, 140t financial performance monitoring, 97–98
governmental activity, 138–40 revenue forecasting, 20
modified accrual basis accounting, 139 Governmental Accounting Standards Board
special revenue funds, 139 (GASB), 122, 230
INDEX 247
Governmental activity Indirect cost, 43–44, 230

defined, 230 Indirect expenses, 129, 230
financial performance monitoring, 88 Institutional/policy changes as revenue option,
governmental fund statements, 138–40 30, 31t, 230–31
resource development analysis (RDA), 28, 29, Interest payable, 117
31t Interest receivable, 117
statement of activities, 129 Intergovernmental assistance as revenue option,
Governmental fund, 230 29, 31t, 231
Governmental fund statements, 138–40 Internal service funds, 141, 231
Grants, 29 Inventory, 117, 231
Investment, 116, 117, 231
H Investment plan, 101–2, 231
Hourly rate, 44–45 Investment return, 99, 231
Investment risk, 184, 231
I Investment trust funds, 141, 231
Income determination focus, 138, 140–41, 230
Increasing taxes as revenue option, 28, 31t, L
230 Legal/regulatory merit of revenue option, 31,
Increasing user charge as revenue option, 28–29, 231
31t, 230 Liabilities
Incremental changes, 8, 9t, 230 defined, 231
Incremental cost (IC), 64–65, 230 financial performance monitoring,
Incremental cost analysis 87–88
case study, 65–67 fund-level statements, 138
cost item evaluation, 66–67 statement of net assets, 116–17
decision-making, 67 statement of net position, 118
incremental cost determination, 67 Liquid assets, 117
concepts, 64–65 Liquidity
examples, 65t, 66t cash management, 99, 102
fixed cost (FC), 64–65 defined, 231
incremental cost (IC), 64–65 financial performance monitoring,
learning objectives, 63–64 87
marginal cost (MC), 64–65 Long-run solvency, 149, 150, 151, 231
mixed costs, 64 Long-term assets, 116, 117, 231
quantity range, 64 Long-term debt (obligation), 117, 231
study exercises Long-term debt per capita, 152, 231
answer key, 209–210 Long-term debt ratio, 151, 231
calculations, 68, 209 Long-term investment, 102
discussion, 68, 209 Low-risk investment, 101, 231
incremental cost analysis, 68–69, 209–10 Lower limit (Miller-Orr Model), 102–3,
key terms, 67 104–6, 231
zero-based budgeting (ZBB), 69, 210
sunk costs, 64 M
total cost (TC), 65–65 Marginal cost (MC), 64–65, 232
variable cost (VC), 64–65 Materiality, 122, 232
248 INDEX
Mean absolute percentage error (MAPE) Monetary denominator, 122, 232

defined, 232 Monitoring frequency, 89–90
exponential smoothing (EXS), 14, 15t Mutually exclusive project objectives, 73, 232
regression against time, 12, 15 Mutually inclusive project objectives, 72–73,
revenue forecasting accuracy, 11, 12, 14, 15t 232–33
transformation moving average (TMA), 12 Myers, S.C., 190
Measurable/quantifiable project objectives, 73,
232 N
Measurement affordability, 150, 232 Negative trend, 8
Measurement controllability, 152, 232 Net asset ratio, 151, 233
Measurement focus, 138, 232 Net assets
Measurement reliability, 150, 232 defined, 233
Measurement validity, 150, 232 financial performance monitoring, 87–88
Measures of association, 154 statement of net assets, 116–17
Microsoft Excel Net assets per capita, 151–52, 233
Data Analysis ToolPak Net cash flow, 103, 233
Excel 2003, 200 Net (expenses) revenues, 130, 131t, 132t, 233
Excel 2007, 199–200 Net investment in capital assets, 118, 233
Excel 2008 (Mac), 200 Net position, 87–88, 89, 233
Excel 2010, 199–200 Net position per capita, 151–52
Insert Function (fx), 199, 200 Net position ratio, 151
websites, 200 Net present value (NPV), 70–71, 72t, 233
Microsoft Excel calculations Net worth, 116, 233
cash management, 103–4 Noncurrent assets
cost comparison, 55–57 defined, 233
debt capacity analysis (DCA), 171–72, 177–78 financial performance monitoring, 87–88
financial condition analysis (FCA), 154, 155f, statement of net assets, 116, 117
156 Noncurrent liabilities, 117, 233
financial risk assessment, 186–87 Nonfinancial indicators, 86, 233
Insert Function (fx), 171–72, 186–87 Nonguaranteed bond
STDEV procedure, 186–87 debt capacity analysis (DCA), 171
revenue forecasting, 4 resource development analysis (RDA), 29
exponential smoothing (EXS), 6–7
regression against time, 9, 10f O
simple moving average (SMA), 5–6 Objective evidence, 122, 233
Millage Operating cost
defined, 232 classification of, 44
financial condition analysis (FCA), 164–65 defined, 233
fund-level statements, 144 study exercise, 52, 206–7
Miller-Orr Model, 102–6, 232 total cost estimation, 45
Mixed cost, 64, 232 Operating ratio, 150–51, 234
Modified accrual basis accounting Operational year, 116, 117
defined, 232 Opportunity cost, 73–74, 234
governmental fund statements, 139 Opportunity rate of return, 74, 234
statement of activities, 133 Optimal cash balance, 99, 102–6, 234
INDEX 249
Outcomes of a project, 73, 234 Quick ratio, 150, 235

Outputs of a project, 73, 234
Overforecast, 8, 234 R
Overhead rate, 43, 234 Regression against time, 8–10, 12, 15, 235
Own-source ratio, 151, 234 Reliability of revenue source, 185, 237
Resource development analysis (RDA)
P case study, 32–37
Pay-as-you-go method, 170, 234 decision-making, 37
Penalty receivable, 117 defining the issue, 33
Pension trust funds, 141, 234 revenue option assessment, 37
Performance Analysis for Public and Nonprofit revenue option development, 36–37
Organizations (Wang), 213 revenue shortage estimations, 33–36
Personnel costs concepts, 22–32
classification of, 44 decision-making matrix, 31–32
defined, 234 defined, 22, 235
full-time equivalent (FTE), 45 expenditure growth estimation, 26–27
hourly rate, 44–45 comparable scenario estimation, 27
total cost estimation, 44–45 demographic estimation, 26–27
Political merit of revenue option, 31, 234 example, 26t
Positive trend, 8 purchase price/cost estimation, 26
Present value, 234 learning objectives, 22
Present value of benefit (PVB), 70–71, 72t, 234 procedure for, 23
Present value of cost (PVC) revenue loss estimation, 25
cost-benefit analysis (CBA), 70–71, 72t block rate, 25
cost comparison, 54–58, 61, 208 flat rate, 25
defined, 234 revenue base, 25
Primary government, 122, 234 revenue base loss, 25
Principles of Corporate Finance (Brealey, revenue rate, 25
Myers, & Allen), 190 revenue option assessment, 30–31
Private-purpose trust funds, 141, 234 financial merit, 30
Probability analysis, 80 legal/regulatory merit, 31
Program revenue, 129–30, 131t, 132t, 234 political merit, 31
Project (accounting) cost, 73–74, 234 revenue-to-cost ratio, 30
Project outcomes, 73, 234 revenue option development, 27–30
Project outputs, 73, 234 bonds, 29
Property taxes receivable, 117 borrowing, 29, 31t
Proprietary fund, 234–35 business-type activity, 28, 29, 31t
Proprietary fund statements, 140–41 economic incentive package, 30
Public service agencies, 41, 235 financial reserves, 30, 31t
Purchase price estimation of expenditure growth, full-faith-and-credit debt, 29
26, 235 general obligation bond, 29
governmental activity, 28, 29, 31t
Q grants, 29
Quantity range, 64, 235 institutional policy, 30, 31t
Quasi-causal forecasting model, 10–11, 235 intergovernmental assistance, 29, 31t
250 INDEX
Resource development analysis (RDA) Revenue forecasting

revenue option development (continued) accuracy measures (continued)
nonguaranteed bond, 29 mean absolute percentage error (MAPE), 11,
revenue bond, 29 12, 14, 15t
spending cuts, 27–28 regression against time, 12, 15
tax increase, 28, 31t simple moving average (SMA), 14, 15t
user charge design, 28–29 transformation moving average (TMA), 11,
user charge increase, 28–29, 31t 12, 15
revenue shortage defined, 22–24 case study, 13–15
revenue shortage estimation, 24–27 data cleaning, 13–14
estimation error, 24 data outlier, 13–14
shortage amount, 24 forecasting cost, 14
shortage time frame, 24, 31t forecasting results, 15
shortage types, 24, 25–27 performance monitoring, 15
study exercises technique selection, 14–15
answer key, 204–5 concepts, 4–12
discussion, 38–39, 204 Delphi technique, 3
expenditure and population growth, 40, 205 examples, 4t, 8t
key terms, 38 exponential smoothing (EXS), 6–8, 14,
sales tax shortage, 39, 205 15t
self-selective activity, 40 absolute percentage error (APE), 14
tax/user charge option, 40 averages, 8
user charge shortage, 40, 205 downward trend, 8
Restricted cash/cash equivalents, 117, 235 mean absolute percentage error (MAPE), 14,
Restricted net assets, 235 15t
Restricted net position, 118 Microsoft Excel calculation, 6–7
Return on assets, 89, 235 overforecast, 8
Return on net assets, 89, 235 revenue trend, 8
Return on net position, 89, 235 smoothing constant, 6
Return point (Miller-Orr Model), 102, 104–6, underforecast, 8
235 upward trend, 8
Revenue, 129–31, 133, 235 forecast horizon, 4
Revenue base, 25, 235 forecast subject, 4
Revenue base loss, 25 forecasting techniques, 4
Revenue bond learning objectives, 3–4
debt capacity analysis (DCA), 171 Microsoft Excel calculation, 4
defined, 235 purpose of, 3
resource development analysis (RDA), 29 qualitative tools, 3
Revenue by source, 86–87 quantitative tools, 3–4
Revenue diversification, 189–90, 236 quasi-causal forecasting model
Revenue forecasting time-series data, 10
accuracy measures, 11–12, 14–15 time-series forecasting, 10
absolute percentage error (APE), 11–12, quasi-causal model, 10–11
14–15 regression against time, 8–10, 12, 15
exponential smoothing (EXS), 14, 15t absolute percentage error (APE), 12, 15
INDEX 251
Revenue forecasting Risk of a revenue portfolio, 187, 236

regression against time (continued) Risk of revenue loss, 184, 236
mean absolute percentage error (MAPE),
12, 15 S
Microsoft Excel calculation, 9, 10f Scope of analysis, 149
responsibility for, 3 Self-supporting bond, 171
simple moving average (SMA), 4–6, 14, 15t Sensitivity analysis, 79–80, 211–12
absolute percentage error (MAPE), 14 Service solvency, 149, 150, 151–52, 236
forecast period, 4 Short-term investment, 101–2
mean absolute percentage error (MAPE), 14, Simple moving average (SMA), 4–6, 14, 15t,
15t 236
Microsoft Excel calculation, 5–6 Smoothing constant, 6, 236
study exercises Solvency, 150, 236
answer key, 201–4 Special item revenue, 131, 236
discussion, 16, 201–2 Special revenue funds, 139, 237
franchise taxes, 18t, 19, 203 Spending cuts, 27–28
key terms, 16 Spread (Miller-Orr Model), 102–3, 104–6, 237
licenses, permits, fees, 17, 18t, 202–3 Stability of revenue source, 185, 237
miscellaneous revenue, 19, 203–4 Standard deviation, 186–87, 237
practicing forecast tools, 16–17, 202 Statement of activities
probability forecasting, 19–20, 204 accounting basis, 132–33
scenario forecasting, 19–20, 204 accrual basis accounting, 132, 133
self-selective activity, 21 cash basis accounting, 132–33
stage forecasting, 20–21 modified accrual basis accounting, 133
water/sewer charge, 17, 202 reporting expenditures, 133
transformation moving average (TMA), 8, 9t, reporting revenues, 133
11, 12, 15 case study, 133–35
absolute percentage error (APE), 11, 15 previous year comparison, 135
incremental changes, 8, 9t solutions/actions, 135
mean absolute percentage error (MAPE), statement examination, 134
12 change in net assets, 131
negative trend, 8 change in net position, 131
positive trend, 8 concepts, 128–33
Revenue growth rate, 186, 236 defined, 237
Revenue loss, 25, 236 expenditures
Revenue per capita, 87 accounting basis for, 133
Revenue portfolio risk ratio, 187–88, 236 business-type activity, 129
Revenue rate, 25, 236 direct services, 129
Revenue risk, 184, 236 examples, 130t, 131t, 132t
Revenue shortage governmental activity, 129
defined, 22–24 indirect expenses, 129
estimation of, 24–27 learning objectives, 128
Revenue-to-cost ratio, 30, 235–36 revenues, 129–31
Revenue trend, 8, 236 accounting basis for, 133
Risk, 183, 236 example, 132t
252 INDEX
Statement of activities Statement of net assets (continued)

revenues (continued) net assets, 116–17
general revenue, 129, 130–31, 132t net worth, 116
net (expenses) revenues, 130, 131t, 132t noncurrent assets, 116, 117
program revenue, 129–30, 131t, 132t noncurrent liabilities, 117
special item revenue, 131 operational year, 116, 117
transfer revenue, 131 penalty receivable, 117
statement information, 129–32 property taxes receivable, 117
study exercises proprietary fund statements, 141
answer key, 216 regulatory principles, 122
CAFR data, 136 restricted cash/cash equivalents, 117
discussion, 136, 216 statement information, 116–17
key terms, 135–36 wage payable, 117
Statement of cash flows, 141 Statement of net position
Statement of changes in fiduciary net assets, 141 accounting process, 118, 120–21
Statement of changes in fiduciary net position, accounting cycle, 120–21
141 accounting journal, 120
Statement of fiduciary net assets, 141 accounting ledger, 120, 121
Statement of fiduciary net position, 141 debit and credit balance, 120–21
Statement of net assets double-entry accounting, 120
accounting process, 118, 120–21 evidence of transactions, 120
accounts payable, 117 examples, 120f, 121f
accounts receivable, 117 financial statement/report, 120, 121
assets, 116–17 assets, 118
balance sheet, 116 case study, 122–26
capital, 117 previous year comparison, 125
cash/cash equivalents, 117 solutions/actions, 125
claims payable, 117 statement review/analysis, 125
common asset accounts, 117 deferred inflows, 118
current assets, 116, 117 deferred outflows, 118
current liabilities, 117 defined, 237
defined, 237 fiscal year, 118
example of, 119t learning objectives, 115–16
fiscal year, 116, 117 liabilities, 118
fixed assets, 116, 117 net investment in capital assets, 118
fundamental accounting equation, 116 proprietary fund statements, 141
interest payable, 117 regulatory principles
interest receivable, 117 accrual concept, 122
inventory, 117 component units, 122
investments, 116, 117 conservatism, 122
learning objectives, 115–16 cost convention, 122
liabilities, 116–17 going-concern concept, 122
liquid assets, 117 materiality, 122
long-term assets, 116, 117 monetary denominator, 122
long-term debt (obligations), 117 objective evidence, 122
INDEX 253
Statement of net position Total revenues, 86–87, 238

regulatory principles (continued) Total revenues by fund, 86–87
primary government, 122 Transaction cost, 103, 238
restricted net position, 118 Transfer revenue, 131, 237
statement information, 117–18 Transformation moving average (TMA), 8, 9t,
study exercise 11, 12, 15, 238
answer key, 215–16
discussion, 127, 215–16 U
financial analysis of CAFR, 127 Underforecast, 8, 238
key terms, 126–27 Unrestricted net assets, 118, 238
unrestricted net position, 118 Unsystematic revenue risk, 189, 238
Statement of operations, 128 Upper limit (Miller-Orr Model), 102–3, 104–6,
Statement of revenues, expenditures, and 238
changes in fund balances, 140, 237 Upward trend (revenue forecasting), 8, 238
Statement of revenues, expenses, and changes in Usage rate depreciation, 46, 238
fund net assets, 141 User charge
Straight-line depreciation, 45–46, 237 revenue design for, 28–29, 238
Sunk cost, 64, 237 as revenue option, 28–29, 31t, 230
Sustainability analysis, 81 Utilization rate, 45
Systematic revenue risk, 188–89, 237
V
T Variable cost (VC), 64–65, 238
Tax increase as revenue option, 28, 31t, 230 Variance of daily net cash flow, 103–4, 238
Tax-supported bond, 170 Volatility of revenue source, 185–86, 238
Theoretical justification of measurement, 152, 237
Time-series forecasting, 10, 237 W
Time value of money (TVM), 54–58, 237 Wage payable, 117
Total asset turnover, 88–89, 237 Wang, XiaoHu, 213
Total cost Warning trends, 153–54
cost estimation, 42, 44–46
defined, 237 Z
incremental cost analysis, 65–65 Zero-based budgeting (ZBB), 69, 210
Total expenditures, 87, 237
About The Author
XiaoHu Wang is a professor at City University of Hong Kong. Previously, he was

professor of public administration at the University of Central Florida. He has degrees
in public administration and economics. A trained specialist in US local government
finance, he has worked as a financial analyst for a number of governmental institutions
in the United States. His applications of financial management tools have helped these
governments improve their financial decision making and operations. He serves on
editorial boards of several academic journals and chaired American Society of Public
Administration’s Section on Public Performance and Management. His research has
been published in the most prestigious academic journals in public administration and
public finance. He is the winner of multiple teaching and research awards.
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FINANCIAL

Published 2015 by Routledge

Routledge is an imprint of the Taylor & Francis Group, an informa business

Copyright © 2014 Taylor & Francis. All rights reserved.

Library of Congress Cataloging-in-Publication Data

Wang, XiaoHu, 1962–

Part I. Tools for Financial Planning 1

2. Resource Development Analysis 22

5. Incremental Cost Analysis 63

Part II. Tools for Financial Implementation 83

7. Financial Performance Monitoring 85

8. Cash Management: Determining the Optimal Cash Balance 99

Part III. Tools for Financial Reporting and Analysis 113

9. Financial Reporting and Analysis: The Statement of Net Assets

A Case Study 122

10. Financial Reporting and Analysis: Statement of Activities 128

11. Financial Reporting and Analysis: Fund-Level Statements 137

12. Financial Condition Analysis 148

Step 6: Taking Action to Improve Financial Condition 165

13. Debt Capacity Analysis 169

Appendix A: Introduction to Microsoft Ofﬁce Excel 199

5.2 Incremental Cost Analysis (Continued) 66

12.4 Population, Revenues, and Revenue Per Capita 156

WHAT IS THIS BOOK ABOUT?

WHY DID I WRITE THIS BOOK?

HOW ARE APPLICATIONS EMPHASIZED IN THIS BOOK?

WHAT IS COVERED IN THIS BOOK?

WHAT WERE THE CRITERIA FOR SELECTING TOPICS TO COVER?

WHO SHOULD USE THIS BOOK?

WHAT IS THE MATH REQUIREMENT FOR THE READER?

WHAT IS NEW IN THE THIRD EDITION?

at Indiana University, Zhirong (Jerry) Zhao at the University of Minnesota, Alfred

TOOLS FOR FINANCIAL PLANNING

s 5SE FORECASTING TOOLS PRESENTED IN THIS CHAPTER

Why forecast revenue? Revenue forecasting helps ﬁnancial planning. Because

CONCEPTS AND THE TOOL

Forecasting Example One

SIMPLE MOVING AVERAGE (SMA)

Excel Screen 1.1 Simple Moving Average

EXPONENTIAL SMOOTHING (EXS)

Excel Screen 1.2 Exponential Smoothing

Forecasting Example Two

TRANSFORMATION MOVING AVERAGE (TMA)

REGRESSION AGAINST TIME (REGRESSION)

Incremental Changes in TMA

Year to year Increment ($)

Forecast revenue = a + b (forecast period)

The Excel output presents three tables of results—regression statistics, ANOVA

Excel Screen 1.3 Regression Against Time

A QUASI-CAUSAL FORECASTING MODEL

DETERMINING FORECAST ACCURACY

Franchise Taxes in City of Sunburn (in thousands)

Incremental Changes of Franchise Taxes in City of Sunburn (in thousands)

Utility Taxes in Sunnytown, Florida

Year Revenues ($)

STEP 1: CLEANING THE DATA

STEP 2: CHOOSING THE FORECASTING TECHNIQUE