Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Editio

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Chapter 1

INTRODUCTION TO FINANCIAL MANAGEMENT

Questions for Discussion 1-1. Financial management is the subset of management that focuses on generating financial information that can improve decisions. The decisions are oriented toward achieving the various goals of the organization while maintaining a satisfactory financial situation. Financial management encompasses the broad areas of accounting and finance.

1-2. In proprietary, or for-profit, organizations, an underlying goal is to maximize the wealth of the owners of the organization.

1-3. In public service organizations, decisions are oriented toward achieving the various goals of the organization while maintaining a satisfactory financial situation.

1-4. Accounting is a system for keeping track of the financial status of an organization and the financial results of its activities. It has often been referred to as the language of business. The vocabulary used by accounting is the language of nonbusiness organizations as well.

1-5. Accounting is subdivided into two major areas: managerial accounting and financial accounting.

Managerial accounting relates to generating any financial information that managers can use to improve the future results of the organization. This includes techniques designed to generate any financial data that might help managers make more effective decisions. Major aspects of managerial accounting relate to making financial plans for the organization, implementing those plans, and then working to ensure that the plans are achieved. Some examples of managerial accounting include preparing annual operating budgets, generating information for use in making major investment decisions, and providing the data needed to decide whether to buy or lease a major piece of equipment. Financial accounting provides retrospective information. As events that have financial implications occur they are recorded by the financial accounting system. From time to time (usually monthly, quarterly, or annually), the recorded data are summarized and reported to interested users. The users include both internal managers and people outside the organization.

Those outsiders include those who have lent or might lend money to the organization (creditors), those who might sell things to the organization (called suppliers or vendors), and other interested parties. These interested parties may include those with a particular interest in public service organizations, such as regulators, legislators, and citizens. Financial reports provide information on the financial status of the organization at a specific point in time, as well as reporting the past results of the organization’s operations (i.e., how well it has done from a financial viewpoint).

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Chapter 1: Introduction to Financial Management

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1-6. Finance focuses on the alternative sources and uses of the organization’s financial resources.

Obtaining funds when needed from appropriate sources and the deployment of resources within the organization fall under this heading. In addition, finance involves the financial markets (such as stock and bond markets) that provide a means to generating funds for organizations.

1-7. Yes. Achieving the goals of the organization requires financial planning. Financial management provides information for managers to use in making their decisions. It helps managers by providing information on the likely financial impact of each proposed alternative. It also provides information about financial stability, efficiency, and effectiveness.

1-8. Clearly, we might expect some public service organizations that are proprietary, such as some hospitals, to earn profits. But what about other public service organizations such as charities? They should make a profit as well. Profits provide a safety margin against unexpected costs, provide resources to replace buildings and equipment, and to expand and improve services.

1-9. Federal government (see text Figure 1-1) ◼ Individual income taxes ◼ Social insurance taxes ◼ Corporate income tax State and local government (see text Figure 1-4) Sales and gross receipts tax ◼ Federal government ◼ Property taxes ◼ Individual income taxes ◼

Health sector (see text Figure 1-6) ◼ Private insurance ◼ Medicare ◼ Medicaid ◼ Other government programs Not-for-profit sector (see text) Private payments for goods and services ◼ Government payments for goods and services ◼ Donations ◼

1-10. Federal government spending exceeded $6 trillion in 2020 and state and local government spending was more than $3 trillion in 2018. In contrast, the GDP was $21 trillion in 2020. For more up to date information, examine the statistical tables of the most recent Economic Report of the President, which is available online.

1-11. The reported surplus includes both on and off budget items. Social security taxes represent an off budget item that until recently raised more revenue than was spent on social security payments.

The surplus in this area offset other government losses, and even resulted in an overall surplus for

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

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Instructor’s Manual to Accompany Financial Management for Public, Health, and Not-for-Profit Organizations

the federal government. This is no longer the case, and, over time, trust fund resources will be used up to provide benefits. As the federal government will not have access to the excess resources from social security, it will have to borrow and increase the total level of federal debt, unless revenues or spending are changed.

1-12. Sometimes gifts come with strings attached. If the conditions of the gift create a burden that the organization does not want to accept, or somehow requires the organization to work in opposition to its mission, it might turn down the gift.

1-13. The World Bank has defined NGOs as "private organizations that pursue activities to relieve suffering, promote the interests of the poor, protect the environment, provide basic social services, or undertake community development" (World Bank Operational Directive 14.70). NGOs are quite similar to the not-for-profit organizations. They are primarily mission-focused rather than profit-focused. NGOs fall into three main categories: community-based, national, and international.

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Chapter 2

PLANNING FOR SUCCESS: BUDGETING

QUESTIONS FOR DISCUSSION 2-1. Planning helps the organization by causing its employees to think ahead and anticipate change.

This is done by establishing specific goals and objectives, communicating those objectives to the individuals who must achieve them, forecasting future events, developing alternatives, selecting from among alternatives, and coordinating activities. The activities are summarized in a document called a budget. The budget describes what we hope to achieve and the resources that will be used to carry out the organization’s activities.

2-2. The organization’s mission represents its reason for existence. For public, health, and not-forprofit organizations, finances often become a means to an end, rather than the end itself. This mission cannot solely be making profits. Financial management must help balance the focus on profit with the public service elements of the organization’s mission.

2-3. Strategic plans translate the mission of the organization into an approach or set of approaches that will be used to accomplish the mission, and a broad set of goals that need to be attained to achieve the mission. Strategic plans set the organization’s long-term direction. They often do not have specific financial targets. However, they set the stage for the specific, detailed budgets that will be established to achieve the organization’s goals.

2-4. Whereas the strategic plan establishes goals, the long-range plan considers how to achieve those goals. Long-range plans establish the major activities that will have to be carried out in the coming three to five years. This process links the strategic plan to the day-to-day activities of the organization. Organizations that do not prepare a long-range plan are often condemned to only sustain current activities, at best.

2-5. Budgets establish the amount of resources that are available for specific activities. However, budgets do not merely limit the resources that can be spent. They represent the detailed plan that supports the organization’s efforts to achieve its mission, and help the organization determine and achieve its goals and objectives. The budgeting process is one of exploring possibilities.

Organizations determine what things they can and cannot do. They examine alternatives and choose those that are likely to yield the best results. They become attuned to possible problems and can work to find solutions. Budgeting forces managers to think ahead, to have clear expectations against which to measure performance, and to coordinate the activities of the organization so that everyone is working toward a common purpose.

Budgets are also used to control results. That is, budgets not only create plans, but they are also used to help accomplish those plans. This is done by comparing actual results to the budget.

Looking at results, we can assess what needs to be corrected. How good a job did the

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Chapter 2: Planning for Success: Budgeting

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organization’s management do? How well did the organization itself do? In order to evaluate performance, one must have a standard or benchmark to compare with actual results. The budget establishes the organization’s expectations.

2-6. An organization may consider undertaking an activity that was not planned for when the annual budget was prepared. At any time an organization can prepare a special budget for a specific purpose. Appropriate approval should be obtained before implementing the budget.

2-7. An organization’s budgets are often organized into a strategic plan, long-range plan, master budget, and special purpose budgets.

2-8. Budgets present specific, measurable goals. An individual is much more likely to work efficiently if there is a target to shoot for, assuming that the target is not unrealistic.

2-9. Most employees would prefer salaries that are substantially larger than the amounts they are currently receiving. Organizations lack the revenues to pay for those raises. Most managers would like more office space with new furniture and remodeled facilities. They would certainly like more staff to carry out existing functions. Organizations must make choices concerning how to spend their limited resources.

2-10. Depending on the specific organization, the volume of services provided may have plunged or soared. This would have resulted in substantially more or less revenues than expected. If revenues plunged, then we would have had more staff than needed, without the resources to pay that staff. We may have found ourselves unexpectly unable to pay rent on our facilities. Even if revenues were up, we may have been faced with soaring costs for items in short supply. A budget is a very important tool. However, we should never assume that it tells us exactly what will happen. Managers need to be flexible, observe events that may cause actual events to differ from the budget, and be prepared to act quickly to take mitigating actions.

2-11.

It is very tempting for a manager to see significant variations from the budget, and want to revise the budget. Generally once a budget has been approved by the governing body of the organization we do not go back and revise the official budget, even if we see significant variations from the budget. However, as a manager starts to see that something has happened which will make results very different from budgeted expectations, the manager has to act to minimize the negative impacts of the changes on the organization. For example, if you manage a museum, and the number of customers to your museum café has plunged, you have to make adjustments to staffing and food purchases to minimize the losses that you will incur. If revenues are insufficient to pay rent, you have to negotiate with your landlord for a moratorium on rent payments. If you see that there is no way you can cover even severely reduced costs given your drop in customer volume, you need to quickly gear up fund-raising activities to bring in more donations to offset losses in sales. The budget is still a valuable tool, because by comparing your original expectations to the actuality you can determine things such as how much additional donations you will need to keep the organization afloat.

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

2-12. The manager should make sure that it is in the staff’s best interests to do the things that are in the organization’s best interests. The key is to establish a means of making the normally divergent desires of the organization and its employees become convergent, or congruent. Organizations often achieve congruence by setting up a system of incentives.

2-13. Financial incentives include retaining one’s job and receiving good raises and bonuses. Bonus systems have a variety of problems. Some bonus systems reward all employees if spending is reduced. This is good unless workers can restrict volume, thus reducing the number of units of service provided in order to save money. Such behavior would likely reduce revenues by a greater amount than it would save costs. Also, if everyone gets a bonus, then no one feels that individual actions have much impact, and each individual may feel that she or he does not have to work particularly hard to reap the benefits of the bonus. If bonuses are given only to some employees, it may create jealousy and discontent. It is also possible that it may create a competitive environment in a situation in which teamwork is needed to provide quality care.

There are incentive alternatives to bonuses; for example, a letter from supervisor to subordinate.

In the real world, praise is both cheap and, in many cases, effective. On the other hand, criticism, especially in writing, can have a stinging effect that managers will work hard to avoid in the future.

2-14. If targets are placed out of reach, people probably will not stretch to their utmost limits to come as close to the target as possible. When people work extremely hard and then fail, they often question why they bothered to work so hard. If hard work results in failure to achieve the target, then why not ease off? If you are going to fail anyway, must it be so painful?

2-15. (1) The budget is first prepared. (2) After review by the body with adoption authority, it is adopted, either with or without changes. (3) Once approved, the budget is implemented. It is the responsibility of the management of the organization or the executive branch of the government to assure that the adopted budget is carried out. (4) Finally, the results must be evaluated.

Accountability is an element of this evaluation.

2-16. In some organizations, support and revenues are only acknowledged if they have been received in cash. In those cases, expenses are recognized when they have been paid. For organizations that record their revenues and expenses in that way, the cash budget would be identical to the operating budget. They are said to use a cash basis of accounting. In contrast, if revenue is recorded in the year the service is provided, whether cash has been received yet or not, then the organization is said to be using an accrual basis of accounting.

Cash accounting is easier, but does it enable us to understand how well our organization is doing? With accrual accounting we accrue, or anticipate, the eventual receipt of money for services provided, as well as recording expenses for resources consumed, even if they have not yet been paid for. When accrual accounting is used, the operating budget gives us a good idea of how profitable we expect the organization to be. However, it does not give an accurate idea of how much cash we will have.

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Chapter 2: Planning for Success: Budgeting

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2-17. Modified cash is a system that treats most revenues and expenses on a cash basis. However, capital acquisitions are depreciated over time, rather than all being treated as an expense in the year cash is paid for them.

2-18. The budget process can be quite complicated and time consuming. The process may take one to three months in small organizations and four to six months or even longer in larger ones. In order to assure that the budget is ready for adoption sufficiently early to be implemented at the start of the coming year, many organizations prepare a budget calendar or timeline. Government timelines are often set by law or regulation.

PROBLEMS The exhibits below are embedded Excel objects. Double-clicking on them will open an Excel spreadsheet.

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i. ii. iii. iv. v.

The first year cash profit is $(7,000).

The accrual basis profit is $2,000.

If Finn Fixes were to stop operations at the end of the first year, it's second-year cash profit would be $9,000 Finn' second-year ending cash balance would be $2,000 - exactly the same amount as the 1styear's accrual budgetpredicted.

Accrual better reflects the long-term stability of the organization.

2-20. 4 3

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

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2-21.

January 31, 2020 Market Close S&P 500 Index value: 3327.71 (Note the market close value on Jan. 31 is the value at the start of the day on February 1.

August 31, 2021 Market Close S&P 500 Index value: 4522.68 Change in S&P 500: 4522.68 – 3327.71 = 1194.97 Percent Change: 1194.97 / 3327.71 x 100 = 35.9% Endowment Start: $100 million Endowment Change: $100 million = 35.9% = $35.9 million Endowment End: $135.9 million.

Clearly, organizations with significant endowments were in a position to sell some of the gains on their endowment over the course of the pandemic to help them survive even if their revenues were dropping significantly.

While many organizations use the interest and dividends earned on their endowment to help them provide marginally more services each year, an endowment also serves a vital safety function for the organization, providing a potential alternative source of resources to help the organization survive hard times.

2-22 1. Earns Uses 2. depreciation 3. cash or cash flows; or the full project life

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Chapter 2: Planning for Success: Budgeting

2-23.

2-6

Monroe Outpatient Surgery Center Operating Budget June 2021

2-24. (Capital Assets and Depreciation Expense)

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Problem 2-25 Billings January

February

220,000 Month of Service Collections as

200,000

25%

240,000

230,000

75%

March $

240,000

Expenses Payroll

April

Month After Service

Operating Budget Total Revenue

March

Cash Budget Beginning Balance

March $

26,000

$

150,000

Cash Receipts 160,000

February Billings

Supplies

48,000

March Billings

Depreciation

12,000

Total Collections

$

210,000

Interest

6,000

Total Cash Available

$

236,000

$

170,000

Total Expenses

$

$

60,000

226,000 Disbursements

Profit/(Loss)

$

14,000

Payroll Payment Supply Payments Building Acquisition

45,000 $

250,000

Total Disbursements

$

465,000

Capital Budget

2-25.

Building Acquisition

$

250,000

Cash Surplus/(Shortfall)

$ (229,000)

Mortgage

$

250,000

Borrowing/(Repayment)

250,000

Ending Cash Balance

$

21,000

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Chapter 2: Planning for Success: Budgeting

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2-26. (Cash and Operating Budgets)

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

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Middleboro Township Operating Budget Fourth Quarter Revenues Income Tax Loan

$

750,000 35,000

Total Revenue

$

785,000

$

720,000

(earned equally throughout year) (revenue under modified accrual)

Expenditures Salaries Interest Supplies

437.50 390,000

Total Expend.

$ 1,110,438

Surplus/(Deficit)

$

Beginning Cash Tax Receipts Loan Receipt Cash Available Salaries Supplies Ending Cash

($35,000 x 5% - $2,800 /4 = $437.50 per quarter (expenditure when legal obligation to pay; i.e., when supplies received)

(325,438)

Middleboro Township Cash Budget Fourth Quarter $300,000 Given 600,000 Cash rather than accrual basis 35,000 $935,000 -720,000 -300,000 From first quarter due to payment lag ($85,000)

Note that operating budget and cash budget results are not the same because of timing differences of when things are recorded under an accrual approach.

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Chapter 2: Planning for Success: Budgeting

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2-27. (Special Purpose Budget)

No, it is not necessarily financially bad. This program may discover patients with hypertension or other medical problems who will become patients of the hospital, generating additional revenues. Also it provides the hospital with a way to advertise their services, generating future patient volume and revenue.

2-28. (Cash Budget)

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

2-29.

.

2-30.

1. a) increase 2. b) decrease 3. b) decrease 2-31. Capital Budget

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Chapter 2: Planning for Success: Budgeting

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2-32. (Operating Budget) The zoo expects the following number of visitors per month:

Budget Revenues County Grant Admissions Total Revenues

$7,000 20,150 $27,150

Expenses Administration Staff Train Costs Maintenance Total Expenses Profit/(Loss)

$12,000 10,000 1,317 3,950 $27,267 ($117)

2-33. (Cash Budget)

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Cash Budget Beginning Cash Cash Receipts Admissions County Grant Total Cash Available

Quarter 1 $5,000

Quarter 2 $5,000

54,000 0 $59,00

45,000 0 $50,000

$55,000 5,400 10,800 $71,20 ($12,200)

$55,000 6,000 9,000 $70,000 ($20,000)

Borrow (Repay) Ending Balance

17,20 $5,00

25,000 $5,000

Note Payable

$17,20

$42,200

Cash Disbursements Administration and Staff Train Costs Maintenance Total Cash Disbursements Subtotal

2-34.

March cash receipts 60% of $13,000 40% of $12,500 Total cash receipts

$ 7,800 5,000 $12,800

2-35.

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Chapter 2: Planning for Success: Budgeting

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2-36.

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

2-37.

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Chapter 2: Planning for Success: Budgeting

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Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Revenue Tuition - Parents Tuition - County Total Revenue Expenses Inside teachers Outside teachers Supplies Software Total Expenses Surplus/(Deficit)

Month 1 250 5,000 $ 5,250

Month 2 410 8,200 $ 8,610

Month 3 $ 520 10,400 $ 10,920

$

$

$

4,000 3,840 492 200 8,532

$

$

4,000 300 200 4,500

$

750

$

78

$

$

Full Qtr. 1,180 23,600 $ 24,780 $

$

$

4,000 5,760 624 200 10,584

$

12,000 9,600 1,416 600 23,616

$

336

$

1,164

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Chapter 2: Planning for Success: Budgeting

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2-38. Marquoya College

Part III Budgeted Receipts Tuition

$14,280,000

Fees

1,288,000

Endowment

514,000

Auxiliary Services

538,000

Athletics Total Budgeted Receipts

1,580,000 $18,200,000

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

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Budgeted Expenditures Faculty Salaries Operation and Maintenance of Plant Mortgage payments

$10,000,000 1,260,000 264,000

Administration & General

1,440,000

Library

1,800,000

Health & Recreation

750,000

Athletics

320,000

Insurance & Retirement Benefits

548,000

Capital Improvements

1,300,000

Payroll Taxes

1,276,000

Federal Income Taxes

36,000

Bank Loan

204,000

Total Budgeted Expenditures

$19,198,000

Projected Deficit Prior to Fund Raising

($998,000)

$1,000,000 + 10,000 + 50,000 Given Given Given Given Given Given Given Total Salaries * 10% Given $200,000 + $4,000

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Chapter 2: Planning for Success: Budgeting

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The Marquoya College problem and solution were written by Ken Milani and Jim Gaertner. Used with permission.

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

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EXTENDED PROBLEM: DENISON SPECIALTY HOSPITAL SOLUTION

Part I Section A 1.

Calculation of patient revenue

Oncology Private Insurance Medicaid/Medicare Self-Pay Charity Cardiac Private Insurance Medicaid/Medicare Self-Pay Charity Rhinoplasty Private Insurance Medicaid/Medicare Self-Pay Charity

2.

Payer Mix (A)

Program Volume (B)

Volume by Payer (C = A  B)

Net Price (D)

Net Revenue (E = C  D)

30% 50% 10% 10%

120 120 120 120

36 60 12 12

$50,000 40,000 37,500 0

$1,800,000 2,400,000 450,000 0

20% 60% 10% 10%

80 80 80 80

16 48 8 8

40,000 30,000 30,000 0

640,000 1,440,000 240,000 0

10% 20% 60% 10%

40 40 40 40

4 25,000 100,000 8 10,000 80,000 24 18,750 450,000 4 0 0 Total Patient Revenue $7,600,000

Endowment revenue

U.S. Bond AT&T Div Growth Stock

Investment $500,000 250,000 250,000 $1,000,000

Rate 6% 8% 0%

Income $30,000 20,000 0 $50,000

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Chapter 2: Planning for Success: Budgeting

3.

2-22

Gift shop revenue: $120,000 for current year. Will remain the same next year. Assume that gift shop revenue varies with the number of patients in the hospital.

Denison Specialty Hospital Revenue Budget for Next Year Net Patient Revenue $7,600,000 Gift Shop Revenue 120,000 Endowment Income 50,000 Total Budgeted Revenue $7,770,000

Section B 1.

Expense Budget

Consider impact of capital budget $500,000  5-year life: Annual Expense = $100,000 Denison Specialty Hospital Expense Budget for Next Year Salaries Supplies Rent Depreciation Expense Total Budgeted Expense

$6,900,000 540,000 300,000 100,000 $7,840,000

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

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3.

Denison Specialty Hospital Operating Budget For Year Ending Last Day of Next Year Revenues Net Patient Revenue Gift Shop Endowment Total Budgeted Revenue Expenses Salaries Supplies Rent Depreciation Total Budgeted Expense Budgeted Excess of Revenues over Expenses

$7,600,000 120,000 50,000 $7,770,000 $6,900,000 540,000 300,000 100,000 7,840,000 $ (70,000)

INSTRUCTOR’S NOTES Denison Specialty Hospital You may wish to distribute copies of the previous tables as you discuss the case and retain the notes below for your discussion preparation.

The numerical solution to the case appears above. Try to stress the importance and use of the information as much as possible. The hardest part of the process is gathering the data that was given in the case. Assembling that data into the actual budgets is the easier element. The solution is organized as follows:

Part I Section A 1.

Calculation of patient revenue—the payer mix is provided in the case, as is the volume of patients for each program. The volume by payer is calculated by multiplying those two factors.

The net price is the same as the charge for the private insurance. The net price is set by the government for Medicare and Medicaid in this example.

New rules for bad debts require that if anticipated, they are treated as a revenue reduction rather than an expense.

The net price is $0 for charity care. This follows current accounting rules for hospitals.

Multiply volume by net price to get net revenue.

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Chapter 2: Planning for Success: Budgeting

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2.

Endowment income is based directly on information given in the case.

3.

Revenue budget simply sums the different elements. Gift shop revenue is given in the case. We might want to discuss whether they have overlooked other revenue. Is there generally contribution revenue? Do we think we can raise our prices? Do we want to raise our prices? Are we happy with our endowment income? If we expect a deficit, are we willing to take a greater risk? Are we confident that we will get our expected volume and prices?

Section B 1.

Expense Budget: The total salaries, supplies, and rent are all given in the case. The result is a lineitem expense budget. This does not tell us much about the relative cost of different programs or of running different departments.

2.

Combine the revenue and expense budgets into one table to yield the operating budget.

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023

Chapter 3

ADDITIONAL BUDGETING CONCEPRS

Questions for Discussion 3-1. Yes. If taxes are deemed to be unacceptably high, people may circumvent them, even if it means moving to another jurisdiction. Unlimited spending can lead to deficits that could bankrupt the government, or at a minimum create rising interest rates and costs that might be more than can be sustained over time.

3-2. A line-item budget shows the costs of the organization broken down by spending for each traditional line-item of expenditure, such as salaries, supplies, rent, depreciation, and interest. Responsibility center budgets show the amount budgeted to be spent by each responsibility center. A responsibility center is a unit or department that is under the direction of a manager who is responsible for its financial performance. A program budget shows the amount of spending for each of the major programs of the organization.

Typically responsibility and program budgets are further subdivided to show line-item expenses.

3-3. The critical issue is in the type of information generated by each. A line item budget will tell Mary how much was spent on art rental, shipping, and salaries for all programs. Mary has to decide which exhibits to eliminate, so she must know all of the costs for each program, regardless of whether they relate to shipping, rent of art, or insurance. Then she can judge which programs to eliminate. She will not necessarily eliminate the most expensive. The cost of each program will have to be weighed against its benefits.

3-4. A top-down budget is one that is prepared by top management. The budgeted amount is given to responsibility center managers, who are expected to achieve the budgeted result.

However, it is very difficult for top managers to be aware of all of the likely factors affecting spending in each responsibility unit. An alternative approach is bottom-up, in which responsibility unit managers propose budgets for their unit and provide justification for the requested spending.

A bottom-up approach makes better use of the expertise of employees throughout the organization, is more likely to result in employees who want to achieve the budget, and is more likely to be achieved. However, it requires top management willing to accept some degree of decentralization. In very autocratic, centralized organizations where top

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 management desires retention of high levels of control, a top-down budget is more likely to be employed.

3-5. False.

3-6. Zero-based budgeting (ZBB) could be very effective here. Rather than simply adding a certain percent to all departments, or even evaluating incremental requests from all departments, ZBB would result in an analysis of the future needs for each department in light of the changing conditions. Rather than an incremental approach, the city needs a method that can substantially reallocate resources among city departments, either upward or downward for each department.

3-7. This is an open question for discussion. Clearly, for starters the mayor needs to budget for the basics. How will these refugees be provided with food, shelter and clothing? What will that cost, and where will the money come from. Next, how will the mayor put these people to work? The factory closed, but can the mayor attract a new company to open the factory if these refugees will work for significantly lower wages than those who were working in the factory when it closed? If not, what other work opportunities are available?

Also, the mayor has to budget for the impact of these new residents on public services.

How many new school teachers will have to be hired? Will there be demands on public health clinics? Will the city be providing intensive English language classes? Etc. The altruistic idea of taking the refugees is certainly admiriable. The more self-interested hope that these immigrants will revitalize a dying population is also laudable. But to avoid it becoming a disaster, a budget is needed that addresses all of the incremental costs the city will incur, and how it will raise the money to cover those costs.

3-8. The COVID pandemic created far more disruption than simply telling everyone to work from home instead of the office. For many organizations there were huge swings in the volumes of services provided (either up or down) as well as the prices of inputs. A flexible budget, more than anything, focuses the manager’s attention on the fact that revenues and some costs move up and down with volume. Although few organizations may have had a flexible budget sufficient to anticipate the impacts of COVID, flexible budgets provide the mindset, and the direction to the manager, to be able to more quickly adapt to the rapidly changing conditions.

3-9. Program services and supporting services. It is nice for a not-for-profit organization to be able to track the portion of spending that is going directly toward providing services, and therefore accomplishing its mission.

3-10. Mandates are requirements that certain spending take place. For example, the state could mandate that every local government spend at least $500,000 per year to provide public library services. Entitlements are benefits that must be given to any individuals who meet

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 eligibility criteria specified in the law creating the entitlement. For example, Medicare applies to everyone over a certain age who applies. If the number of eligible applicants increases, the government must provide Medicare benefits to those individuals, even if it causes government spending levels to be higher than desired.

3-11. Performance budgeting is an approach designed to improve the budget process by focusing more on what we hope to accomplish than simply on inputs used. The method calls upon the manager and organization to define goals, plan the amount of resources needed to accomplish those goals, and then assess how well the goals have been achieved. The method is particularly useful when it is possible to apparently do the same amount of work with different budgeted amounts of resources (e.g., maintain 10 parks), yet the underlying quality of worked performed does not remain constant.

The first step is to clearly define objectives, referred to as performance areas. Next, one must identify the operating budget. Then the percent of operating budget resources that will be devoted to each objective must be determined. The operating budget resources can then be allocated to the performance areas. Measures of performance for each objective or performance area must be established. Then a performance budget can be developed.

3-12. False.

3-13. This is a technique that argues that all costs in the budget must be justified each year, not just budget increases from year to year. The method also focuses on the evaluation of alternatives and their costs and benefits.

3-14. C. 3-15. A flexible budget is an operating budget for varying workload levels. It gives managers an understanding of what is likely to happen to revenues, expenses, and profits (surpluses or deficits) if the volume of services provided varies from the expected level.

3-16. No. There may be trend or seasonality. If so, the average will obfuscate such variability.

3-17. The closer a forecast line is to historical data points, the closer it is likely to be to future results. By fitting historical data to a curved line rather than a straight line, they are likely to be closer to that line. Projecting that curved line into the future is therefore likely to produce a more accurate prediction of the actual future results.

3-18. False. Computers fail to take into account what people know. Managers may have information about why the future is unlikely to be a reflection of the past. Such managerial information should be used to modify computer-generated predictions.

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 3-19. There are two common techniques designed specifically to help improve the accuracy of estimates when no specific historical information is available. These are the Delphi and nominal group techniques. In both approaches, a team or panel must be selected that consists of individuals who are likely to have reasoned insights with respect to the item being forecast. The nominal group technique is one in which the individuals are brought together in a structured meeting. Each member writes down a forecast. Then all of the written forecasts are presented to the group by a group leader without discussion. Once all the forecasts have been revealed, the reasoning behind each one is discussed. After the discussions, each member again makes a forecast in writing. Through a repetitive process, a group decision is eventually made. In the Delphi approach, the group never meets. All forecasts are presented in writing to a group leader, who provides summaries to all group members. After several rounds a decision is made based on the collective responses. The weakness of the Delphi method is that it takes more time and is more cumbersome than the nominal group method. Nevertheless, Delphi decisions are based more on logic than on personality or position.

3-20. These statements separate activities into their major functions of providing services, administration, and fundraising.

Problems The exhibits below are embedded Excel objects. Double-clicking on them will open an Excel spreadsheet.

3-21

1. a. Zero-based 2. f. Flexible

3-22. Salaries, benefits, supplies, rent, interest, etc.

3-23.

1.

f. Flexible

2.

e. Capital budgets

3.

a. Zero-based

4.

d. Accrual

3-24. Performance budgets focus on outcomes or results, what they were trying to achieve, goals and objectives, mission or other similar answers rather than solely on outputs.

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 3-25.

3-26

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023

3-27. (Flexible Budget) The Zoo expects the following number of visitors per month:

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023

3-28. (Flexible Budget)

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023

3-29. (Performance Budget)

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 3-30 (Line-Item Budget) Also See Excel File for More Details.

PART A.

PART B. (Responsibility Budget) Also see Excel file for more details.

PART C. (Responsibility Budget Showing Line Items) See also Excel file.

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023

3-31 (Functional Budget) See also Excel file.

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023

3-32. (Line-Item, Responsibility, and Functional Budget Using Chart-of-Account Numbers) See also Excel solution.

PART A.

Solutions Manual Financial Management for Public Health, and Not-for-Profit Organizations 7th Edition by Steven, Calabrese, Smith

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 PART B.

12

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 PART C.

13

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 PART D.

OR

14

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023

3-33.

15

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023

16

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 Given the lack of any trend, the forecast is based on a simple moving average for each quarter.

QT

Visits

1

20,000

2

23,000

3

27,000

4

20,000

5

21,000

6

25,000

7

29,000

8

20,000

9

19,000

10

24,000

11

26,000

12

21,000

13

20,000

14

24,000

15

27,333

16

20,333

17

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 Forecast - Patient Visits 35,000 30,000

Visits

25,000 20,000

Visits Forecast

15,000 10,000 5,000 1

2

3

4

5

6

7

8

9 10 11 12 13 14 15 16 17

Quarter

3-34.

18

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023

19

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 3-35.

EXTENDED PROBLEM: Denison Specialty Hospital

SOLUTION

Part II Section C 1.

Departmental Expense Budget

20

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023

2.

Expense Budget by Program Radiology 80% 15% 5%

Oncology Cardiac Rhinoplasty

Denison Specialty Hospital Expense Budget for Next Year $

Oncology* Cardiac Rhinoplasty General—Rent Total

$

Nursing 50% 40% 10%

4,528,000 2,360,000 652,000 300,000 7,840,000

* Note: Cost of new oncology equipment is charged to oncology program.

21

Admin.

50% 35% 15%

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023

Section D 1.

Flexible Budget

22

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023

Section E 1.

a.

Patient Revenue by Quarter

\

23

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 1b. Patient Revenues by Quarter for Current Year and Next Year Revenue this Year (Current Year) Jan.–Mar. Apr.–Jun. July–Sept. Oct.–Dec. 30% 25% 20% 25% Onc. Private Card. Priv.

Rhino. Priv.

$

Subtotal

$

Oncology M/M Cardiac M/M Rhino. M/M

$

Oncology Self Cardiac Self Rhino. Self

540,000 $ 450,000 $ 360,000 $ 192,000 160,000 128,000 30,000 25,000 20,000 762,000 $ 635,000 $ 508,000 $

450,000 160,000 25,000 635,000

720,000 $ 600,000 $ 480,000 $ 600,000 $ 720,000 $ 600,000 $ 480,000 $ 432,000 360,000 288,000 360,000 432,000 360,000 288,000 24,000 20,000 16,000 20,000 24,000 20,000 16,000 $ 1,176,000 $ 980,000 $ 784,000 $ 980,000 $ 1,176,000 $ 980,000 $ 784,000 $

600,000 360,000 20,000 980,000

$

112,500 60,000 112,500 285,000

$ Onc. Charity Car. Charity RhinoCharity

c.

Revenue Next Year (Budget Year) Jan.–Mar. Apr.–Jun. July–Sept.

Oct.–Dec. 30% 25% 20% 25%

540,000 $ 450,000 $ 360,000 $ 450,000 $ 192,000 160,000 128,000 160,000 30,000 25,000 20,000 25,000 762,000 $ 635,000 $ 508,000 $ 635,000 $

135,000 $ 112,500 $ 90,000 $ 112,500 $ 72,000 60,000 48,000 60,000 135,000 112,500 90,000 112,500 342,000 $ 285,000 $ 228,000 $ 285,000 $ 0 0 0 $

0 0 0 $

0 0 0 $

0 0 0 $

135,000 $ 112,500 $ 90,000 $ 72,000 60,000 48,000 135,000 112,500 90,000 342,000 $ 285,000 $ 228,000 $ 0 0 0 $

0 0 0 $

0 0 0 $

Patient Collections by Quarter

Private Ins.—1 Quarter lag Med/Med—Half 1 quarter lag, half 2 quarter lag Self-Pay—1/3 collected each of three following quarters Charity—no collections

Jan.–Mar. Apr.–Jun. July–Sept. Oct.–Dec. $ 635,000 $ 762,000 $ 635,000 $ 508,000 882,000 1,078,000 1,078,000 882,000 266,000 285,000 304,000 285,000 0 0 0 0

Net Patient Collections by Quarter

$ 1,783,000

24

$2,125,000

$ 2,017,000 $ 1,675,000

0 0 0 $0

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 d.

Cash Budget

Beginning Cash Bal. Plus Cash Receipts Patient Revenue Private Insurance Medicare and Medicaid Self-Pay Gift Shop Endowment Cash Available

2.

Jan.–Mar. Apr.–Jun. July–Sept. Oct.–Dec. $ 50,000 $ 50,000 $ 50,000 $ 50,000

635,000 762,000 882,000 1,078,000 266,000 285,000 30,000 30,000 0 0 $ 1,863,000 $ 2,205,000

635,000 508,000 1,078,000 882,000 304,000 285,000 30,000 30,000 50,000 0 $ 2,147,000 $ 1,755,000

Less Cash Disbursements Salaries Supplies Capital Acquisitions Rent Interest Total Disbursements

$ 1,725,000 $ 1,725,000 128,000 150,000 500,000 75,000 75,000 18,450 $ 2,428,000 $ 1,968,450

$ 1,725,000 $ 1,725,000 124,000 138,000

Subtotal Borrow/(Repay) Loan Ending Cash Balance

$ (565,000) $ 236,550 615,000 (186,550) $ 50,000 $ 50,000

$

210,146 $ (191,049) (160,146) 241,049 $ 50,000 $ 50,000

Note Payable Balance

$

$

615,000 $

428,450

75,000 75,000 12,854 8,049 $ 1,936,854 $ 1,946,049

268,304 $

509,353

Revised Operating Budget. We must now revise the operating budget to account for interest expense on the loan.

25

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 Denison Specialty Hospital Operating Budget For Year Ending Last Day of Next Year Revenues Net Patient Revenue Gift Shop Revenue Endowment Income Total Budgeted Revenue

$7,600,000 120,000 50,000 $ 7,770,000

Expenses Salaries Supplies Rent Depreciation Expense Interest Expense Total Budgeted Expense

$

6,900,000 540,000 300,000 100,000 39,353 $ 7,879,353

Budgeted Excess of Revenues over Expenses

$

(109,353)

Note that we now project a loss of $109,353. We also budgeted $500,000 in cash to buy the new equipment. Why did we only need a note payable of $509,353 instead of $609,353?

What can we do if the Trustees will not accept a deficit budget?

26

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023

INSTRUCTOR’S NOTES Denison Specialty Hospital (Continued) You may wish to distribute copies of the previous tables as you discuss the case and retain the notes below for your discussion prep. (Solution to Part I is in Chapter 2 solutions.)

Part II Section C 1.

Departmental expense budget: The detailed information needed is provided directly in the case, except for bad debts calculated earlier.

The interesting, and potentially difficult, question coming out of this analysis is the possible allocation of rent and depreciation to departments. Rent and depreciation are interesting. Are there separable pieces of equipment for different departments? We don’t know, but it might be appropriate to allocate at least direct equipment.

2.

Expense budget by program: The case tells how much of each department’s services are consumed by each program. We need only multiply the appropriate percent times the expense budget by department. For example, the oncology budget is 80% of the radiology budget, plus 50% of the nursing budget, plus 50% of the administration budget.

The allocation issue is even more pointed here. We are considering buying $500,000 of oncology equipment. The depreciation expense on that equipment is all allocated to that program, in addition to the oncology share of each of the departments as discussed in the previous paragraph. One could also argue for keeping it as general overhead.

Note that the total expenses are the same no matter how you slice them. That is, lineitem, department, and program are all ways to look at the same expenses. However, they give a manager very different information. Depending on the decisions to be made, one may be much more appropriate than another. For example, how much would we save if we cut all salaries 5%? The line-item is most useful. Nursing is 25% of the budget of most hospitals. How about programs? We average $40,000 of revenue (before bad debts) from each oncology patient. How does that compare to the budgeted cost per oncology patient?

27

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 Section D 1.

Flexible Budget.

The key here is identification of fixed and variable items. Patient revenue varies with volume. Gift shop revenue also varies. Ask the students why they think this is true.

Endowment income does not vary with patient volume.

Salaries have been broken into fixed and variable. In the case, it is noted that all managers and administration staff are fixed. Other staff are variable. The case breaks salaries down by manager and staff.

Supplies are variable. Although the case doesn’t say so, it is a reasonable assumption, at least for the bulk of items used by radiology and nursing.

This budget does not include interest expense from the cash budget. Interest is dependent on available cash. If the budget is flexed up and down for volume of patients, that will change the cash flows. Thus, the interest will change. However, the arithmetic is complicated unless the problem has been solved using a spreadsheet program. A future edition of the book may provide the solution using a spreadsheet template and will include an update of the flex budget for interest expense changes.

Section E 1.

Cash Budget.

Note that this should really be done on a monthly basis; it was only done quarterly to make the case simpler. In real life, different organizations use different time periods-banks, for example, budget cash daily, because they need more cash some days of the week than other days.

Hospitals develop a monthly cash budget. Some not-for-profits might only do quarterly budgeting, as in this case. a.

Revenue and Collections by Quarter: Patient revenue is the primary cash receipt. The patient flow is not constant throughout the year, so revenue is not constant. The first step is to determine revenue by quarter. The percentage for each quarter is given in the case. The calculation groups the patients by payer, because different payers have different payment histories.

b.

Revenues for quarters in the prior year are the same as this year.

c.

Once we have determined the total revenue by payer by quarter, we can determine the quarterly cash flow.

Private insurance pays with a one-quarter lag. Therefore, in the first quarter of this year we will collect revenue from patients for the last quarter of last year. We were

28

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 told that patient volume and prices haven’t changed, so we can simply look to the last quarter of this year to determine what was owed the last quarter of last year.

Medicare and Medicaid similarly are calculated in each quarter by taking half of the revenue from one quarter earlier and half of the revenue from two quarters earlier.

Self-pay receipts for each quarter are 25% of the revenue from each of the preceding three quarters. Only 75% of self-pay charges are ever collected.

No charity care results in receipts. d.

2.

Cash Budget The case says to start each quarter with at least $50,000.

Cash receipts from patient revenue comes from the previous calculation. It will be important to stress the difference between the revenue for a given quarter and the cash receipts generated by patient revenue.

It was assumed that the gift shop revenue is spread evenly throughout the year.

One could make a good argument for varying this revenue with the flow of patients, but without any lag.

We are told in the case that endowment income is received at the start of the third quarter.

Salaries are paid monthly, so they have been spread evenly. Again, this is a simplification. Because there are busy and slow periods for patients, there might be some variation in salary. It is worth prodding the students on this point.

Supplies were given in the case. Be sure to account for the one-quarter lag in payment. The capital equipment is paid for as soon as purchased, at the start of the year.

Avoid discussing interest just yet. It is better to explain a cash budget by going down the first column, rather than across.

Because cash available is $565,000 less than cash needed in the first quarter, and because we desire to start the next quarter with a $50,000 balance, we will need to borrow $615,000.

The second quarter is similar, except there is now 12%  1/4 year  $615,000 = $18,450 of interest. Note that we can’t prepare a cash budget without revenue and expense information. However, now we must go back and fix the budgeted income statement because we have interest expense.

Revised Operating Budget The revised operating budget takes interest into account. Note that the organization ends the year with a loan of only $509,353, even though it has purchased equipment for $500,000 and incurred a loss of $109,353 for the year. This is because it has a noncash expense of $100,000 for equipment depreciation expense.

It should be pointed out that if we eliminate the equipment purchase to reduce the deficit, the operating budget, cash budget, and flexible budgets will all change. Budgets are interrelated. A change in one budget has ripple effects through all the budgets.

3.

As far as the loss goes, we can cut salaries, reduce staff levels, not buy new equipment, raise prices, and market more aggressively for more volume. A key point is that a budget is 29

Finkler, Financial Management for Public, Health, and Not-for-Profit Organizations 7e © CQ Press, 2023 rarely accepted as developed. Modifications and revision are often needed and usually require negotiation and compromise.

30

4-1

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Chapter 4 UNDERSTANDING COSTS QUESTIONS FOR DISCUSSION 4-1.

It is quite important for the County to first consider what types of costs of the County are fixed and would not change as a result of this effort. Those costs should not be included. The only costs that should be considered as costs of the vaccine program would be those that are incremental. That is, costs that would not have been incurred if the effort had not been made. For example, if the county paid rent on the vacant K-Mart stores to use as vaccination and testing sites, that would be a cost to include. If the county used existing stocks of tables and chairs and wall cubicle walls to set up the facilities, those costs are not included. If the county had to buy or rent tables, chairs, and wall cubicles those costs would be considered. If the staff were volunteers that does not create a cost. If the county hired medical and clerical staff specifically to run the vaccine sites, those costs would be included. A careful detailed operational plan would be needed, right down to "I've been vaccinated" stickers, and pens and paper, and all incremental costs would have to be estimated and included.

4-2. Anything in particular for which a measurement of cost is desired. This could be a unit of service, a program, department, or organization. For example, one might be interested in the cost of plowing snow from the roads of the Town of Millbridge. The most basic point in costing is to clearly define and communicate the cost objective. Communication is critical, and data only become useful information if they are communicated in a way that everyone understands.

4-3.

Full cost refers to the total of all costs associated with a cost objective. This includes direct and indirect costs. Direct costs are the costs incurred within the organizational unit for which the manager has responsibility, or the costs of resources for direct production of a good or service. Indirect costs are costs that are assigned to an organizational unit from elsewhere in the organization, or costs of resources that are not used for direct production of a good or service. Direct and indirect costs are particularly difficult to understand because their definitions relate to the object of the analysis. If one is interested in the direct cost of the public works department, it is appropriate to include department supervisory personnel in that cost. In contrast, if one is interested in the direct cost per mile of road plowed, that would include the plow, the driver, and the cost of the salt spread on the road, but not the cost of supervisory personnel. In that example, the supervisors are direct costs of the public works department (i.e., what it costs to operate the public works department) but indirect costs of plowing the road (i.e., what it costs to plow the roads). The various scheduling and other administrative activities carried out by supervisory personnel are essential to running the department, but they are not a direct cost of plowing snow.

4-2

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

4-4.

Average cost is the full cost of any cost objective divided by the number of units of service provided. Fixed costs: those costs that do not change in total as the volume of service units changes over a relevant range of activity. Variable costs: those costs that vary directly with changes in the volume of service units over a relevant range of activity. If all of the costs of plowing snow, both direct and indirect, are added and the total is divided by the number of units, the result is the cost per unit or the average cost. So, the total cost could be divided by the number of miles to find the cost per mile plowed. Once Meals for the Homeless (Meals) rents space for a soup kitchen, the rent will not change from day to day, even if the number of meals provided varies by a substantial amount. Perhaps Meals is serving 300 people a day at a given soup kitchen. If Meals were to feed another person, the rent would stay the same. Therefore, it is a fixed cost. In contrast, the amount of food that Meals must purchase represents a variable cost. If more people are served, meals will need more food. Activity represents the volume of services provided.

4-5.

Marginal costs are the extra costs incurred as a result of providing one more service unit (such as one more meal). At first, marginal costs would appear to be identical to variable costs. In both cases, if there is one more unit of activity, there will be an increase only in variable costs. Marginal costs, however, more broadly look at all costs that might change as a result of a decision. Suppose that HOS has an x-ray machine that can take 5,000 x-rays per year. What is the cost of doing one more x-ray? If HOS has to buy another machine to do the 5,001st x-ray, then on the margin, the costs of the additional patient are the variable cost of one more patient plus the cost of acquiring another machine.

4-6.

Cost per unit depends on volume. If volume is low, the cost per unit is higher than if volume is high. This is because as volume rises, fixed costs get shared resulting in less fixed cost per unit. Furthermore, for historical purposes measuring the average cost may be adequate. For prospective decision making, we are often interested in the marginal costs. Therefore the appropriate measure of cost depends in part on the reason we want to know the cost.

4-7. Suppose the activity is the cost of educating students. One could argue that the teacher and supplies used in the classroom are direct costs and that the principal and secretaries in the school office and the superintendent at the central office are indirect costs. Alternatively, if the activity is the cost of running each of the school district’s elementary schools, then the direct costs would include the principal, secretary, and heat, in addition to the teacher and classroom supplies.

However, it would not include the district superintendent, who would be an indirect, or overhead, cost. The superintendent only becomes a direct cost when the activity is the cost of running the school district.

4-8. For changes in activity volume within the relevant range, marginal costs are the same as variable costs. If a proposed change is beyond the relevant range of some fixed cost, then the marginal costs will include the change in fixed cost as well as the variable costs.

4-9. In order to assign costs from one objective to another, a base is needed. For example, we could choose to allocate costs based on patient days. In that case, the

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

4-3

number of patient days would be the base. Alternatively, costs could be allocated based on hours. It is common to allocate housekeeping costs based on hours of service provided. The total number of hours of housekeeping service becomes the base. If this base is divided into the total cost for providing housekeeping services, the result is an overhead application rate, in this case, a cost per hour of service.

4-10. Activity-based costing (ABC) considers that volume is not the only generator of cost. Often activities with low volume may generate significant amounts of cost.

If indirect costs are allocated based on volume, they will be over-assigned to some units of service and under-assigned to others. A more accurate approach would be to allocate indirect costs based on the activities that drive them.

INSTRUCTOR’S NOTE Activity Based Costing One could contend that if you perform cost measurement correctly to begin with, there is no need for ABC. The problem is that a model T Ford was mostly direct cost and very little overhead, but a modern Ford is mostly overhead and very little direct cost. Why? Because we got sloppy and started allocating direct costs as if they were indirect because it is easier to allocate on broad bases rather than to actually try to track the costs. So, ABC is sold as an approach to allocate indirect costs more accurately. But that is a contradiction. There is no accurate way to allocate costs that are really indirect. ABC is really a movement toward treating more of our direct costs as being direct. If there is a cause-and-effect relationship, it can be hidden by broad allocation approaches. Cost accounting has long taught that it was necessary to focus on direct costs and to use multiple cost bases when you do have to allocate costs in order to incorporate as much of the cause and effect as possible. On the other hand, ABC does serve a role because organizations have become so confused by their cost allocations that they often don’t know which of their costs are truly direct costs nor to which specific cost objective they relate.

4-11.

The decision of whether to “make or buy” is one that is best addressed using an approach called marginal cost analysis. This approach is sometimes referred to as incremental analysis or out-of-pocket analysis. The essence of the approach is that decisions such as whether to provide a service or to change the volume of a service should be based on marginal rather than average costs.

4-12.

If a particular program, service, or activity is expected to have a volume of activity that is too low to break even, the activity may not be feasible. However, sometimes changes in the activity can be made to achieve a break-even status.

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

One approach is to lower the volume needed to break even. There are three ways to reduce the required break-even level. One can lower the fixed costs by getting by with less expensive or fewer fixed resources. That may or may not be possible, depending on the specific circumstances. A second way to lower the break-even point is to increase prices. Price increases would increase the contribution margin per unit. That would have the effect of lowering the break-even point. However, based on the principles of supply and demand, price increases might reduce the expected volume for many activities or services. In that case, the price increases may be defeating their purpose. Also, prices are sometimes regulated and beyond the control of the organization. Finally, one could try to reduce the variable cost per unit. This might be accomplished by increased efforts toward improved efficiency.

If it is not feasible to change the fixed costs, price, or variable costs, an organization can try to increase the number of units of activity through marketing activities, focused on services or customers that have a particularly high contribution margin.

MULTIPLE CHOICE AND FILL IN THE BLANK QUESTIONS 4-13. d. Who is measuring the cost e. Whether the person asking the question is inside or outside the organization 4-14.

b. the number of children that will be added to the program d. the impact of adding the children to the existing facility

4-15.

b. there is a change in fixed costs

4-16. 1. Full Cost.

2. Average Cost.

3. Marginal Cost 4-17.

1. b. Indirect cost 2. a. Direct cost

4-18. 1. d. Unit variable cost remains constant and unit fixed cost decrease 2. d. Relevant range 4-19. c. total revenues = total costs 4-20. 1. total revenue equals total expense _ 2. price or variable revenue minus variable cost 3. b. decreases

.

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

4-5

4. price per unit or marginal revenue and variable cost per unit or marginal cost.

5. a. increase 6. reduce the contribution margin per unit of service.

7. contribution margin or marginal contribution 8. a. a loss or deficit 4-21. 1. a. the cost objective 2. b. indirect and fixed 4-22. 1. weighted average; 2. either profit or break even 3. b. decreases 4-23. 1. a. Direct

Country staff, clinic staff and supplies

b. Indirect DWB’s central staff c. Fixed all staff expenses d. Variable supplies 4-24. 1. a. Direct faculty researcher, research assistants, laboratory costs and supplies b. Indirect administrative staff, building expenses, research director c. Fixed building and laboratory expenses, administrative expenses, faculty researcher and research assistants d. Variable supplies 2. cost objective 4-25. a. increases

PROBLEMS The exhibits below are embedded Excel objects. Double-clicking on them will open an Excel spreadsheet.

4-26. (Break-Even)

4-6

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Break-even Quantity =

Fc

=

$15,300 $2,675 − $2,425

P − VC 15,300 = = 61.2 250 15,300 − 10,000 Break-even with Subsidy = 250 5,300 = = 21.2 250

Note: the break-even calculations can also be found on the spreadsheet by scrolling down below the excerpt shown.

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Is the hotel cost variable per teen, or per group of four teens? Will the cost go up $160 per night for the first extra teen over 4, and then be fixed for the next three? If so, the breakeven will be higher.

What about the fact that the budget is for 50 teens? That is not divisible by 4.

Is there an extra room cost that hasn’t been accounted for? It is unclear. Is the hotel cost really $160 per room per night, or has the travel agent given a total room cost that works out on average to $160 per room per night?

If there are only 20 teens, how many chaperones will be needed? We can reduce the break-even point by going to two chaperones.

It is important to note that in many cases, budgets are approximations. For example, while the airfare may be known with certainty, the food cost is likely to be approximate, depending on the specific restaurants that are actually used.

4-27. a. Fixed: depreciation, doctor, nurse, cooks and camp director b. Step-Fixed or Semi-Variable costs: counselors c. Variable: food and transportation d. Not included in the camp’s cash budget: depreciation 4-28.

1. BEQ = FC/(VR – VC) = ($5,000 per week/5 days per week)/((15-5)) = 1000/10 = 100 per day 2. b. decreases

4-29. 1. $800,000-$400,000 = $400,000 2. 400,000 x 1.10 = 440,000 Total costs = 400,000 + 440,000 = $840,000 4-30.

4-31.

Weighted Average Price .30 * $100 = 30

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

.70*.80*$100

= 56 $86

FC = $210,000 VC = $65 per exam P = $86 per exam BEQ = $210,000 / (86 – 65) = 10,000 exams 4-32. 1.

2.

3.

BEQ = FC / (P – VC) = 10000/(275 – 75) = 50 people $300 - $75 = $225 TR – TE = Profit Q*P – (FC + VC * Q) = Profit Q*P = Profit + (FC + VC * Q) P = (Profit + (FC + VC * Q))/Q P = (100,000 + 10,000 + 500 * 75)/500 = 147,500/500 = $295 per ticket

4-33.

.

4-34.

(Break-Even Analysis)

Note: The actual calculation yields the result 39,473.68. However, in this case, we should round up. If we sold only 39,473 tickets, the Symphony would lose money because it would be below its breakeven point. Even if the value had been 39,473.15, we would have to round up to avoid a loss.

Discussion: What if price falls, variable costs rise, etc.? What if we expect demand for only 35,000 tickets?

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

4-9

4-35. Relevant Costs = $120,000 - $25,000 = $95,000 4-36. 1. variable salary expenses of $570,000 ($650,000 - $80,000) variable benefit expenses of $570,000*30% = $171,000 printing costs of $150,000 These costs will change (will be eliminated) if Hudson accepts the contract. All of the other costs are fixed or sunk.

2. YES the cost of the contract is $750,000 and the savings are $570,000 + $171,000 + $150,000 = $891,000 4-37.

1.

Breakeven Number of People = Total Fixed Expenses/Unit Contribution Margin = ($5,000 + $1,000) / ($150 - $50) = 60 people

2.

Average cost = Total cost / volume TC= 6,000 + (50*100) = 11,000 AC= 11,000 / 100 = $110 per person

1.

Fixed costs = $180 VC= 5 Q=12 Q = FC/(P – VC) 12=180/(P-5) 12(P-5)=180 12P-60=180 12P=240 P=$20

2.

Fixed costs = $180+300 = $480 treat profit as a fixed cost VC= 5 Q=12 Q = FC/(P – VC) 12=480/(P-5) 12(P-5)=480 12P-60=480 12P=540 P=$45

4-38.

4-39. Q = FC/P-VC Q = 30 days P = 2,000*$10 = $20,000 per day

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

VC = $1,000 per day 30 = FC/(20,000-1,000) 30 x 19,000 = FC FC = $570,000 4-40. 1. BEQ = FC/(VR – VC) = ($18,000)/((300-30)) = 18,000/270 = 67 2. a. increases 4-41. 1. BEQ = (FC-City revenue)/(Weighted VR – Weighted VC) or BEQ = (FC-City revenue)/(Weighted CM)

2. a. increases 4-42. 1. BEQ = (FC-grant)/(total VR – total VC)

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

2. increases

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

4-43. 1. New visit contribution margin: $50 - $40 = $10 * 20% = $ 2 Follow up visit contribution margin: $50 - $30 = $20 * 80% = $16 Weighted average contribution margin: = $18 Breakeven volume = Total Fixed Cost/Weighted Average Contribution Margin = ($12,000 + $6,000)/$18 = 1,000 visits 2. Total Contribution Margin = $18/visit*12 visits/day*21 days/physician*5 physicians = $22,680 Profit = Total Contribution Margin – Monthly Fixed Cost = $22,680 – 18,000 = $4,680

4-44. 1. Fixed Cost = $750 + 600 + 400 = $1,750; Unit Variable Cost = $20; BEQ = 250 students 250 = 1,750/ (p – 20) p = $27 2. Contribution margin on student tickets = $25 – $20 = $5 Contribution margin on student tickets = $75 – $20 = $55 Weighted average contribution margin = $5 * 75% + $55 * 25% = $17.50 BEQ = $1,750 / $17.50 = 100: 75 students and 25 alumni

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

4-45.

Note: By double clicking on the spreadsheet excerpt and scrolling up, you can see all of the inputs to the model.

4-46. a. Fixed: Rent, Nurse and Secretary or staff b. Step-Fixed or Semi-Variable costs: Doctors c. Variable: exam supplies and vaccines 4-47. (Marginal Cost Analysis)

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

4-14

Cost

$3,500

Series1 $1,000 $500 $0 0

500

1000

1500

2000

2500

3000

3500

Volume

c. Accept the contract. Marginal revenues are greater than marginal costs Average cost at 2,500 patients = $370 per patient Average cost at 3,000 patients = $350 per patient Revenue = $300 per patient Marginal cost = $250 per patient Total revenue rises by $150,000 = 500 * $300 Total cost rises from $925,000 to $1,050,000 or $125,000 Profit rises by $150,000 - $125,000 = $25,000

4-48. (Break-Even Analysis—Multiple Products)

or

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

FC FC BEQ = = = P - VC/Unit CM

$250,000 = $53.00 - $3.00

40% x 5,000 = 2,000 pool passes.

4-49. (Break-Even Analysis—Step-Fixed Costs)

$250,000 = 5,000 total passes $50

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

We can do more than 2,000 but less than 3,000. What costs rise when we go above 2,000? Staff and food. If we start to back away from 3,000, what costs go down on the margin? Only the food. They go down at a rate of $40 per arrest.

If we lose $18,000 at 3,000, then we could break even at 2,550. Divide the loss by the variable cost. Reduce volume by the result to arrive at a break-even point.

18,000  40 = 450 3,000 − 450 = 2,550 Budgeted Volume of Arrests: 2550 Revenue $1,400,000 Payroll Police Desk Supervisor Food Total Expense

$100,000 648,000 413,000 137,000 $102,000 $1,400,000

Surplus

$0

4-50. (Flexible Budgets and Break-Even Analysis) FC $70,000 Q = ---------- = ----------------- = 36,459 riders P – VC $2.00 - $.08 The New City Subway makes money if it has more than 36,459 riders.

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Here we see that the subway makes money at all volumes shown. How can that be, given the 36,459 in the break-even calculation? Note that in the flexible budget we did not just change volume. The price also changed. The increase in the price lowers the break-even point.

Intuitively we would expect higher profits for 50,000 riders per day than for 30,000, yet the flex budget shows that the profits are lower at the higher rider volume. This is because the higher volume was accompanied by a lower price. That lower price raised the break-even point. In fact, it turns out that the current $2 price results in a higher profit than would occur if the price were to rise or fall!

Breakeven analysis often makes the somewhat unrealistic assumption that price is constant over a range of volumes. We can see that if volume changes are accompanied by price changes, higher volume does not necessarily increase profits.

4-51. (Relevant Costs)

Keep the location open. There will be savings of only $35,000 and they will lose a $40,000 grant, so they will be $5,000 worse off.

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

4-18

What qualitative issues of relevant here? If it made financial sense to close the location we would still have to consider the impact on the mission of the organization.

4-52. (Allocation Base and Overhead Rates) One base is the number of tax bills. The rate would be $32,000/8,000 = $4 per bill. A second possible base would be tax collector department clerical hours consumed in processing bills. The rate would be $32,000/1,000 = $32 per hour.

4-53. (Cost Allocation and Overhead Rates) a.

Calculation of overhead rate on direct-labor-hour basis: Cost

Overhead rate =

=

$810,000 90,000 hours

Direct labor hours = $9 per hour Overhead applied to Mr. Robbins = Direct labor hours  rate = 20 hours  $9 per hour = $180 b.

Calculation of overhead rate on direct-labor-dollar basis: Cost Overhead rate =

$810,000 =

Direct labor dollars

$1,350,000 = $.60 per direct labor dollar

Overhead applied to Mr. Robbins = Direct labor dollars  rate = 380 direct labor dollars  .60 = $228 The results differed under the two different bases. The probable reason for this difference is that some patients consume labor hours from more highly skilled, highly paid workers.

A direct-labor-hour basis system will assign a patient just as much overhead for having consumed an hour of licensed practical nurse (L.P.N.) labor as it will for having consumed an hour of registered nurse (R.N.) labor.

A system that assigns overhead on the basis of direct labor cost will assign more overhead for the consumption of an hour of a more highly paid worker’s time.

Which basis is preferable? That depends on whether the overhead items in question are more closely related to the amount of labor an individual patient consumes or to the type of labor consumed.

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

4-54. (Cost Allocation—Direct Distribution) Direct distribution.

4-55. (Cost Allocation—Step-Down) Step-down distribution

4-56. (Cost Allocation—Step-Down) allocation.

Step-down distribution—changed order of

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

It is clear that the order of step-down does matter!

4-57. (Activity Based Costing) The first step would be to determine the total costs of the maintenance department. These consist of the $100,000 spent on supplies, the $15,000 spent on administration, and the labor cost of $192,000 (i.e., 10,000 hours @ $12 plus 4,000 hours @ $18, or 14,000 hours @ $13.71 per hour). This is a total cost of $307,000. The traditional application rate would be as follows: $307,000 = $3.07 square foot 100,000 square feet That rate would cover both routine maintenance and repairs. Because the pharmacy has 2,000 square feet, it would be assigned a cost of $6,140.

Alternatively, because the pharmacy is 2% of the total square feet (2,000/100,000  100%), we could simply multiply the total maintenance department cost of $307,000 by 2% to get the $6,140 in the traditional step-down approach.

What allocation would an ABC approach yield? First, we must make some choices about allocation bases. Given that administration is supervising personnel, we can allocate the administrative cost based on direct labor hours.

What about the labor cost? First consider labor for repairs. The cost could be allocated based on square feet, or on the number of repairs, or on the length of the repair. The cost for labor is driven by the number of hours the workers work. It is not the volume of repairs, but rather how long they take that is critical to an accurate allocation. Therefore, repair labor should be allocated based on direct labor hours.

It could be argued that routine labor should also be allocated in that fashion.

However, is it worthwhile to gather that information? In the example, hours spent on routine maintenance in the pharmacy department were not supplied. Therefore, routine labor must be allocated based on square feet. However, consider whether

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

the extra accuracy would justify the collection of additional data on where workers spend their time.

Similarly, supplies used for routine maintenance will have to be allocated based on square feet. Supplies for repairs could be allocated based on the number of repairs, how long they take, or the specific supplies used. In actuality, it is likely that major supplies (repair parts) could be assigned specifically to each repair based on actual costs. Other supplies (nuts, nails, etc.) would probably be assigned based on direct labor hours, assuming that workers use supplies fairly evenly over the time they work. In this case, we have been given actual costs for supplies used.

The actual allocation becomes somewhat tricky, because routine maintenance is being allocated using different cost drivers from repairs. First, consider administration. The total cost is $15,000. There were 14,000 labor hours, so the rate would be $1.071 per hour. The pharmacy had 6 hours of repairs and would be charged $6.43. Repairs in other departments took 3,994 hours and would be charged $4,279.29.

However, what about the remaining $10,714.28 of administrative cost? The administration related to routine work cannot be charged based on hours because we do not know the hours for each department, as discussed above. The pharmacy is 2% of the square feet, so it will be allocated 2% of this remaining administrative cost, or $214.29, with the balance of $10,499.99 being charged to other departments.

The pharmacy department consumed repairs that required 6 hours of labor at $18 per hour, or a total of $108. The other departments consumed 3,994 hours at $18 per hour, or $71,892. The remaining 10,000 hours at $12 per hour, or $120,000, are allocated based on square feet; 2% of $120,000 is $2,400, and 98% of $120,000 is $117,600.

The supplies used for repairs can be allocated directly, as given in the solution below; $200 for pharmacy and $79,800 for other departments, based on actual costs incurred and assigned to repair projects directly. The remaining $20,000 of routine supplies would be allocated based on square feet; 2% of $20,000 is $400, and the remaining 98% is $19,600.

In sum, the total pharmacy costs under the ABC approach are as follows:

This total of $3,328 is only a little more than half the original allocation of $6,140.

Clearly, the more accurate costing approach does have a significant impact in this instance.

The solution table is as follows:

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Chapter 5

CAPITAL BUDGETING

QUESTIONS FOR DISCUSSION 5-1. No. Operating budgets charge the entire cost of acquisitions into the current year. Because benefits of an acquisition may extend well beyond the current year, we may incorrectly believe that an acquisition is not worthwhile if the capital budget is made part of the operating budget. A capital budget is needed because it considers costs and benefits of an acquisition over its entire useful lifetime.

5-2. Yes. Approved items from the capital budget are depreciated over their useful lifetimes. The annual depreciation expense becomes a cost included in the operating budget.

5-3. False. In theory, a capital asset is any resource that will provide benefits to the organization in more than one fiscal year. To simplify bookkeeping, however, most organizations only consider items that are expensive and have a lifetime of more than one year to be capital assets.

5-4. Some reasons that capital assets warrant special attention are that (1) the initial cost is large, (2) the items are generally kept a long time, (3) we can only understand the financial impact if we evaluate the entire lifetime of the assets, and (4) because we often pay for the asset early and receive payments as we use it later, the time value of money (or interest cost) related to the acquisition must be considered. Mistakes can be particularly costly because of the long-term commitment. Further, interest costs may not be obvious and may need to be explicitly considered.

5-5. A dollar today is not worth the same amount as a dollar at some future time. If you have the money today, you can invest it and earn a positive return during the time period you would otherwise be waiting to receive the money. Money has an opportunity cost.

5-6. Compound interest simply refers to the fact that when money is invested going forward in time, at some point the interest earned on the money starts to earn interest itself. Discounting is just the reversal of this process as we go backward in time.

5-7. The quarterly interest rate for 3% annually is .75%. The table does not have a column for a .75% interest rate. You could take the average of the .5% and 1% columns to get an approximation of the correct answer. Alternatively, you could solve the exercise using a calculator or a computer that can solve for any interest rate.

Chapter 5: Capital Budgeting

5-2

5-8. The net present cost method is very helpful for comparing projects that have identical lifetimes. If projects have differing lifetimes, you are not comparing equal benefits unless you equalize the lifetimes. We could use the lowest common denominator of the lifetimes, extending both alternatives until their lifetimes are equal. However, the uncertainties in replacement and operating costs going forward in time may be substantial. The annualized cost method overcomes these problems. In that approach, one first finds the Net Present Cost for each alternative. Then, that cost is translated into a periodic payment for the number of years of that individual project’s lifetime.

The project with the lower annualized cost is less expensive, on an annual basis, in today’s dollars.

5-9. Aside from the complexity of calculations, when cash flows are uneven from year to year, there are two important limitations. IRR assumes that cash inflows during the project are reinvested at the same rate that the project earns. Second, sometimes use of the IRR method will cause you to chose incorrectly from two mutually exclusive projects by picking a smaller project with a higher IRR rather than a larger project with a somewhat smaller IRR. 5-10. The objection to the method is that it ignores everything that happens after the payback period. It also does not consider the time value of money.

EXERCISES Note: the spreadsheet excerpts below are embedded Excel objects. If you double click on them, you will be able to see the underlying spreadsheets.

Important Notes Re: A. Rounding B. Excel Solutions C. Clearing data from calculator memory D. Solutions using Time Value of Money Tables A. It is common to have some rounding errors in time value of money calculations. In the following exercises and problems, answers are rounded either to the penny or to the dollar.

Exercise care when rounding off before the final calculation. For example, if dividing 8% by 12 to get a monthly rate, the rate should be carried out to at least 4 decimal places. It will not be unusal for answers to differ slightly when using different solution approaches (calculator, formula, Excel) because of different rounding conventions used.

B. When solving using Excel or a similar spreadsheet, your actual TVM spreadsheet formula will refer to cell references, such as D12 or E32, rather than numbers or values. However, since each student’s solution may place the raw data in different cells, the cell references in the formulas shown in different solutions to the problem will be different. If the students are asked to indicate values rather than cell references in their spreadsheet formulas, it will make grading or comparison across students easier. This can also facilitate testing students’ ability to use Excel for time value of money problems during a test, without computers.

C. A common error is failure to clear the calculator memory between calculations. It is important to press the All Clear button on your calculator when starting a new calculation.

D. Starting with Exercise 14 and going through Exercise 18, and for selected problems, solutions are shown using the Time Value of Money tables. The tables appear at the end of Chapter 5 in

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Appendix 5-A and the use of such tables is discussed in that appendix. Students who have not been assigned Appendix 5–A should ignore the part of the solutions referring to those tables.

5-11.

(Future Value)

5-12. A. Spreadsheet Solution

B. Calculator Raw Data: Result: 5-13.

80 N

I/Y = 1.52%

-15000 PV

PMT

50000 FV

Chapter 5: Capital Budgeting

5-4

5-14. (Future Value with Monthly Compounding) A. Spreadsheet Solution

B. Financial Calculator Solution Annual Compounding Raw Data: Result:

53 N

-20000 I/Y PV

PMT

FV = 23,185.48

5-5

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Quarterly Compounding Raw Data:

60 N

.25 I/Y

-20000 PV

PMT

Result:

FV = 23,232.48

5-15. (Present Value) A. Spreadsheet Solution

B. Financial Calculator Solution Raw Data:

8 N

5 I/Y

Result:

PV = 3,384.20

PMT

-5000 FV

PMT

10,000 FV

5-16. (Number of Compounding Periods) A. Spreadsheet Solution

B. Financial Calculator Solution Raw Data: Result:

N = 5.50

3 I/Y

-8500 PV

Chapter 5: Capital Budgeting

5-17.

(Annuity Payment – Annuity in Arrears) A. Spreadsheet Solution

5-6

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

5-7

B. Financial Calculator Solution Raw Data:

8 N

5 I/Y

Result:

PV

PMT = -7,854.14

75000 FV

5-18. (Annuity in Arrears - Future Value) A. Spreadsheet Solution

B. Financial Calculator Solution Raw Data:

7 N

6 I/Y

PV

-5000 PMT

Result:

FV = 41,969.19

5-19.

A.

Spreadsheet Solution

B. Financial Calculator Solution 2ND, BGN then: Raw Data: Result:

N =425.98

0.42 -1000000 I/Y PV

5000 PMT

FV

Chapter 5: Capital Budgeting

5-8

5-20.

A.

Spreadsheet Solution

B.

Financial Calculator Solution 2ND BGN then: Raw Data: 240 N Result:

0.42 -1000000 I/Y PV

PMT =6572.17

FV

5-21. (TVM) For part a through part e: FV nper in years

$

50,000 4

Part a.

A. Spreadsheet Solution

B. Financial Calculator Solution Raw Data: Result:

16 N

1.25 I/Y

PV PMT = 40,987.32

-50000 FV

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Part b.

A. Spreadsheet Solution

B. Financial Calculator Solution Raw Data:

16 N

.6 I/Y

-37500 PV

PMT

Result:

FV = 49,972.88

No, she will not have $50,000. She is about $27 short of that amount.

Part c.

A. Spreadsheet Solution

B. Financial Calculator Solution Raw Data: Result:

16 N

I/Y = 1.90

-37000 PV

PMT

50000 FV

Chapter 5: Capital Budgeting

5-10

Note that this is 1.90% per quarter, or 7.60% per year without compounding.

Part d.

A. Spreadsheet Solution

B. Financial Calculator Solution Raw Data:

48 N

6/12 I/Y

Result:

PV PMT = -39,354.92

50000 FV

You must pay $39,354,92 now to get $50,000 in 4 years.

PROBLEMS The exhibits below are embedded Excel objects. Double-clicking on them will open an Excel spreadsheet.

5-22 1.

2.

3.

4.

5.

6.

c. Annualized Cost a. Net Present Value e. Internal Rate of Return f. Cost-benefit analysis b. Net present cost a. Net present value

5-23

b. greater than the original amount invested

5-24

annuity

5-25

a. Accept

5-26

a. Increase

5-27

present value; cash inflows ; cash outflows.

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

5-11

5-28. (TVM) A. Spreadsheet Solution

B. Financial Calculator Solution In advance Raw Data: Result:

5-29. (NPC) A. Spreadsheet Solution

60 N

.75 I/Y

-399 PV PMT = 20,455.52

FV

Chapter 5: Capital Budgeting

5-12

B. Financial Calculator Solution High Security Raw Data:

36 N

.75 I/Y

Result:

PV = 78,617.01

-2500 PMT

FV

Net Present Cost = 78,617.01 + 50,000 = 128,617.01 Tight Security Raw Data: Result:

36 N

.75 I/Y

-1675 PV PMT = 52,573.40

Net Present Cost = 52,573.40+ 75,000 = 127,673.40 Choose Tight Security. It is less expensive.

5-30. (Annualized Cost).

A. Spreadsheet Solution

FV

5-13

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

5-31. (Annualized Cost) A. Spreadsheet Solution

Chapter 5: Capital Budgeting

5-14

B. Financial Calculator Solution Gravel Raw Data:

10 N

8 I/Y

Result:

PV =100,651

-15000 PMT

FV

NPC = 100,651 + 200,000 = $300,651 Sure Pack Cash Flow 1

Raw Data:

5 N

8 I/Y

Result:

-55000 PV PMT = 37,432.08

FV

Cash Flow 2 Raw Data: Result:

10 N

8 I/Y

-55000 PV PMT FV = 25,475.64 NPC = 37,432 + 27,475 + 200,000 = $326,908

(difference due to rounding)

Gravel Raw Data:

10 N

8 I/Y

300651 PV PMT FV =-44805.90

15 N

8 I/Y

326908 PV PMT FV =-42,398.34

Result: Sure Pack Raw Data: Result:

Sure Pack has the lower annualized cost. Select Sure Pack 5-32. (Annualized Cost) A. Spreadsheet Solution

5-15

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

B. Calculator Solution Model A Raw Data:

20 N

6 I/Y

20 N

6 -127027 I/Y PV

30 N

6 I/Y

30 N

6 -149553 I/Y PV

Result: Raw Data:

PV =47,027

Result:

-4100 PMT

PMT =11,075

FV

FV

Model B Raw Data: Result: Raw Data: Result:

PV =49,553

-3600 PMT

PMT =10,865

FV

FV

Model A will cost $11,075 per year in today’s dollars, and Model B will cost $10,865, so Model B is less expensive.

5-33. (NET PRESENT VALUE)

Chapter 5: Capital Budgeting

5-16

A. Spreadsheet Solution

B. Financial Calculator Solution

Raw Data:

3 N

8 I/Y

4 N

8 I/Y

Result:

Raw Data: Result:

-115 PMT

FV

PMT

-315 FV

PV =296.37

PV =231.51

NPV = 296.37 + 231.51 - 650 = $122.12

(difference due to rounding)

or Raw Data:

1 N

8 I/Y

2 N

8 I/Y

Result:

Raw Data: Result:

PV =106.48

PMT

-115 FV

PV =98.59

PMT

-115 FV

5-17

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Raw Data:

3 N

8 I/Y

Result: FV = 315

N=4

PV PMT =91.29PV = ? i = 12%

Raw Data:

4 N

8 I/Y

Result:

PV PMT =231.523

-115 FV

-315 FV

NPV = 106.48 + 98.59 + 91.29 + 231.53 - 650 = $(122.10) Decision: Do NOT pursue the investment. It has a negative net present value.

Chapter 5: Capital Budgeting

5-18

5-34 (NET PRESENT VALUE) A. Spreadsheet Solution

B. Financial Calculator Solution Raw Data:

1 N

8 I/Y

2 N

8 I/Y

3 N

8 I/Y

4 N

8 I/Y

Result: Raw Data: Result: Raw Data: Result: Raw Data: Result:

PV PMT =416,667

PV PMT =385,802

-450000 FV

-450000 FV

PV =277,841

PMT

-350000 FV

PV =180,082

PMT

245000 FV

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

5-19

Net Cash Flow FV = 450,000, FV = 450,000, FV = 350,000, FV = 245,000,

Rate i = 8%, i = 8%, i = 8%, i = 8%,

Period N = 1, N = 2, N = 3, N = 4,

PV = PV = PV = PV = Subtotal

Less Purchase Price NPV =

$416,667 385,802 277,841 180,082 $1,260,292 (1,300,000) ($39,607)

Yes, the NPV is > than 0. Acquire the equipment.

5-35. (TVM) A. Spreadsheet Solution

B. Financial Calculator Solution Raw Data: 20 N Result:

6 I/Y

40000 PV PMT = -458,796.85

FV

No. The pension should have been funded over the years that the clerk worked. The taxpayers of those years received the benefits, and money for the pension should have been put aside during those years, rather than upon retirement or in the future.

Chapter 5: Capital Budgeting

5-20

5-36. (Retirement Analysis) A. Spreadsheet Solution

B. Financial Calculator Solution Part A. 34 N

7.5 I/Y

-30000 PV

PMT

Raw Data: 34 N Result:

7.5 I/Y

PV

-5000 PMT

Raw Data: Result:

FV = 350,759

FV = 712,798

5-21

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

FV = 350,759 + 712,798 = $1,063,557 Part B. Raw Data:

360 N

.6667 I/Y

Result:

-1001907 PV PMT = 7,352

FV

Part C Raw Data

30 N

7.5 I/Y

360 N

.5 I/Y

PV -57,110.52

PMT

500000 FV

‘ Part D Raw Data

A. B. C. D.

1006446.82 PV

PMT -6,034.16

FV

You will have $1,063,557 at retirtement age.

You will be able to draw out $6,376.56 each month during retirement, You would have to invest $57,110.52 to fund the children's inheritance.

After investing the money for the children, your momnthly retirement income would be $6,034.16

Chapter 5: Capital Budgeting

5-22

5-37. (Buy or Lease) A. Spreadsheet Solution

B. Financial Calculator Solution NPC Lease

Raw Data

4 N

8 I/Y

PV 11,426.84

-3450 PMT

FV

NPC = 750 + 11,426.84 = $12,176.84 Annualized Cost of the Lease Raw Data

4 N

8 I/Y

-12176.84 PV

PMT 3,676.44

FV

5-23

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

NPC Ownership Maintenance Annuity Raw Data

6 N

8 I/Y

PV 3,504.97

-750 PMT

FV

PMT

1,000 FV

Residual Value Raw Data

6 N

8 I/Y

PV 630.17

NPC = $14,000 + 3,504.97 - 630.17 = $16,874.80

Annualized Cost of Ownership Raw Data

6 N

8 I/Y

16874.80 PV

PMT 3,650.28

Buy the copier. It costs less on an annualized-cost basis.

FV

Chapter 5: Capital Budgeting

5-38.

5-24

(NPV) A. Spreadsheet Solution

B. Financial Calculator Solution

Raw Data: Result:

120 N

.5 I/Y

-6000 PV PMT = 540,441

FV

NPV = 500,000 + 540,441 - 1,032,000 = $8,441

5-25

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

5-39 (IRR) A. Spreadsheet Solution

B. Financial Calculator Solution Raw Data: Result:

10 N

I/Y = 9.06

-3200 PV

500 PMT

FV

Chapter 5: Capital Budgeting

5-40. (IRR)

A. Spreadsheet Solution

5-26

5-27

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Chapter 5: Capital Budgeting

5-28

On an annual basis, the project returns 13.63%, without compounding, and 14.52% with compounding.

The project meets the required 12% hurdle rate.

5-41.

(Capital Asset Schedule)

6-1

Instructor’s Manual for Financial Management for Public, Heath, and Not-for-Profit Organizations, 7E

Chapter 6

LONG-TERM FINANCING

QUESTIONS FOR DISCUSSION 6-1. Long-term debt includes unsecured notes, notes secured with collateral, mortgages, bonds, and leases.

6-2. Collateral is a specific asset that the lender will be able to take possession of if the borrower fails to make payment of amounts due. For example, if the organization has made an investment, buying 10,000 shares of Microsoft stock, it may offer that stock as collateral when it borrows money. By providing the lender with specific valuable collateral, the loan is less risky. Therefore, the lender is more likely to be willing to make the loan and to charge a lower interest rate.

6-3. Mortgages are loans typically secured by real estate collateral. Generally, mortgages are repaid with equal monthly payments that include interest and principal. With each payment, some principal is repaid. Therefore, subsequent payments include less interest because you owe a lower amount. Since each payment is the same, if there is less interest paid each period, then each subsequent payment repays more principal. The monthly payments are computed using time value of money calculations for annuity payments.

6-4. Governments issue bonds that are backed by the full faith and credit of the government issuer to borrowers. The government promises to pay interest and principal when due, and may even increase taxes if necessary to meet these payments.

6-5. Interest rates frequently fluctuate. Investors are only willing to pay what the current market rate demands, not what the stated rate is.

6-6. Zero-coupon bonds do not pay any interest to the owner until the bond matures. Because the term “coupon” refers to bond interest payments, zero-coupons means no coupons are paid.

6-7. A capital lease is a long-term commitment to pay the owner of a capital asset for the right to use this asset. Similarly, a mortgage commits an organization long-term to use a capital asset.

6-8. Leasing is more flexible, can save money, can protect you from unexpected events, can provide a higher level of financing, and can have tax advantages. If you expect to need a piece of equipment for only half of its useful life, you can set the lease term for that period and will not have to get involved with selling it, as you would if you purchased the item. Leases may protect you from obsolescence. They provide 100% financing. In some cases, a for-profit organization can save

Chapter 6: Long-Term Financing

6-2

taxes by purchasing certain items and pass some of that tax savings on to the not-for-profit organization in the form of lower lease payments.

On the other hand, leasing tends to be more expensive than purchasing assets. Leasing adds another middleman, the leasing company. Leasing companies also charge the lessor extra for the various benefits discussed above.

6-9. Social impact bonds allow governments to address certain issues with little or no cash upfront.

Further, the structure of these instruments permit the use of for-profit or not-for-profit organizations to achieve their goals. However, some programmatic goals may be difficult to measure, which makes writing the required contracts difficult or impossible. Further, critics of SIBs have suggested that the profit motive of the organizations takes precedent over solving the problem. Because of the importance of having measurable outcomes, SIBs should be used when such outcomes actually can be measured and sustained over several years.

EXERCISES Important Notes Re: A. Rounding B. Excel Solutions C. Clearing data from calculator memory D. Embedded Excel Objects A. It is common to have some rounding errors in time value of money calculations. In the following exercises and problems, answers are rounded either to the penny or to the dollar.

Exercise care when rounding off before the final calculation. For example, if dividing 8% by 12 to get a monthly rate, the rate should be carried out to at least 4 decimal places. It will not be unusal for answers to differ slightly when using different solution approaches (calculator, formula, Excel) because of different rounding conventions used.

B. When solving using Excel or a similar spreadsheet, your actual TVM spreadsheet formula will refer to cell references, such as D12 or E32, rather than numbers or values. However, since each student’s solution may place the raw data in different cells, the cell references in the formulas shown in different solutions to the problem will be different. If the students are asked to indicate values rather than cell references in their spreadsheet formulas, it will make grading or comparison across students easier. This can also facilitate testing students’ ability to use Excel for time value of money problems during a test, without computers.

C. A common error is failure to clear the calculator memory between calculations. It is important to press the All Clear button on your calculator when starting a new calculation.

D. The spreadsheet excerpts below are embedded Excel objects. Double clicking on them will let you see the spreadsheet calculations.

Instructor’s Manual for Financial Management for Public, Heath, and Not-for-Profit Organizations, 7E

6-3

6-10. (Mortgage) A. Spreadsheet Solution

B.

Financial Calculator Solution Raw Data:

10 N

6 I/Y

Result:

10000 PV

PMT FV = -1,358.68

Meals will pay $1,358.68 per year.

6-11. (Value of a Bond) A. Spreadsheet Solution

B. Financial Calculator Solution Raw Data: Result:

20 N

2.25 I/Y

-30000 PV PMT = 559,863.92

-500000 FV

Chapter 6: Long-Term Financing

6-4

6-12. (Value of a Zero Coupon Bond) A. Spreadsheet Solution

B. Financial Calculator Solution Raw Data:

20 N

1.6 I/Y

Result:

PROBLEMS 6-13.

i. fall

6-14.

twice each year or every six months maturity date

6-15.

primary market secondary market or aftermarket

6-16.

coupon rate coupons in a year par, face, maturity or face value

6-17.

PV PMT = 18,561.76

-25000 FV

Instructor’s Manual for Financial Management for Public, Heath, and Not-for-Profit Organizations, 7E

6-5

There was no calculation required for part 2-a. When bonds are sold at their coupon rates, they are always worth their par value.

6-18.

B. Financial Calculator Solution Raw Data: Result: 6-19. (Capital Lease) A. Spreadsheet Solution

20 N

2.25 I/Y

-4300000 PV PMT =132,725,610.36

-100000000 FV

Chapter 6: Long-Term Financing

B.

6-6

Financial Calculator Solution in arrears Raw Data: Result: in advance

10 N

6 I/Y

-750 PV PMT = 5,520.01

FV

PV = 5,851.27

C. How much did the bank lose by allowing payments at the end of each year?

The difference between the present value of annuity payments in advance versus annuity payments in arrears is ation is $5,851.27 - $5,520.07 = $331.20. That is the cost of the bank’s concession.

6-7

Instructor’s Manual for Financial Management for Public, Heath, and Not-for-Profit Organizations, 7E

6-20. (Bonds) A. Spreadsheet Solution

B. Financial Calculator Solution a. Value of $200 million par bonds Raw Data:

60 N

2.475 I/Y

Result:

-4800000 PV PMT = 195,337,179.14

-200000000 FV

b. Value of additional bonds issued Ratio of receipts to par value = 195,337,179.14 / 200,000,000 = 97.699% (rounded)

Chapter 6: Long-Term Financing

6-8

Value of bonds to be issued

= par value / ratio = 200,000,000 / 97.699% = 204,774,125.32

Additional bonds issued

= 4,774,125.32

6-21. (Mortgage Refinance) A. Spreadsheet Solution

B. Financial Calculator Solution 10,000  7% = 700  1/2 year = 350 interest every six months Mortgage payments Old mortgage Raw Data: Result:

360 N

.5 I/Y

-500000 PV PMT = 2,997.75

FV

6-9

Instructor’s Manual for Financial Management for Public, Heath, and Not-for-Profit Organizations, 7E

New mortgage Raw Data:

180 N

.36 I/Y

Result: Monthly Savings

-375,000 PV PMT = 2,834.35

FV

= 2,997.75 - 2,834.35 = $163.40

PV of savings annuity Raw Data:

180 N

.5 I/Y

Result:

-163.40 PV PMT = 19,364.05

FV

NPV = -20,000 + 19,364.05 = $(635.95) 6-22. (Bond) A. Spreadsheet Solution

B. Financial Calculator Solutions Raw Data:

20 N

2.98 I/Y

20 N

2.98 I/Y

Result:

Raw Data:

Result:

- 60000 PV PMT = 894,301.33

PV PMT = 1,111,660.68

FV

-2000000 FV

Chapter 6: Long-Term Financing

6-10

Bond value = 894,301.33 + 1,111,660.68 = 2,005,962.01 Or:

Raw Data:

6-23. (Zero Coupon Bond) Result: A. Spreadsheet Solution

20 N

2.98 I/Y

B. Financial Calculator Solution N = 40 i = 2% Raw Data:

40 N

60000 PV PMT = 2,005,962.01

PV = 2264.45 2 I/Y

2264.45 PV

Result:

6-24.

(NIC and TIC calculation) See Excel Solution

PMT

-2000000 FV

FV = ?

FV = -5000.00

7-1

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 6E

Chapter 7

MANAGING SHORT-TERM RESOURCES AND OBLIGATIONS

QUESTIONS FOR DISCUSSION 7-1. Working capital is defined as the organization’s current assets and current liabilities. Net working capital is the current assets of the organization, less its current liabilities. Management of current assets and current liabilities of the organization to maximize results is called working capital management.

7-2. Each day when a store opens for business, there must be some money in the cash register to make change for the first customer who makes a purchase. That individual may well not have the exact amount of the purchase. Also, the store will have to pay its suppliers and employees with money from the cash register, even if it has not yet received payment for everything that it has sold. In similar fashion, every organization needs some cash to pay bills and employees.

7-3. In performing working capital management, it is the manager’s role to ensure that there is adequate cash on hand to meet the organization’s needs and also to minimize the cost of those resources. To do this, the manager must carefully monitor and control cash inflows and outflows. Cash not immediately needed should be invested, earning a return for the organization. Loans should be approved in advance to provide money when cash shortages are likely to arise. Excess supplies (inventory) should not be kept by the organization. The sooner we collect all of our receivables, the sooner the organization will have that cash available for its use, or at least for investment in its bank account. Short-term obligations, called current liabilities, must also be managed carefully.

7-4. Paycheck Protection Program. No, they were available to most not-for-profit organizations as well.

7-5. Cash is needed for transactions, safety, and investment. Cash is needed for the normal daily transactions of any activity. For example, cash is needed to pay employees and suppliers. Although many activities can be anticipated, managers can never foresee everything that might happen.

Experience has shown that it makes sense for organizations to have a safety cushion available for emergencies. A third reason for holding cash is to have it available if an attractive investment opportunity arises. Investment possibilities are not limited to those that earn a profit—they might represent an opportunity to provide a new, valuable service to the organization’s clients.

7-6. Neither. There should be sufficient cash on hand to meet the needs of transactions, safety, and investment, but no more. Any excess cash should be placed in investments that either earn a higher return for the organization or help it provide services to meet its mission.

Chapter 7: Managing Short-Term Resources and Obligations

7-2

7-7. Cash is held for transactions, safety, and investment. In this case, they expected to need cash to buy masks (transactions). Typically they would have needed $.40 x 20,000 = $8,000. Then they likely realized they would need more masks than usual, and the cost per mask skyrocketed. They paid $10 x 25,000 = $250,000. Having extra cash allows this purchase to be paid (safety). So transactions and safety. However, when we talk about holding cash, it is not generally kept in currency. There are many suitable highly liquid investments that are very close to cash. For example, a checking account is considered to be the same as cash. Savings and money market accounts are nearly cash and are often considered to be interchangeable with cash. Treasury bills are extremely safe and marketable, and are a safe short-term safe investment. Certificates of Deposit and Repurchase Agreements are appropriate short-term investments for those organizations who have sophisticated money managers working for them.

7-8. Yes. Profits are often based on accrual accounting. Revenues are recorded when they are earned, even if they have not yet been received. It is possible for an organization’s cash payments for expenses to precede its receipts of revenues to such an extent that it will run out of money. This is a particular problem for apparently healthy, growing organizations. The growth requires cash investment to expand operations. That cash investment comes well before cash receipts resulting from that investment. Careful planning is critical to avoid sudden, unexpected cash shortages.

7-9. Cash is of such importance that many organizations prepare a cash budget for each month of the coming year. It is not enough to budget total cash inflows and outflows for the year. We need to know on a more current basis, usually month to month, how much cash will be received and paid.

7-10. Marketable securities are investments that have a ready market for purchase and sale. They can generally be sold almost immediately, and cash from the sale can be received within a few days at most. The two major categories of marketable securities are equity securities and nonequity instruments. Equity refers to having an ownership interest. Shares of stock are referred to as equity securities. Obligations such as bonds and notes are referred to either as debt instruments, or nonequity instruments. They do not infer ownership. If the organization that has borrowed money by selling bonds does poorly, it is still obligated to repay the full amount it has borrowed.

7-11. In general, marketable securities have a risk/return trade-off. The riskier the investment is, the higher its expected return. Why would anyone buy a corporation’s bond unless they expected a higher return than they could get from a bank account? The bank account is insured by the government, whereas the corporate bond is not. When investing available cash in either bonds or stocks, the manager must carefully consider whether the expected increase in return is adequate to pay for the extra risk that the organization is taking.

7-12. In order to collect payment in a timely manner, we must have a system that is set up to bill the right party and to provide them with the information they need in order to verify and pay the bill.

Credit policies relate to deciding to whom the organization will provide service without receiving immediate cash payment. If we provide services to a poor financial credit risk, we may fail to collect payment. If this occurs frequently enough, it can threaten the financial stability of the organization. On the other hand, by excluding individuals or organizations from buying our goods

7-3

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 6E

or services on account, we take a chance of losing the opportunity to provide services to some individuals and organizations that would have paid at a later date. The manager must weigh the risk of nonpayment against the potential loss of business.

7-13. This can be faster and more accurate. Collections will be received sooner, providing an interest benefit. In addition to faster collection, electronic billing may prove to be less expensive to process than paper billing. Paperwork requires labor, and labor may be more expensive than computer systems. Electronic billing also allows for quicker communication of problems. If a bill is sent electronically and is rejected electronically, the problem can be addressed at an earlier point in time and it is more likely that it will ultimately be paid.

7-14. An aging schedule shows how long it has been between the current date and the date when uncollected bills were issued. The aging schedule is a valuable tool because problem areas can be quickly identified. Efforts to collect payment should begin as soon as the invoice is issued. If anything goes beyond the current column (i.e. 1–30 days), we see that from the aging schedule.

There should be a formal procedure, such as the issuance of a reminder statement. If an account exceeds 60 days, there should be procedures such as mailing another statement, often colored pink to get greater attention. The “over 90 day” category in an aging schedule is a particular concern, even though it may be a small part of the total. All organizations should have specific follow-up procedures for accounts that fall into this category. These procedures should include not only monthly statements, but also late charges and telephone calls to determine why payment has not been made.

In some cases it is necessary to use a collection agency if other efforts have failed and it is believed that the receivable is from some person or organization that does have financial resources.

This is a costly approach, because collection agencies retain as much as half of all amounts that they are successful in collecting.

7-15. Lock boxes are usually post office boxes that are emptied by the bank. The bank opens the envelopes and deposits payments received directly to the organization’s account. One advantage of this approach is that the money gets into an interest-bearing account faster. Secondly, use of a lock box tends to substantially decrease the risk that receipts will be lost or stolen.

7-16. Inventory management can save money for the organization. The lower the level of inventory, the less you have paid out to suppliers, and the greater the amount of money kept in your own interestbearing savings accounts or investments. On the other hand, managers must assure that there are adequate levels of inventory for current use and as a safety measure. For example, in the case of a hospital, having inventory on hand can literally be a question of life or death.

7-17. The periodic inventory approach tracks inventory balances and usage by taking an inventory count from time to time, usually once a year. Presumably all amounts purchased that are not still on hand, have been used to provide goods and services. Perpetual inventory is a system in which the organization keeps a record of each use of each type of item. A running balance is maintained so that the organization always knows how much of each item it has on hand. With a periodic inventory system, it is hard to know when to reorder, because you never know exactly how much you have on hand. However, it is usually less costly than a perpetual inventory system. Periodic

Chapter 7: Managing Short-Term Resources and Obligations

7-4

systems are also flawed in that they cannot distinguish between normal usage, theft, obsolescence, or other reasons for inventory decreases.

7-18. JIT philosophy seeks to minimize those costs associated with handling and storing inventory that add no value to the product and to thereby reduce the cost per unit. Many would argue that it is unrealistic to believe that many public service organizations will ever be able to count on JIT inventory. What if the Hospital for Ordinary Surgery is about to perform an operation, and a critical supply is not delivered just when it is needed? Given the life-and-death issues faced by some organizations, a pure JIT approach may not be feasible. On the other hand, it could represent a philosophy to be adopted to the extent possible and reasonable. What if Meals for the Homeless runs out of canned peas? At worst, they would have to go to a supermarket and buy supplies at retail prices until a new shipment can arrive. Rather than viewing JIT as all or nothing, we could think of it as representing a goal to strive toward to the extent reasonable.

7-19. Managers often delay payment of short-term obligations. This keeps resources in the organization, available to earn interest or be used to provide services. Managers also want to avoid unnecessary short-term borrowing, which would cause the organization to make interest payments that wouldn’t otherwise be necessary.

7-20. The notation “2/10 N/30” is called credit terms. This would be read as “two ten, net thirty.” A discount of two ten, net thirty indicates that if payment is received within 10 days of the invoice date, the payer can take a 2% discount off the amount of the bill. If payment is not made within 10 days, then the bill is due 30 days from the invoice date in full. The organization should take advantage of the discount unless they can earn a higher rate of return in the interim. In the case of 2/10, N/30, money would have to earn more than 37.2% annual return for the company to not take the discount.

One confusing element of discounts is that the amount to be paid is called “net” if you are paying the full amount. Usually net refers to a number after a subtraction has been made. Often organizations negotiate a discount from the full price at the time an order is placed. Net means the list price less any discount from that price, not including discounts for prompt payment. For example, if the list price is $5,800 and the buyer negotiates an $800 discount off the list price, the net price would be $5,000. If credit terms allow a 2/10 N/30, then the buyer pays $4,900 if payment is made within 10 days. Otherwise the net price of $5,000 is due at the end of 30 days.

Implicit interest rate =

$100  365 days 100% = 37.2% $4,900 20 days

7-21. Typically, organizations obtain short-term debt by borrowing money from banks using unsecured notes. In some cases money can be borrowed from financing and factoring companies, using inventory or accounts receivable as collateral. In some cases an alternative way to obtain shortterm debt is through the use of commercial paper (unsecured) or banker’s acceptances (secured).

A secured loan is one that is backed by collateral to guarantee repayment. If the lender does not require any collateral for the loan, it is said to be unsecured. Unsecured loans are riskier than those having collateral, and therefore they often have higher interest rates to offset the lender’s higher risk. Unsecured loans are generally referred to as notes because there is a specific

7-5

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 6E

document, called a note, that gives the details of the loan arrangement, including the agreed-upon interest rate and information about when interest and principal payments will be made. The outstanding balance owed on the note is called the note payable.

Another approach for obtaining short-term financing is to borrow money using receivables as collateral (financing) or to sell receivables (factoring).

Often the interest rate on short-term debt is higher long-term debt. In general, this is because short-term loans are usually unsecured and have transaction costs that must be recovered over a shorter period of time.

7-22.

b amounts owed to the organization by outsiders

7-23.

b money that must be repaid within the next 12 months

7-24.

Dollar Amount Percentage (Type of payer is an alternate acceptable answer.)

7-25.

b. over the next year

7-26.

accounts receivable

7-27.

c. accounts payable

7-28. b. periodic method 7-29. Any two of the following are acceptable answers: early data collection, credit policies, aging of accounts-receivable, lock boxes, electronic billing, electronic payment.

7-30.

Wages payable, notes payable, supplies payable, interest payable, taxes payable or any other category of expenses payable.

Chapter 7: Managing Short-Term Resources and Obligations

7-31.

7-32.

7-6

7-7

7-33.

7-34.

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Chapter 7: Managing Short-Term Resources and Obligations

7-35.

7-8

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Chapter 7: Managing Short-Term Resources and Obligations

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CASE STUDY: The Case of the Missing Check (Managing Cash) There are an infinite number of possible acceptable solutions, based on discussion of the various elements of short-term resource management. A good answer should at least touch upon the following: 1. The three reasons for holding cash (transactions, safety, investment).

2. The fact that when we speak of holding cash, most of that cash is held in the form of bank accounts, rather than currency on hand.

3. The potential benefits of using a lock box and/or electronic payment.

4. The tradeoff of liquidity versus higher return on invested cash.

5. The importance of a cash budget in providing information about when cash will be needed.

6. The benefits of concentration banking.

7. The importance of maintaining security over cash.

8. Alternative short-term investments.

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 6E

Chapter 8

ACCOUNTABILITY AND CONTROL

QUESTIONS FOR DISCUSSION 8-1. A management control system is a complete set of policies and procedures designed to keep operations going according to plan. Such systems also detect variations from plans and provide managers with information needed to take corrective actions when necessary. Management control systems have often been compared to thermostats. We might set a thermostat for 70 degrees. That is our plan. It is the temperature that we hope will exist in a room. It is predetermined, as a budget would be. However, a thermostat does more than just establish the desired temperature. It also monitors the existing temperature in the room. Similarly, a MCS assesses the actual outcomes for the organization. If the temperature in the room varies from the desired 70 degrees, the thermostat activates the furnace to send heat if it gets too cold, or turns off the furnace if it gets too hot.

Similarly, the MCS must set in motion actions that are needed if it determines that we are varying from our plan. Further, management control systems attempt to establish an environment for the organization to come as close to its plans as possible.

8-2. Responsibility accounting is the assignment of the responsibility for keeping to the plan and carrying out the elements of the management control system. Responsibility accounting should not be primarily focused on assigning blame. Responsibility accounting is oriented toward clearly communicating expectations ahead of time and then tracking results to generate feedback after the fact. The most important reason for the feedback is to improve future outcomes.

8-3. Philisophically, either of these methods may work. Many managers strongly believe that the “carrot” is better than the stick. However, some MCSs employ rewards for managers and staff that meet or exceed budgets (the carrot), while others take the approach of doling out punishments if targets are not achieved (the stick).

8-4. Whether employees are in the office or working from home, a control system should be established to evaluate performance. If employees are working 5 feet apart, or 50 miles apart, the control system can keep things on track. Set expectations; make sure employees know their responsibilities; develop a set of measurable deliverables; use key performance indicators which measure employee performance equally as well if they are at home as if they are in the office; set dates for deliverables.

8-5. These elements or sections are Competence, Confidentiality, Integrity, and Objectivity.

First, the IMA code indicates an expectation that individuals must be competent in their job. To some extent this means one must find ways to assure that skills are not eroding. It also means that

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8-2

as the field changes around you, there is an obligation to keep up to date. Competent ethical behavior also requires managers to comply with all laws, regulations, and industry standards. The Code calls upon its members to generate reports that are understandable, comprehensive, and based on appropriate analysis using dependable information.

A second major section of the Code relates to the issue of confidentiality. It is unethical to disclose confidential information unless properly authorized by the organization or legally required to do so.

Integrity is a major focus of the Code. Ethical behavior bans conflicts of interest, inappropriate influence, bribes, working against the organization, failure to disclose personal skill inadequacies, and failure to disclose important information.

Objectivity—information should be communicated in a way that is fair, objective, and relevant. Intent is critical. It is inappropriate to present material in a way that you know may be technically correct, but will give the user an incorrect impression.

8-6. This is a system designed to protect the resources of the organization from misappropriation and to assure that resources are used as efficiently and effectively as possible.

8-7. An internal control system uses accounting controls and a set of administrative controls.

Accounting controls are often referred to as preventive, or before-the-fact, controls. Although a primary purpose of accounting controls is to prevent employee misuse of assets (such as embezzlement and fraud), they also attempt to prevent suboptimal use of resources where no wrongful intent is involved. Administrative controls tend to be after-the-fact. They are often referred to as feedback systems. After a loss is incurred, administrative controls help the organization take corrective actions to avoid additional losses in the future. This is done by making adjustments based on observed problems in the past.

8-8. An internal control system includes having an audit trail, reliable personnel, separation of duties, proper authorization, adequate documents, proper procedures, physical safeguards, bonding, vacations and rotation of duties, independent checks, and cost-benefit analysis.

An audit trail refers to the ability to trace each transaction in an accounting system back to its source. In order for an audit trail to be an effective tool for control, there must be regular use of the trail to identify and examine discrepancies or unusual spending patterns.

The organization must start its internal control system with a group of employees that are both capable and trustworthy. In addition, employees must be capably supervised. There should be separation of functions: e.g., the individual at Meals for the Homeless who approves bills for payment should not be the same person who writes checks. One benefit of such separation is that each individual may catch a problem that is missed by another. This system of separation is also an especially powerful tool for reducing the potential of embezzlement.

Another control element is to require all spending to be supported by proper authorization. A system of authorization for spending helps the organization set spending policies and then adhere to them. General authorization is a standing approval of certain spending. Items under a certain dollar limit or for certain purposes may fall under that general authorization. Items that cannot be acquired using general authorization require specific authorization. Specific authorization would require an individual to obtain written permission to override the general authorization policies.

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Adequate documentation is required. In light of technological changes in data storage, it is essential that organizations carefully think out what documentation will be available to allow them to trace back, explain, and prove that transactions have occurred.

Internal control systems often rely heavily on standard operating procedures, usually in the form of a procedures manual. Doing things “by the book” may seem rigid to some employees, but following clearly documented procedures is likely to reduce the number of errors.

Common sense dictates the need for physical safeguards. Cash and blank checks should obviously be kept locked when not in use. Backup copies of computer records should be maintained in a separate location.

If individuals are in positions where it would conceivably be possible for them to steal significant amounts from the organization, it is appropriate to bond them. Bonding means that the organization purchases insurance to protect itself against theft by the employee. Also, staff should be forced to take vacations, and there should be a rotation of duties.

The employees of an organization should review and evaluate their internal control systems on a regular basis. Additionally, outside auditors should review the control system. They have the benefit of experience from reviewing many other control systems.

Systems should be cost effective. We shouldn’t spend more on the systems than they are worth. For example, we wouldn’t spend $1,000 to prevent someone from possibly stealing $10.

8-9. There are several principal ways that SOX may affect not-for-profit organizations. First, the Board of Trustee's Audit Committee will have an enhanced role. The Audit Committee will retain and supervise the outside auditors. Key executives, such as the CEO and CFO will be excluded from the committee. Audit Committee members will not be allowed to be paid consultants, and Audit Committees will be required to have some members with financial expertise. Next, key executives of the organization will be required to certify the organization's financial statements. Third, there will be limits on the types of consulting that an organization's auditor can provide to it. These prohibited areas include: bookkeeping, information systems design, appraisal services, actuarial services, internal audit outsourcing, human resources, investment advising, and legal or expert service unrelated to the audit. Finally, there will be a higher level of manager accountability.

Senior managers will have to certify that they are aware of the internal processes that the organization uses to collect the financial information used to prepare the financial statements issued to the public, and of any concerns, issues or problems that might hamper accurate reporting.

8-10. D 8-11. Variances are calculated for three principal reasons. By understanding why results were not as expected, the budget process can be improved and made more accurate in future planning. Second, by understanding why variances are occurring, actions can be taken to avoid additional unfavorable variances over the coming months. The third reason for variance analysis is to evaluate the performance of units or departments and their managers.

8-12. Outcomes can be measured in terms of private benefits to the organization, public benefits to society, effectiveness, efficiency, quality, and quantity.

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8-13. Effectiveness relates to whether the organization is accomplishing its desired outcomes. Efficiency relates to whether the organization uses the minimum needed resources to accomplish its outcomes. Although most organizations strive to be both efficient and effective, an organization can be efficient, but not effective or effective, but not efficient.

8-14. Finance can calculate the amount of the variances. However, variance analysis requires the knowledge, judgment, and experience of the manager. Only the person who has supervised a department has enough actual knowledge of that department to effectively determine why actual results differed from expectations.

8-15. Absolutely. The variance should be investigated and its cause determined. If the price increase is likely to persist, then the organization will continue to go over budget. It must decide how this excess spending can be covered.

8-16. This may or may not be the case. It depends largely on how revenues change as volume changes.

Volume increases that increase revenues may be good for the organization, even though some expenses are rising as well. If some costs are fixed, it is possible for volume increases to cause revenues to increase by more than expenses increase, resulting in larger profits or smaller losses.

8-17. The amount of resources consumed will vary with the level of workload actually attained. It is critical to evaluate whether variances are occurring because we are spending more or less money to provide the expected level of services or are spending more money or less money because a greater or lesser amount of services are being provided.

8-18. Using the flexible budget technique, the variance for any line item can be subdivided into three pieces: a volume variance, a price variance, and a quantity variance. The volume variance is defined as the portion of the variance in any line item that is caused by the fact that the output level differed from the budgeted expectation. The price, or rate, variance is the portion of the total variance for any line item that is caused by spending more per unit of some input resource than had been anticipated. The quantity, or use, variance is the portion of the overall variance for a particular line item that results from using more of a resource than was expected for a given output level. These three variances together equal the traditional variance for a line item.

8-19. Certainly volume variances are quite likely. Depending on the business, volume may be expected to fall (meals served in a restaurant) or soar (take-out meals sold by a restaurant). For example, hospitals might encounter both increases in severe infected patients in their ICUs, and at the same time drastic drops in patients for many types of routine elective procedures. Price variances are also likely as shortages drive up costs (eg for ventilators or N95 face masks. Governments might encounter volume variances as ridership plummets on public transportation, and increased public health costs as vaccines and virus testing is provided to the public without charge.

8-20. Common internal causes of variances include shifts in quality of service provided, changes in technology used, changes in efficiency, changes in organization policy, or simply budgets based on

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 6E

unrealistic expectations. External causes of variances commonly include price changes for supplies, volume changes, and unexpected shifts in the availability of staff.

8-21. The more we aggregate information, the greater the chance that we will misinterpret what has happened. An entire organization may spend nearly the same amount for a given month as it expected. In total, there is nearly no variance. However, that does not mean that there are no problems that need to be investigated. Some departments might have large favorable variances and other departments might have large unfavorable variances. Within just one department, two line items might have offsetting variances, both of which should be investigated. Even within one line item, there may be offsetting price, quantity, and volume variances that warrant attention.

8-22. For large organizations with numerous departments, we cannot expect either the Chief Executive Officer (CEO) or the Chief Financial Officer (CFO) to have time to review all variances each month. To cope with this problem, organizations use exception reports. Exception reports consist of a listing of only those variances that are deemed to warrant a manager’s attention. Usually large dollar or percent variances are included in the exception report.

8-23. No, volume variances arise because we expect some costs to vary as volume changes. Fixed costs would not be expected to vary, and therefore would not have a volume variance.

8-24. No. Variances can result from uncontrollable, random events. If a variance is very small, it is often not worth the manager’s time to investigate. However, it requires skill and experience to know when a variance is large enough to indicate the possibility of problems that require management investigation.

8-25. 1. planned or budgeted (or the budgeted amounts, the actual amounts) actual (in either order) 2. Volume, price/cost and quantity

PROBLEMS 8-26

Chapter 8: Accountability and Control

8-27.

The total variance is $100,000 – (450 * 4 * $65) or $117,000 = -17,000 The variance is favorable because the expense was lower than they had anticipated.

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8-7

8-28. Budget total labor cost: $100,000 Actual total labor cost: 6000 hours x $16/hour = $96,000 The total labor variance is $4,000 favorable because they spent less in total than the budgeted amount.

Volume variance is unfavorable. They expected 500 dogs and actually had 640. Since labor costs vary with the number of dogs, more dogs means more spending, and that results in an unfavorable volume variance.

Budget: 10 hours per dog Actual hours per dog were: 6,000/640 dogs = 9.375 This results in a favorable quantity variance, because we used less labor hours per dog than expected.

8-29.

(Expense Variances)

Calculate the volume, quantity, and rate variances, and provide some possible explanations for each.

Original Budget: Flex Budget: or

Budgeted Volume x Budgeted Quantity x Budgeted Rate Actual Volume x Budgeted Quantity x Budgeted Rate 125 x 10 x $20 - 150 x 10 x $20 Volume Variance

Flex Budget: VQA Budget: or

Actual Volume x Budgeted Quantity x Budgeted Rate Actual Volume x Actual Quantity x Budgeted Rate 150 x 10 x $20 - 150 x 8 x $20 Quantity Variance

VQA Budget: Actual: or

= $25,000 = - $30,000 = $ (5,000) U

= $30,000 = - $24,000 = $ 6,000 F

Actual Volume x Actual Quantity x Budgeted Rate Actual Volume x Actual Quantity x Actual Rate 150 x 8 x $20 - 150 x 8 x $25 Price Variance

= $24,000 = - $30,000 = $ (6,000) U

Investigation of why there were 20% more trials is required. The $5,000 Unfavorable Volume Variance might reflect an increased amount of crime, or simply greater efficiency of the Courts in providing a speedy trial. The Judge is correct in arguing that more cases tend to raise costs, other

Chapter 8: Accountability and Control

8-8

things being equal. However, everything else did not stay the same. The trials have become shorter resulting in a Favorable Quantity Variance of $6,000. Shorter trials require less labor hours. This could reflect greater efficiency, or simply a mix of cases that tend to be shorter. If it is the result of efficiency, that improvement should be noted and rewarded to encourage its continuation. In any case, the shorter trials more than made up for the increased number of trials.

The Unfavorable Rate Variance caused spending of $6,000 over the expected level. One might argue that the additional volume of cases required overtime, accounting for the higher wage.

However, because the trials were shorter we actually used only 2,400 labor hours as compared to the 2,500 budgeted. The variance could be due to a new union contract, or perhaps we hired stenographers with more experience who earn a higher wage. Perhaps there was a payroll error, and the stenographers were paid at the wrong hourly wage. In any event, investigation of this rate variance is clearly warranted.

8-30.

(Expense Variances) Fire Department

The Total Variance = $108,680 Actual - $100,000 Budget = $8,680 Unfavorable Original Budget: Flex Budget:

Budgeted Volume x Budgeted Quantity x Budgeted Rate Actual Volume x Budgeted Quantity x Budgeted Rate 100 x 40 x $25 - 110 x 40 x $25 Volume Variance

= $100,000 = - $110,000 = $ 10,000 U

There was a $10,000 Unfavorable variance due to the higher than expected number of fires.

Flex Budget: VQA Budget:

Actual Volume x Budgeted Quantity x Budgeted Rate Actual Volume x Actual Quantity x Budgeted Rate 110 x 40 x $25 - 110 x 38 x $25 Quantity Variance

= $110,000 = - $104,500 = $ 5,500 F

There was a favorable Quantity Variance of $5,500 because it took less labor to fight each fire than expected.

VQA Budget: Actual:

Actual Volume x Actual Quantity x Budgeted Rate Actual Volume x Actual Quantity x Actual Rate 110 x 38 x $25 = $104,500 - 110 x 38 x $26 = - $108,680 Price Variance = $ 4,180 U

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There was an unfavorable Rate Variance of $4,180 because the hourly rate was higher than expected, perhaps because of overtime.

8-31.

(Revenue Variances) Budget Actual 300  $3,000 400  $2,700 Revenue $900,000 $1,080,000

Variance 180,000 F

Price variance—average sale price per car Volume variance—number of cars donated Original Budget:

Budgeted Volume x Budgeted Mix x Budgeted Price Cars: 300 x 100% x $3,000 = $ 900,000

Flex Budget:

Actual Volume x Budgeted Mix x Budgeted Price Cars: 400 x 100% x $3,000 =

Original Budget: Flex Budget: VMA Budget:

Volume Variance = Actual Volume x Actual Mix x Budgeted Price Cars: 400 x 100% x $3,000 =

Flex Budget: VMA Budget: Mix Variance

=

$1,200,000 $ 900,000 - 1,200,000 $ 300,000 F $1,200,000 $1,200,000 - 1,200,000 $ 0U

Since there is only one type of product, the mix variance must be zero.

Actual:

Actual Volume x Actual Mix x Actual Price Cars: 400 x 100% x $2,700 =

$1,080,000

Price Variance

$1,200,000 - 1,080,000 $ 120,000 U

VMA Budget: Actual:

8-32.

=

(Expense Variances) Medical Group Expense Variances

The term “rate” may be substituted for “price” throughout this solution.

Chapter 8: Accountability and Control

Original Budget: Flex Budget:

8-10

Budgeted Volume x Budgeted Quantity x Budgeted Price Actual Volume x Budgeted Quantity x Budgeted Price 2,000 x .5 x $40 - 2,600 x .5 x $40 Volume Variance

= $40,000 = - $52,000 = $12,000 U

There was a $12,000 Unfavorable variance due to the higher than expected number of patients.

Flex Budget: VQA Budget:

Actual Volume x Budgeted Quantity x Budgeted Price Actual Volume x Actual Quantity x Budgeted Price 2,600 x .5 x $40 = $52,000 - 2,600 x .4615 x $40 = - $48,000 Quantity Variance = $ 4,000 F

There was a favorable Quantity Variance of $4,000 because it took less labor per patient than expected.

This might not be good. It might mean that patients received a lower quality of care than expected.

Favorable variances do not always mean that something good has happened.

VQA Budget: Actual:

Actual Volume x Actual Quantity x Budgeted Price Actual Volume x Actual Quantity x Actual Price 2,600 x .4615 x $40 - 2,600 x .4615 x $41.67 Price Variance

= $48,000 = - $50,000 = $ 2,000 U

There was an unfavorable Price Variance of $2,000 because the hourly rate was higher than expected.

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8-11

8-33.

(Revenue Variances) Medical Group Revenue Variances

Original Budget:

Flex Budget:

Budgeted Volume x Budgeted Mix x Budgeted Price Flu Shot: 2,000 x 400/2,000 x $50 = $ 20,000 Treatment: 2,000 x 1,600/2,000 x $80 = 128,000 $148,000 Actual Volume x Budgeted Mix x Budgeted Pric Flu Shot: 2,600 x 400/2,000 x $50 = $ 26,000 Treatment: 2,600 x 1,600/2,000 x $80 = 166,400 $192,400

Original Budget: Flex Budget: Volume Variance

VMA Budget:

=

Actual Volume x Actual Mix x Budgeted Price Flu Shot: 2,600 x 1,200/2,600 x $50 = Treatment: 2,600 x 1,400/2,600 x $80 =

Flex Budget: VMA Budget: Mix Variance Actual:

=

Actual Volume x Actual Mix x Actual Price Flu Shot: 2,600 x 1,200/2,600 x $55 = Treatment: 2,600 x 1,400/2,600 x $70 =

VMA Budget: Actual: Price Variance Volume Variance Mix Variance Price Variance Total Revenue Variance

=

$148,000 - 192,400 $ 44,400 F

$ 60,000 112,000 $172,000 $192,400 - 172,000 $ 20,400 U $ 66,000 98,000 $164,000 $172,000 - 164,000 $ 8,000 U $44,400 F 20,400 U 8,000 U 16,000 F

Chapter 8: Accountability and Control

Flu shot Treatment

Budgeted # of patients 400 1,600 2,000

Percent of patients 20% 80%

X

Budg. price $50 $80

8-12

Weighted avg. price $10 64 $74

Actual # of patients 1,200 1,400 2,600

Percent of patients 46.15% 53.85%

x x

Budg. price $50 $80

Weighted avg. price $23.08 $43.08 $66.15

Actual # of patients 1,200 1,400 2,600

Percent of patients 46.15% 53.85%

x x

Actual Price $55 $70

Weighted avg. price $25.38 $37.69 $63.08

Percent equals number over total. For example 400 flu shot patients ÷ 2,000 total = 20%.

Things are better off because there was a large favorable volume variance, which exceeded the unfavorable mix and price variances. The $16,000 favorable total revenue variance is greater than the $10,000 unfavorable total expense variance (Problem 8-30), thus profits have increased by $6,000 over expectations.

8-34. (Case-mix Variances) The case-mix variance is the current volume times the current cost, less the prior volume times the current cost, as follows:

Type X Type Y

Current volume  Current cost 8  $5,000 = 10  $8,700 =

Type X Type Y

Prior volume 7 11

 Current cost  = $5,000  = $8,700

Case-mix variance

favorable

$40,000 87,000 $127,000

$35,000 95,700 $130,700 $ 3,700

The shift by Dr. Eger from high-cost Type Y patients toward lower cost Type X patients resulted in a $3,700 decrease in the cost of treating his patients. Thus, we are observing a strong case-mix change.

The cost variance is the prior volume times the current cost, less the prior volume, times the prior cost, as follows: Type X Type Y

Prior volume 7 11

 Current cost  $5,000 =  = $8,700

Type X Type Y

Prior volume 7 11

  

Prior cost $4,300 $9,000

= =

$35,000 95,700 $130,700

$30,100 99,000 $129,100

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 6E

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Cost variance

unfavorable

$

1,600

As we can see from the cost variance, once we have adjusted for the change in case mix, Dr. Eger’s cost of treating patients has actually risen, not fallen!

In addition to these variances, it would also be quite helpful to have the reimbursement rate for Type X and Type Y. The relative rate increases for different patient types can inpact the appropriate decision.

8-35. (Expense Variance) Calculate the total, volume, quantity, and rate variances.

Monthly Solution: Original Budget: Flex Budget: or

Budgeted Volume x Budgeted Quantity x Budgeted Rate Actual Volume x Budgeted Quantity x Budgeted Rate 1,500 x 0.20 x $12 = $3,600 - 1,350 x 0.20 x $12 = $3,240 Volume Variance = $360 F

Flex Budget: VQA Budget: or

Actual Volume x Budgeted Quantity x Budgeted Rate Actual Volume x Actual Quantity x Budgeted Rate 1,350 x 0.20 x $12 = $3,240 - 1,350 x 0.25 x $12 = $4,050 Quantity Variance = ($810) U

VQA Budget: Actual: or

Actual Volume x Actual Quantity x Budgeted Rate Actual Volume x Actual Quantity x Actual Rate 1,350 x 0.25 x $12 = $4,050 - 1,350 x 0.25 x $12.40 = $4,185 Price Variance = $ (135) U

Total = ($585) U Daily Solution: Original Budget: Flex Budget: or

Budgeted Volume x Budgeted Quantity x Budgeted Rate Actual Volume x Budgeted Quantity x Budgeted Rate 50 x 0.20 x $12 - 45 x 0.20 x $12

= $120 = $108

Chapter 8: Accountability and Control

Volume Variance Flex Budget: VQA Budget: or

= $12 F

Actual Volume x Budgeted Quantity x Budgeted Rate Actual Volume x Actual Quantity x Budgeted Rate 45 x 0.20 x $12 - 45 x 0.25 x $12 Quantity Variance

VQA Budget: Actual: or

8-14

= $108 = $135 = ($27) U

Actual Volume x Actual Quantity x Budgeted Rate Actual Volume x Actual Quantity x Actual Rate 45 x 0.25 x $12 = $135 - 45 x 0.25 x $12.40 = $139.50 Price Variance = $ (4.50) U

Total = ($19.50) U

8-36. (Control Systems) There are an infinite possible number of correct answers, drawing on principles discussed throughout this chapter. See the solution to discussion question 8-7 for ideas of some elements that should be included in a solution to this problem.

8-37. There are an infinite possible number of correct answers, drawing on principles discussed throughout this chapter.

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Chapter 9

TAKING STOCK OF WHERE YOU ARE: THE BALANCE SHEET

QUESTIONS FOR DISCUSSION 9-1. Assets are anything of value that the organization owns. Liabilities are obligations owed to outsiders. Owner’s equity represents the share of the organization’s assets owned by its owners.

9-2. Net worth or net assets or fund balance: Individuals often refer to their equity as their net worth.

Not-for-profit organizations use net assets to represent the fact that owner’s equity is the difference between assets and liabilities. Governments use fund balance, because it represents the leftover amount in each fund after assets are used to pay liabilities.

9-3. The balance sheet is a representation of the equation. The left-hand side of the equation contains the assets from the balance sheet. The right-hand side of the equation contains the liabilities and owner’s equity from the balance sheet. Both the equation and the balance sheet must remain in balance.

9-4. Intangible assets are often particularly hard to measure. Some intangibles, such as goodwill, will only appear on the balance sheet if they have been purchased, rather than developed by the organization. Also, assets often appear on the balance sheet based on their acquisition cost to the organization, rather than based on their current market value.

9-5. GAAP, or Generally Accepted Accounting Principles, are a set of rules and conventions. They are established by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB). The CPA’s audit examines the financial statements and the underlying financial records of an organization. Based on their examination, they issue a letter that gives their opinion as to whether the financial statements are free of material (substantial) misstatements and whether they conform to Generally Accepted Accounting Principles (GAAP).

GAAP help create some degree of uniformity.

9-6. In order to avoid confusion, we want to specifically identify the entity that is the focus of a set of financial reports. Each entity views the world from its own perspective. One transaction could give rise to an asset on the financial records of one entity and a mirror-image liability on the records of another entity.

9-7. All events that have a financial element must have a monetary figure attached to them. The reason this convention exists is related to the need for communication. Suppose that you were trying to tell someone what assets the organization has. You could try to list each desk, chair, building, and

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everything else the entity owned. The resulting list of items would likely be hundreds or perhaps thousands of pages long. The benefit of the monetary denominator is that it allows us to summarize information into a more useful form.

9-8. In order to avoid subjectivity, we often wind up recording assets based on their cost, rather than their current value. This results in values on the balance sheet that can be quite misleading.

9-9. Equity securities are now reported on the balance sheet based on their fair market value, rather than on the lower of cost or market.

9-10. If there is a significant question regarding an organization’s ability to continue operations, the valuation of all of its assets must be reconsidered, based on liquidation values. Users of the financial statements must be informed of the significant uncertainties that exist.

9-11. CPAs try to find and eliminate all material errors. However, it is virtually impossible to find every error. Material errors are those that might affect a decision made by a user of the financial report.

9-12. GAAP require organizations to report their financial position and results of operations on an accrual basis. This means that revenues are recorded in the year that the organization provides goods or services, fulfills a performance obligation, and becomes legally entitled to payment.

Expenses are recorded in the year that assets have been consumed in the process of providing goods and services. This contrasts sharply with the cash basis of accounting, which would record revenue when cash is received and expense when cash is paid. The rationale for using accrual accounting is that it provides a better measure of how well the organization has done for the year.

The cash basis can be quite misleading because there may be a poor matching of revenue and expense in any one year. This can lead to substantially over or understated measures of income.

9-13. The primary requirement for classification as a current asset is management’s expectation or intention to convert the asset to cash or use it up within a year. Thus, an investment in Microsoft stock would be a current asset only if we expect to sell it in the coming year. Otherwise the stock would be treated as a long-term asset.

9-14. Assets are shown on the balance sheet in the order of liquidity, with the most liquid assets listed first. Liquidity refers to how close an asset is to being cash. The more quickly an asset can become cash available for spending, the more liquid the asset is. Liquid assets are readily available to pay the organization’s obligations. Cash, and cash equivalents, are always considered to be the most liquid assets, assuming that they are available for use. Therefore, cash is always the first item listed under current assets.

9-15. A finance lease is a long-term lease that is noncancellable. It is an arrangement in which the lease arrangement is usually used as a means to purchasing the asset. An operating lease is short-term and cancellable. These are used when an organization may need to use but not own an asset longterm.

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

9-16. The Titanic is a boat that sank. Sinking funds have nothing to do with sinking. They are asset investment accounts that are earmarked for a specific purpose, such as repaying a bond or replacing buildings and/or equipment.

9-17. The details of total cost and accumulated depreciation tell much more about the size of an organization and the age of its facilities than we can learn from the net value.

9-18. Assets are recognized when three conditions have all been met. They must (1) be owned by the entity, (2) have a monetary value, and (3) have a monetary value that is able to be objectively measured.

9-19. Liabilities are recognized when they are legally owed and will have to be paid and the amount to be paid can be objectively measured.

9-20. The central recording device used by accountants is the journal, generally referred to as the general journal. A journal is simply a chronological listing of every financial event that affects the organization. The journal is similar to a diary in that events are listed in the order they occur and as concurrently as possible. When an event occurs and is entered into the journal, the process is referred to as making a journal entry.

9-21. It is impossible for an event to affect only one account and leave the fundamental equation of accounting in balance. In order to describe an entire event, it is necessary to record a change to at least two elements in the fundamental equation. That does not mean, however, that there must be a change on each side of the equation. There can be off-setting changes in items on just one side.

Nor does it mean that a transaction can affect just two accounts. Double-entry bookkeeping doesn’t limit the number of accounts that can change as part of one transaction.

9-22. The words debit and credit are commonly used in the process of recording financial information. A debit represents an increase in an asset or expense. A credit represents an increase in a liability or revenue. A debit is an increase in anything on the left side of the transformed fundamental equation:  A+E =  L+R

A credit is an increase in anything on the right side of this equation. Conversely, a credit is a decrease in anything on the left side of the equation. A debit is a decrease in anything on the right side of the equation.

Chapter 9: Taking Stock of Where You Are: The Balance Sheet

9-4

PROBLEMS 9-23.

EXERCISE 9-23 Assets

Liabilities

Transaction

Up

Down

1. Purchases supplies with cash.

X

X

2. Purchases supplies on account.

X

X

3. Takes out a loan.

X

X

4. Repays loan principal.

Up

X

5. Receives payment on a pledge.

X

6. Makes a payment on an amount it owes.

X

X X

7. Prepays for insurance.

X

8. Pays employees wages.

9. Begins using office space with a 10-year lease for the property

X

X X

X

X

X

9-24.

1. No 2. No 3. Yes 9-25 a. b. c. d. e. f.

iii ii v i vi iv

9-26 Date 1.

2.

Assets (A) Cash + $50,000 No transaction recorded.

= =

Liabilities (L) Loan Payable + $50,000

Down

+ Net Assets (NA) +

No change

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

9-5

3.

4.

Supplies + $1,750 Cash – $5,000

=

Accounts Payable + $1,750

+

No change

=

No change

+

No change

Office Sign + $5,000 5.

Cash -$5,000

Accounts Payable +$5,000

Office Equipment +$10,000

1.

Cash Loan Payable

Journal Entries Dr. $50,000

$50,000

2.

No transaction recorded.

3.

Supplies Accounts Payable

$1,750

Office Sign Cash

$5,000

Office Equipment Accounts Payable Cash

$10,000

4.

5.

Cr.

is

$1,750

$5,000

$5,000 $5,000

9-27. See Excel Solution 9-28. See Excel Solution 9-29.

Date 1.

Assets (A) Cash + $250,000

=

Liabilities (L)

=

No change

+ Net Assets (NA) +

No change

Chapter 9: Taking Stock of Where You Are: The Balance Sheet

9-6

Accounts Receivable - $250,000 2.

3.

Cash – $100,000

Cash -$25,000

=

Line of Credit -$100,000

+

No change

=

No change

+

No change

+

No change

Supplies +$25,000 4.

No Transaction

5.

Cash -$10,000

Accounts Payable +$40,000

Equipment +$50,000 6.

1.

2.

3.

Cash – $65,000

=

Wages Payable – $65,000

Journal Entries Dr. Cash $250,000 Accounts Receivable

$250,000

Line of Credit Cash

$100,000 $100,000

Supplies Cash

$25,000

4.

No Transaction

5.

Equipment Accounts Payable Cash

Cr.

$25,000

$50,000 $40,000 $10,000

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

9-7

6.

Wages Payable Cash

$65,000 $65,000

9-1

9-30.

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9-31.

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Chapter 10

REPORTING THE RESULTS OF OPERATIONS— THE ACTIVITY AND CASH FLOW STATEMENTS

QUESTIONS FOR DISCUSSION 10-1. The Activity Statement is often referred to by other names, including the Income Statement, Statement of Changes in Net Assets, the Operating Statement, Profit and Loss (P&L) Statement, Earnings Report, Statement of Revenues and Expenses, and Statement of Revenues and Expenditures.

10-2. All organizations need to measure their net income, surplus, or excess of revenues over expenses. This allows them to determine whether their asset inflows exceed or fall short of their asset outflows. Public service organizations need to have adequate profits to sustain, update, and expand the services provided. Failure to earn a profit, or at least break even, can endanger the organization. However, because their mission is largely one of public service, many organizations do not wish to maximize their profits. The purpose of the income statement is to provide management with information they need to steer the organization as necessary to best accomplish its objectives.

10-3. Revenues and expenses can only be recorded if certain conditions are met, and exchange transactions follow a five step process. First, the organization must identify the contract with the customer. Second, the organization identifies the performance obligation of the contract (that is, the goods or services to be transferred). Third, the organization determines the transaction price.

Fourth, the organization allocates this price to the performance obligations. Fifth, the revenue is recognized as the performance obligation is met.

The five-step process only applies to exchanges. Support recognition is allowed even though the gift has not been received, and even though no goods or services have actually been provided. In fact, pledges are enforceable contracts. We record pledges as support if there is a specific amount and a reasonable likelihood of collection.

10-4. Some types of expenses are product costs, and other types of costs are period costs. Product costs are those expenses that are directly connected to providing goods and services. They become expenses as they get used up. Period costs are those that relate to the passage of time, rather than the direct provision of services. They become expenses as they expire over time. For example, rent on a machine for a specific month or year expires as time passes.

10-5. It is unlikely that all numbers in the organization’s bookkeeping records are exactly correct. If numbers are reported to the nearest dollar or to the penny, there is an inference of greater accuracy than is likely to actually exist. By rounding off numbers, the financial statements

Chapter 10: Reporting the Results of Operations: The Activity and Cash Flow Statements

10-2

provide a better sense to the user that this is approximately what has occurred, rather than exactly and precisely what has happened.

10-6. This is a fairly open-ended question. Although the revenue from telephone is down, there is an equal increase in revenues from mail solicitations. Perhaps management decided it would be less expensive to increase the number of pieces of mail and reduce the number of phone calls. One would wonder whether it did turn out that this form of solicitation was less expensive, per dollar raised. If so, perhaps we should pursue it even more in the future. On the other hand, if we spent just as much on telephone solicitation as in the past, but had lower yields, the organization should be trying to find out why. The point of this exercise is to encourage students to look more critically at the numbers in the statement and to start using them as an effective management tool.

10-7. The balance sheet reflects a single moment in time. It includes all accounts receivable from the current year, but also prior years. It is unlikely that all revenues will be collected in the same fiscal year in which these revenues are recorded. The accounts receivable balance, then, will reflect any uncollected revenues not just from the current year, but also prior years.

10-8. No. The primary goal of depreciation is not determining the current value of the asset to place on the balance sheet. Depreciation strives to allocate the cost of the asset over the asset’s useful life.

In accord with the matching principle of GAAP, the goal of depreciation is to assign expense for use of the asset into the periods that the asset is used up, generating revenue. Depreciation is based on assigning the cost incurred when we acquired the asset, rather than on some measure of replacement cost if we were to buy the asset now.

10-9. At best, estimates are subjective guesses. We can try to base them on historical experience, but they still introduce the possibility of errors into the financial statements. Another problem is that estimates open the door to manipulating results. If we want to look poor to encourage donations, we might be tempted to overstate bad debt expense or to underestimate the salvage value of a piece of equipment. Both of those actions would tend to lower current net income, making us look poorer now. Estimates increase the chances that the financial statements will not be free of material misstatements.

10-10. No, for organizations using the accrual basis of accounting, the activity and cash flow statements are complementary, rather than being substitutes. Income statements measure profitability, but profitability alone does not assure viability. We must know how much cash was received and used, where it came from, and what it was spent on. An organization can be profitable but run out of cash if payment for its expenses precedes receipt of cash from revenues. An organization can appear to have sufficient cash, but that cash may be from one-time sources that will not repeat, and the future may be worse than the present. We should know if that it is the case. The cash flow statement helps by showing not only the amount of cash flow, but also the specific major categories of sources and uses of cash.

10-11. The statement shows Cash Flows from Operating Activities, Cash Flows from Investing Activities, and Cash Flows from Financing Activities. Cash from operating activities helps us

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

understand the organization’s ability to continue operations over time. If this number is positive, then the routine operations are self-sustaining. Cash from investing activities allows us to determine if the organization is spending cash to either acquire productive assets or investments in stocks and bonds. Alternatively, we might learn that the organization is selling its fixed assets to raise cash. That would send a warning signal of potential problems. Cash from financing activities shows sources of cash such as loans and issuance of stock. If the organization is taking out long-term loans to finance cash losses from current operations, that would also send a warning signal.

10-12. The balance sheet, activity statement, and cash flow statement are interconnected. The information from each relies to some extent on information from the others. Suppose that we use up inventory as we provide services during the year. Our asset—inventory—goes down on the balance sheet. Our expense related to supply use increases on the activity statements. Just the reverse happens with revenues. When we charge clients for our services, accounts receivable rise, increasing assets and the balance sheet. Revenues also rise, affecting the activity statement.

The net of the revenues and expenses helps account for the change in net assets on the balance sheet from the beginning to the end of the year.

The cash flow statement has linkages to both the activity statement and balance sheet. The first line on the cash flow statement is the change in net assets, taken from the activity statement.

The ending balance of the cash flow statement is the cash balance, which appears at the beginning of the balance sheet.

The balance sheet provides information on the current assets and current liabilities (working capital). The change in each working capital account has an impact on the organization’s cash balances. These changes primarily show in the adjustments that are made in the cash from operations section of the cash flow statement. Changes in fixed assets and investments on the balance sheet are reflected in the cash from investing activities section of the cash flow statement. Similarly, financing activities will appear on the cash flow statement, but also are reflected in changes in long-term liability values on the balance sheet.

10-13. Permanent accounts are those whose balance carries over from the end of one year to the beginning of the next. For example, the amount of cash that the organization has at the end of one year becomes its beginning cash balance at the start of the next year. In contrast, the balance in temporary accounts is emptied out each year. For example, revenue and expense accounts, which are temporary accounts, transfer their balances to net assets at the end of the year. As a result, net assets are adjusted to show the impact of profits on the equity of the organization, and the revenue and expense accounts begin the next accounting period with a zero balance. This is appropriate, because revenue and expense are measurements for a specific period of time, rather than being cumulative balances for the entire existence of the organization.

Chapter 10: Reporting the Results of Operations: The Activity and Cash Flow Statements

10-4

Problems 10-14.

10-15. (Transaction Analysis) 1.

Jan. 12 Assets (A) Cash + $300,000

=

Liabilities (L)

+

Net Assets (NA)

=

No change

+

No change

Pledges receivable – $300,000 Date

Dr.

Cr.

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

10-1

1/12

Cash Pledges receivable Collection of pledges

$300,000 $300,000

2.

Feb. 4 No journal entry. There has been no exchange by either party.

3.

Mar. 1 Assets (A) Cash – $50,000 Date 3/1

=

Liabilities (L)

+ –

= Dr. $50,000

Grant Expense Cash

Net Assets (NA) Grant Expense $50,000 Cr. $ 50,000

Pay grant to GARCH

4.

May 29 Assets (A) Deposit + $5,000

=

Liabilities (L)

+

Net Assets (NA)

=

No change

+

No change

Cash – $5,000

Date 5/29

Dr. $5,000

Deposit Cash

Cr. $5,000

Deposit on ordered partitions

5.

Jun. 12 Assets (A) Cash + $80,000 Date 6/12

=

Liabilities (L)

+

=

Cash Donation revenue

+ Dr. $80,000

Net Assets (NA) Donation revenue + $80,000 Cr. $80,000

Chapter 10: Reporting the Results of Operations: The Activity and Cash Flow Statements

10-6

Donation revenue.

6.

Sept. 1 Assets (A) Inventory + $60,000

= =

Liabilities (L) Accounts payable + $30,000

+

Net Assets (NA)

+

No change

Cash – $30,000 Date 9/1

Dr. $60,000

Inventory Cash Accounts payable

Cr. $30,000 30,000

Purchase bookstore inventory.

7.

Oct. 15 Assets (A) PPE + $15,000

=

Liabilities (L)

+

Net Assets (NA)

=

No change

+

No change

Deposit – $5,000 Cash – $10,000 Date 10/15

Dr. $15,000

PPE Deposit Cash Received partitions (property, plant, and equipment)

8.

Nov. 10

Cr. $ 5,000 10,000

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

10-1

Assets (A) Cash + $75,000 Date 11/10

= =

Liabilities (L) Notes payable + $75,000

+

Net Assets (NA) No change

Dr. $75,000

Cash Notes payable

Cr. $75,000

Borrow with note payable.

9.

Dec. 5 Assets (A) Cash – $28,000 Date 12/5

= =

Liabilities (L) Notes payable – $25,000

+ –

Net Assets (NA) Interest expense $3,000

Dr. $ 3,000 25,000

Interest expense Notes payable Cash

Cr.

$28,000

Payment on note and interest expense

10.

Dec. 28 Assets (A) Cash – $75,000

Date 12/28

= =

Liabilities (L) Wages payable +$15,000

Wage expense Wages payable Cash Record wage expense and payment

+ –

Dr. $90,000

Net Assets (NA) Wage expense $90,000

Cr. $ 15,000 75,000

Chapter 10: Reporting the Results of Operations: The Activity and Cash Flow Statements

11.

10-8

Dec. 31 Assets (A) Cash + $98,000

=

Liabilities (L)

+

=

Net Assets (NA) Sales revenue + $110,000

+

Accounts receivable + $12,000 Inventory - $58,000

-

Cash -$30,000 Date 12/31

Cost of goods sold -$58,000

Accounts payable -$30,000 Dr. $68,000 58,000 12,000 30,000

Cash Cost of goods sold Accounts receivable Accounts payable Sales revenue Inventory

Cr.

$110,000 58,000

Record bookstore sales

Note: The cash and accounts payable transaction occur because the balance of the unpaid inventory is paid at the end of the year (see #6).

12.

Dec. 31 Assets (A) Accounts receivable, net – $2,000

= =

Liabilities (L)

Date 12/31

+ Net Assets (NA) – Implicit Price Concessions $2,000

Dr. Implicit Price Concessions Accounts receivable, net

Cr.

$2,000 $2,000

10-1

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Record estimated uncollectible receivables

OR Assets (A) Allowance for Uncollectible Accounts – $2,000 Date 12/31

13.

= =

Liabilities (L)

+ Net Assets (NA) – Implicit Price Concession $2,000

Implicit Price Concession Allowance for Uncollectible Accounts

Dr. $2,000

Cr. $2,000

Dec. 31 Assets (A) PPE, net – $40,000 Date 12/31

= =

Depreciation expense PPE, net Record depreciation expense

Liabilities (L)

+ –

Dr. $40,000

Net Assets (NA) Deprec. expense $40,000 Cr. $40,000

10-1

10-16.

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Chapter 10: Reporting the Results of Operations: The Activity and Cash Flow Statements

10-2

10-1

10-17.

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Chapter 10: Reporting the Results of Operations: The Activity and Cash Flow Statements

10-2

ARCH Statement of Financial Position as of December 31, Year 2 and Year 1 Assets Liabilities & Net Assets Year 2 Year 1 Year 2 Year 1 Current assets Liabilities Cash $335,000 $10,000 Current liabilities 36,000 26,000 Accounts payable $27,000 $27,000 Accounts receivable, net of estimated uncollectibles of Wages payable 47,000 32,000 $2,000 in Year 2 Total current liab. $74,00 $59,000 Pledges receivable

50,000

350,000

Inventory Total current assets

27,000 $448,00

$25,00 $411,00

Long-term liabilities Notes payable

$320,00

$270,000

Total long-term liab.

$320,00

$270,000

Total liabilities

$394,00

$329,000

Long-term assets Fixed assets Buildings & Equip., net Total long-term assets

Total assets

$325,00

$350,00

$325,00

$350,00

$773,00

$761,00

Net assets Without donor restrictions

$249,000 $302,000

With donor restrictions

130,000

130,000

Total net assets

$379,00

$432,000

Total equities

$773,00

$761,000

10-1

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E INDIRECT METHOD

ARCH Statement of Cash Flows for the Year Ending December 31, Year 2 Cash flows from operating activities Decrease in net assets Add expenses not requiring cash: Depreciation Other adjustments: Subtract the increase in accounts receivables Add the decrease in pledges receivable Subtract the increase in inventory Add the increase in wages payable Net cash from operating activities

($53,000) 40,000 (10,000) 300,000 (2,000) 15,000 $290,000

Cash flows from investing activities Purchase of PPE Net cash used in investing activities

($15,000) ($15,000)

Cash flows from financing activities Borrowing with notes Net cash from financing activities

$50,000 $50,000

Net increase/(decrease) in cash Cash, beginning of year Cash, end of year

$325,000 10,000 $335,000

Chapter 10: Reporting the Results of Operations: The Activity and Cash Flow Statements DIRECT METHOD

ARCH Statement of Cash Flows for the Year Ending December 31, Year 2 Cash flows from operating activities Cash received from donors Cash received from sale of books Cash used to pay employee wages Cash used for grants given Cash used to purchase book inventory Cash used to pay interest on note Net cash used for operating activities

$380,000 98,000 (75,000) (50,000) (60,000) (3,000) $290,000

Cash flows from investing activities Cash used for purchase cubicle partitions Net cash used in investing activities

($15,000) ($15,000)

Cash flows from financing activities Cash received from issuance of note payable Cash used to repay note payable Net cash from financing activities

$75,000 (25,000) $50,000

Net increase/(decrease) in cash Cash, beginning of year Cash, end of year

$325,000 10,000 $335,000

1) Strengths:

Strong Cash position, strong cash from operations, low current liabilities

2) Concerns: Operating loss for the year, long-term debt increasing

10-4

10-1

10-18.

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Chapter 10: Reporting the Results of Operations: The Activity and Cash Flow Statements

10-2

10-1

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

The Science Road Show Statements of Financial Position As of August 31, 2024 and August 31, 2023 2024 2023 Assets Current Assets $122,000 $40,000 Cash Grants Receivable 50,000 100,000 Pledges Receivable, Net 15,000 10,000 Inventory 9,000 4,000 Prepaid Rent 12,000 10,000 Total Current Assets $208,000 $164,000 Long-Term Assets PP&E, Net $260,000 $75,000 Total Assets $468,000 $239,000 Liabilities Current Liabilities Wages Payable Accounts Payable Deferred Revenue Notes Payable - Current Portion Total Current Liabilities Long-Term Liabilities Notes Payable - Long-Term Portion Total Liabilities Net Assets Total Liabilities and Net Assets

$25,000 5,000 25,000 25,000 $80,000

$20,000 0 0 50,000 $70,000

$175,000 $255,000 $213,000 $468,000

$0 $70,000 $169,000 $239,000

Chapter 10: Reporting the Results of Operations: The Activity and Cash Flow Statements

The Science Road Show Statement of Activities For the Year Ending August 31, 2024 Revenues and Support Ticket Sales Memberships Grants Donations Total Revenue and Support

$375,000 25,000 50,000 56,000 $506,000

Expenses Wages Rent Supplies Interest Depreciation Total Expenses

$300,000 120,000 15,000 12,000 15,000 $462,000

Change in Net Assets Net Assets, Beginning Net Assets, Ending

$44,000 $169,000 $213,000

Note that Implicit Price Concessions reduced the Donation support.

10-4

10-1

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Chapter 10: Reporting the Results of Operations: The Activity and Cash Flow Statements

INDIRECT METHOD The Science Road Show Statement of Cash Flows For the Year Ending December 31, 2024 Cash From Operating Activities Change in Net Assets $44,000 Adjustment for Non-Cash Expense: Depreciation 15,000 (Increases)/Decreases in Non-Cash Current Assets: Grants Receivable 50,000 Pledges Receivable, Net (5,000) Inventory (5,000) Prepaid Rent (2,000) Increases/(Decreases) in Current Liabilities: Wages Payable 5,000 Accounts Payable 5,000 Deferred Revenue 25,000 Net Cash From Operating Activities $132,000 Cash From Investing Activities Purchase of Equipment Net Cash (Used For) Investing Activities

($200,000) ($200,000)

Cash From Financing Activities Loan Proceeds Principal Repayment Net Cash From/(Used For) Financing Activities

$200,000 (50,000) $150,000

Net Increase/(Decrease) in Cash Cash, Beginning of Year Cash, End of Year

$82,000 40,000 $122,000

10-6

10-1

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

DIRECT METHOD The Science Road Show Statement of Cash Flows For the Year Ending December 31, 2024 Cash From Operating Activities 50,000 Sale of Memberships Sale of Tickets 375,000 Grants 100,000 Collection of Donor Pledges 51,000 Program booklets (15,000) Employee Wages (295,000) Leases (122,000) Interest (12,000) Net Cash From Operating Activities $132,000 Cash From Investing Activities Purchase of Equipment Net Cash (Used For) Investing Activities

($200,000) ($200,000)

Cash From Financing Activities Loan Proceeds Loan Repayment Net Cash From/(Used For) Financing Activities

$200,000 (50,000) $150,000

Net Increase/(Decrease) in Cash Cash, Beginning of Year Cash, End of Year

$82,000 40,000 $122,000

Chapter 10: Reporting the Results of Operations: The Activity and Cash Flow Statements

10-19.

10-8

10-1

10-20.

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

11-1

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Chapter 11

UNIQUE ASPECTS OF ACCOUNTING FOR HEALTH AND NOT-FOR-PROFIT ORGANIZATIONS

QUESTIONS FOR DISCUSSION 11-1. A not-for-profit (NFP) organization is an entity that receives donations, does not consider profits to be an end (although they will likely be a means to the organization’s ends), and does not have owners.

11-2. The net assets section of the balance sheet must show two different groups of net assets: without donor restrictions and with donor restriction. Donor restrictions relate to net assets restricted in perpetuity (endowments), and also use or time restricted net assets. Net assets without donor restrictions have no restrictions from donors attached to the resources.

It is important to note that there is a distinction between donor-imposed restrictions and selfimposed restrictions. Self-imposed restrictions often arise when the board of trustees or directors decides that money should be segregated and saved for a future purpose, such as building replacement. It is allowable to indicate such board-designated restrictions on assets and net assets. However, only donor-imposed restrictions create restricted net assets. Self-imposed restrictions would create a subtotal within the net assets without donor restrictions category.

11-3. A not-for-profit organization that has decided to put money aside as a safety reserve generally could reverse that decision and use the money for general operations. In the case of a union, this is more complex. The money in the strike fund often comes from union members. It is possible that the strike fund could be considered to be donor-restricted money. There may also be laws that restrict the use of money once it is placed in a strike fund.

11-4. Although an activity statement includes revenues and expenses as an income statement would, it is more comprehensive, showing all changes in net assets. It uses terms such as Change in Net Assets or Change in Equity, rather than net income. Thus the Activity Statement includes the information that for-profits show in the Income Statement as well as information that would be contained in a for-profit organization’s Statement of Changes in Owner’s Equity. An income statement per se reflects revenues and expenses, gains and losses. There are other things that can affect stockholders’ equity or net assets, such as dividends, issuance of stock, or restricted donations. When items similar to these exist, they appear on an activity statement, but often do not appear on an income statement.

11-5. As “used in nonprofit accounting, a fund is an accounting entity with a self-balancing set of accounts for recording assets, liabilities, the fund balance, and changes in the fund balance.

Chapter 11: Unique Aspects of Accounting for Health and Not-for-Profit Organizations

11-2

Separate accounts are maintained for each fund to ensure that the limitations and restrictions on the use of resources are observed. Though the fund concept involves separate accounting records, it does not entail the physical segregation of resources. Fund accounting is basically a mechanism to assist in exercising control over the purpose of particular resources and amounts of those resources available for use.”1 11-6. A variety of different funds are used in organizations, depending on the specific types of restrictions faced by the organization. Funds are divided into two main categories—unrestricted and restricted. Virtually all not-for-profit organizations have a current unrestricted or general fund. The main categories of restricted funds are donor restricted versus board restricted. Donorrestricted funds are funds that exist to comply with various requirements donors have placed at the time of donation. These might include building replacement funds, building expansion funds, endowment funds, custodian funds, and strike funds among other restricted funds. Boardrestricted funds are those that are established to track the use of resources that the board has decided to devote to a specific purpose. If board-restricted resources are needed for other purposes, the board can remove the restriction, and the resources can be transferred to an unrestricted fund.

11-7.

Three types of events can occur that concern more than one fund in an organization. One is a loan, where one fund borrows money from another. A second is the sale of services, where one fund consumes services provided by another fund. The third type of event is a transfer, where one fund gives resources to another.

Loans between funds are treated the same as a loan from a bank. The borrowing fund has a liability on its balance sheet, reflecting the need to repay the loan, and the lending fund has a receivable. These are called “Due to” and “Due from.”

When one fund purchases services from another, the event is recorded by both funds just as if the organizations were totally separate.

A transfer between funds is a permanent movement of resources from one fund to another.

The assets and fund balance or net assets of one fund are reduced, and for another fund they are increased. Some transfers are done at the discretion of management. Other transfers may be mandatory.

11-8. None. Under current accounting rules, all not-for-profit organizations are required to depreciate their buildings and equipment.

11-9. Contributions, gifts, or donations are recorded at their fair market value at the time of donation.

They are included with the organization’s revenue, although they are often called support. When the donated resources are used up, they are treated as expenses. They are reported as support when the promise is made if it is unconditional or when all conditions have been met.

Nonfinancial assets that are contributed must be reported separately from cash donations.

Donated services, one particular type of nonfinancial assets, can only be recorded if the services (a) create or enhance nonfinancial assets or (b) require specialized skills, are provided by individuals with those skills, and would have to be purchased if the services weren’t donated.

1

Vincent M. O’Reilly, Murray B. Hirsch, Philip L. Defliese, and Henry R. Jaenicke, Montgomery’s Auditing, 11th. (New York: John Wiley and Sons, 1990), 791.

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

11-3

“Services requiring specialized skills are provided by accountants, architects, nurses, plumbers, teachers, and other professionals and craftsmen. Contributed services that do not meet the above criteria can not be recognized in the financial statements.”2 Not-for-profit organizations are required to distinguish among contributions that increase net assets with and without restrictions. By providing this information, the user of financial statements is better able to understand the resources the organization has and the extent to which they are available for various purposes. Organizations must also indicate when restrictions have expired.

11-10. Under FAS 124, investments in equity securities that have readily determinable fair values and all debt securities are reported at their fair value in the statement of financial position (balance sheet). Gains and losses, both realized and unrealized, on investments are shown in the activity statement. If a security has been sold during the year, the gain or loss has been realized and the security will not appear on the balance sheet at the end of the period, because the organization no longer owns it.

11-11. Yes, depreciation of buildings and equipment is required for healthcare organizations. Unless superseded by the healthcare accounting and audit guide or clearly inappropriate, healthcare organizations follow GAAP used by other for-profit and not-for-profit organizations. GAAP requires depreciation for both, thus healthcare organizations must employ depreciation.

11-12. Both are recorded in net assets with donor restrictions.

11-13. Both are recorded in net assets without donor restrictions.

Problems 11-14. a. Yes, because it is specialized and would have been purchased anyway. b. No, because it is not specialized (even though it may yield more donations). c. No, because it is not specialized.

11-15. a. With donor restrictions b. Without donor restrictions c. Without donor restrictions d. Without donor restrictions e. With donor restrictions f. With donor restrictions

11-16.

2

Ibid., 3.

Chapter 11: Unique Aspects of Accounting for Health and Not-for-Profit Organizations

11-4

The organization would record the donated services of the accountant who performed tasks consistent with her specialized skill, but it would not record the donated services of the accountant on the board because there is no indication that this service requires specialized skills. Further, in the absence of the donated accounting skills, the organization would have had to purchase these services. Hence, the organization would record $500 per hour X 100 hours = $50,000 of donated revenue and expenses.

11-17.

ASSETS

=

LIABILITIES

+

FUND BALANCE

a. Operating Fund Cash -$10,000 Due from Environmental Program +$10,000 Environmental Fund Cash +$10,000

Due to Operating Fund $10,000

b. Operating Fund Cash -$20,000

Transfer to DSF -$20,000

Debt Service Fund Cash +$20,000

Transfer from Operating Fund +$20,000

c. Operating Fund A/R +$4,000

Operations Revenue +$4,000

Environmental Fund A/P -$1,000

Operation Expense -$1,000

A/P -$1,000

Operation Expense -$1,000

Gardening Fund

11-5

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Education Fund A/P -$1,000

Operation Expense -$1,000

A/P -$1,000

Operation Expense -$1,000

Reforestation Fund

Chapter 11: Unique Aspects of Accounting for Health and Not-for-Profit Organizations

11-18. See Excel worksheet

11-6

11-7

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E FYA Balance Sheet As of December 31, 2024 and December 31, 2023

Assets Current Assets Cash Pledges Receivable, net Contracts Receivable Prepaid Expense Total Current Assets

2024

2023

$11,900 250 7,500 12,000 $31,650

$2,000 500 1,000 0 $3,500

Long-Term Assets Equipment Total Long-Term Assets

$2,200 $2,200

$2,500 $2,500

TOTAL ASSETS

$33,850

$6,000

Liabilities Current Liabilities Note Payable Total Current Liabilities

2024

2023

$8,800 $8,800

$0 $0

Net Assets Net Assets without Donor Restriction Net Assets with Donor Restrictions Total Net Assets

$24,550 500 $25,050

$6,000 0 $6,000

TOTAL LIAB. AND NET ASSETS

$33,850

$6,000

FYA Statement of Activities For the Year Ending December 31, 2024

Revenues and Support Donation Revenue Contract Revenue Donated In-Kind Service Released from Restriction Total Revenue

Without Donor Restrictions $24,750 6,500 5,000 800 $37,050

Expenses Recreation Counseling Administrative Interest Donated In-Kind Service Depreciation Total Expenses Change in Net Assets Net Assets, Beginning Net Assets, Ending

With Donor Restrictions $1,300

(800) $500

Total $26,050 $6,500 $5,000 $0 $37,550

$3,800 8,000 1,000 400 5,000 300 $18,500

$0

$3,800 8,000 1,000 400 5,000 300 $18,500

$18,550 6,000 $24,550

$500 0 $500

$19,050 6,000 $25,050

Chapter 11: Unique Aspects of Accounting for Health and Not-for-Profit Organizations

INDIRECT METHOD FYA Cash Flow Statement For the Year Ending December 31, 2024 Cash from Operating Activities Change in Net Assets Depreciation Changes in Current Assets Add decrease in Account Re Contracts Receivable Prepaid Expense Restricted Cash Net Cash from Operations

$19,050 300 250 (6,500) (12,000) (500) $600

Cash from Financing Activities Restricted Cash Note Payable Net Cash from Financing

$500 8,800 $9,300

Net Change in Cash Cash, Beginning Cash, Ending

$9,900 2,000 $11,900

DIRECT METHOD FYA Cash Flow Statement For the Year Ending December 31, 2024 Cash from Operating Activities Donations Interest Expense Purchase Athletic Equipment Prepaid Rent Counseling Programs Recreation Programs Administration Restricted Cash Net Cash from Operations

$26,300 (800) (400) (12,000) (8,000) (3,000) (1,000) (500) $600

Cash from Financing Activities Restricted Cash Note Payable Net Cash from Financing

$500 8,800 $9,300

Net Change in Cash Cash, Beginning Cash, Ending

$9,900 2,000 $11,900

11-8

12-1

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Chapter 12

UNIQUE ASPECTS OF ACCOUNTING FOR STATE AND LOCAL GOVERNMENTS PART I: THE RECORDING PROCESS

QUESTIONS FOR DISCUSSION 12-1. Governments have three major classes of funds. These are Governmental Funds, Propriety Funds, and Fiduciary Funds.

Governmental Funds are the typical funds used to operate most governments. These include funds such as the General Fund, Special Revenue Funds, Capital Project Fund, and Debt Service Fund. The General Fund is similar to the Operating Fund or Unrestricted Fund in not-for-profit organizations. This is the fund that is used for the bulk of the day-to-day revenues and expenses of the government. Special Revenue Funds are used for specific identifiable purposes. These are akin to temporarily restricted funds for not-for-profit organizations. The Capital Projects Fund is used to account for acquisitions of plant or equipment. The Debt Service Fund is used to account for current payments of principal and interest on long-term debt. Governmental funds also include permanent funds, which are similar to endowment funds.

Proprietary Funds are used to account for activities that are run on a businesslike basis. The two primary types of proprietary funds are Internal Service Funds and Enterprise Funds. When the government is essentially running a business, such as a golf course, charging the public for services they consume, an Enterprise Fund is established. Internal Service Funds are established for elements of government that are established to provide specific services to other government units such as a carpool.

Fiduciary funds contain resources that the government does not actually own. Rather, they are funds that are being held for other individuals or organizations. The four major classifications of fiduciary funds are 1) pension and other post employment trust funds, 2) investment pool trust funds, 3) private purpose trust funds, and 4) custodial funds. Pension and other post employment trust funds hold assets to pay retirement and health care benefits to retirees. Investment pool trusts account for pools of available cash from multiple governments to invest together. Private purpose trusts are funds established for any other purpose where the money is intended for some other party than the government. Custodial funds are used when a government holds money that it intends to pass through to another government or entity.

12-2. Budgetary accounting helps to keep the government in compliance with legal restrictions. If an approved budget only allows $493,000 to be spent, we want to ensure that spending does not exceed that amount. Budgetary accounts are also used for improved government-wide budgetary control. For example, if revenues are coming in below budgeted expectations, budget directors can instruct agency directors to cut their spending, so that the government avoids a deficit for the year. The government needs to keep budgetary transactions or budgetary entries separate from

Chapter 12: Unique Aspects of Accounting for State and Local Governments – Part I The Recording Process

12-2

the nonbudgetary transactions that record actual revenues and expenditures. An appropriation is an amount that the government is authorized to spend. An expenditure represents actual spending. An encumbrance is a bookkeeping device that keeps the government from spending money that has already been committed for some other purpose.

12-3. Cash records revenue when cash is received and expense when cash is paid. Accrual records revenue when earned and expense when assets are used to generate revenues. Modified accrual considers an item to be an expenditure when there is a legal obligation to pay for it with current resources. Thus, acquisitions do not generate assets in general. Revenues arise when resources are owed to the organization and are “measurable and available.” Availability means that they will be collected no later than shortly after the end of the accounting period. This is a more stringent rule than that followed under full accrual accounting.

As a result, balance sheets under modified accrual do not have long-term assets. Under modified accrual, governments do show some short-term assets. Primarily these are cash, receivables, marketable securities, and inventory. Similarly, the balance sheet will show some short-term liabilities such as wages and accounts payable. Short-term loans will also appear as liabilities on the balance sheet, as they are not treated as fund balance increases, but as liabilities.

Long-term liabilities for loans, however, do not exist, because money received for a long-term loan is treated as a fund balance increase. When long-term loans are repaid, they are treated as expenditures.

12-4. Expenses reduce net assets when resources are consumed in the process of generating revenues.

Expenditures reduce fund balances when resources are acquired; that is, expenditures are associated with reductions in financial resources.

PROBLEMS 12-5. (Modified Accrual Transactions Analysis) 1.

General Fund Assets (A) Cash – $480,000

=

Liabilities (L)

+ Fund Balance (FB) – General Government Expenditure = Salaries Payable – Education Expenditure – $80,000 – Public Works, Safety, & Sanitation Expenditure

General Government Expenditure Education Expenditure Public Works, Safety, & Sanitation Expendenditure Salaries Payable Cash

Dr. $200,000 140,000 60,000 80,000

$200,000 140,000 60,000 Cr.

$480,000

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

12-3

Explanation: to record salary expenditures and payments.

2.

General Fund Assets (A) Inventory $10,000 -$6,000

= Liabilities (L) + Fund Balance (FB) = Accounts Payable – $10,000 – – General Government Expenditure Education Expenditure Public Works, Safety, & Sanitation Expenditure

Dr. $2,000 2,000 2,000 4,000

General Government Expenditure Education Expenditure Public Works, Safety & Sanitation Expenditure Inventory Accounts Payable Explanation: to record acquisition of inventory.

3.

$2,000 2,000 2,000

Cr.

$10,000

General Fund

a.

Assets (A) = Real Estate Tax Receivables = + $300,000

Liabilities (L) Deferred Tax Revenue + $8,000

+

Fund Balance (FB) Real Estate Tax Revenue + $292,000

260,000 collected from this year + 80%  40,000 balance = 292,000. Therefore $8,000 is deferred tax revenue. On an accrual basis the full 300,000 levy would be revenue.

b.

Assets (A) Cash +$280,000

= Liabilities (L) + = No changes on right side.

Fund Balance (FB)

Real Estate Tax Receivables – $280,000

a.

Real Estate Tax Receivables Real Estate Tax Revenues Deferred Tax Revenue

Dr. $300,000

Cr. $292,000 $8,000

Chapter 12: Unique Aspects of Accounting for State and Local Governments – Part I The Recording Process

12-4

Explanation: to record annual real estate tax levy. b.

Cash Real Estate Tax Receivables

$280,000 $280,000

Explanation: to record receipt of real estate taxes.

4.

General Fund

a.

Assets (A) State Grants Receivable + $100,000

b.

Cash +$20,000

= =

Liabilities (L)

+

Fund Balance (FB) State Grants Revenue + $100,000

= No changes on right side.

State Grants Receivable – $20,000

a.

Dr. $100,000

State Grants Receivable State Grant Revenue

Cr. $100,000

Explanation: to record annual state block grants. b.

Cash State Grants Receivable

$20,000 $20,000

Explanation: to record receipt of state aid payments.

5.

General Fund Assets (A) Cash – $70,000

= Liabilities (L) + Fund Balance (FB) = Due to Debt Service Fund Transfer to Debt Service Fund – $10,000 – $60,000 Dr. $60,000 10,000

Transfer to Debt Service Fund Due to Debt Service Fund Cash Explanation: to record transfer and payment to Debt Service Fund.

Cr.

$70,000

Debt Service Fund Assets (A) Cash

= =

Liabilities (L)

+

Fund Balance (FB) Transfer from General Fund

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

12-5

+ $70,000

+ $60,000

Due from General Fund – $10,000 Dr. $70,000

Cash Due from General Fund Transfer from General Fund Explanation: to record transfer and payment from General Fund.

6.

Cr. $10,000 60,000

Capital Projects Fund a.

b.

a.

Assets (A) Cash

= =

Liabilities (L)

+

+ $200,000

Fund Balance (FB) Note Payable—Other Sources of Financing + $200,000

Cash – $200,000

Capital Outlay Expenditure + $200,000

–

Dr. $200,000

Cash Note Payable—Other Sources of Financing

Cr. $200,000

Explanation: to record proceeds of note. b.

Capital Outlay Expenditure Cash

$200,000 $200,000

Explanation: to record acquisition of firetruck

On an accrual basis, one would record an asset and long-term liability.

7.

Debt Service Fund Assets (A) Cash – $38,000

= =

Liabilities (L)

+ –

–

Fund Balance (FB) Interest Expenditure $8,000 Debt Service Principal Expenditure $30,000

Per GASB Statement 34 paragraph 46, interest is generally treated as a separate line item, rather than being included in a function’s expenses. In this case one might argue for inclusion in Public Works, Safety, and Sanitation. However the more typical treatment is used in this solution.

Chapter 12: Unique Aspects of Accounting for State and Local Governments – Part I The Recording Process

Interest Expenditure Debt Service–Principal Expenditure Cash

Dr. $8,000 30,000

Cr.

$38,000

Explanation: to record payment of debt service.

On an accrual basis one would record a liability reduction of $30,000.

12-6

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

12-7

12-6. (Modified Accrual Transactions Analysis Worksheet)1 a. The General Fund Liabilities and Assets

=

Liabilities

Real

Cash

nd Balance Fund Balanc and Changes in Fund Balance

Due to

Estate

State

Taxes

Grants

Receivable

Receivable

Inventory

Debt

Deferred

Accounts

Service

Tax

Salaries

Fund

Payable

Fund

Revenue

Payable

Balance

Beginning Balance $300,000 Transaction # 1

$20,000

$10,000

$0

$0

$16,000

$0

(480,000

Transaction # 2

10,000

$90,000

$224,000

(80,000

(200,000

General Government Expenditures

(140,000 (60,000

Education Expenditures Public Works, Safety & Sanitation Expenditures General Government Expenditures

10,000

(2,000

(6,000)

(2,000

292,000

Education Expenditures Public Works, Safety & Sanitation Expenditures Real Estate Tax Revenues

100,000

State Grant Revenues

(60,000

Transfer to Debt Service Fund

(2,000 Transaction # 3a Transaction # 3b

300,000 280,000

8,000

(280,000

Transaction # 4a

100,000

Transaction # 4b

20,000

Transaction # 5

(70,000

(20,000 (10,000

Transaction # 6a Transaction # 6b Transaction # 7 Ending Balance

$50,000

$40,000

$90,000

$4,000 =

$10,000

$6,000

$8,000

$10,000

$150,000

Due to the implementation of GASB Statement No. 63 in 2012, the modified accrual transactions analysis worksheet should separately report “Deferred Tax Revenues” under “Deferred Inflows of Resources.” Because the new accounting equation for governments is not introduced until Chapter 14, however, the solution provided here is acceptable.

1

Chapter 12: Unique Aspects of Accounting for State and Local Governments – Part I The Recording Process

b.

12-8

The Debt Service Fund Assets = Liabilities Due from General Cash Fund Beginning Balance $ 4,000 $16,000 $ 0 Transaction # 1 Transaction # 2 Transaction # 3 Transaction # 4 Transaction # 5 70,000 (10,000) Transaction # 6 Transaction # 7 (38,000) _ Ending Balance $ 36,000 $ 6,000 = $ 0

Liabilities and Fund Balance Fund Balance and Changes in Fund Balance Fund Balance $ 20,000

60,000 Transfer from General fund (8,000) Interest Expenditure (30,000) Debt Service—Principal Expenditure $ 42,000

c. The Capital Projects Fund

Beginning Balance Transaction # 1 Transaction # 2 Transaction # 3 Transaction # 4 Transaction # 5 Transaction # 6a Transaction # 6b Transaction # 7 Ending Balance

12-7.

Fund Balance $ 0

200,000 (200,000)

200,000 Other Sources of Financing—Note Payable (200,000) Capital Outlay Expenditure

$

1. b. accrual a. modified accrual 2. b. accrual

Liabilities and Fund Balance Fund Balance and Changes in Fund Balance

Assets = Liabilities Due from General Cash Fund $ 0 $ 0 $ 0

0

$

0 =

$

0

$

0

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

12-9

12-8.

1.

Assets Cash $10,000,000

Capital Project Fund

=

Liabilities

+

Cash ($10,000,000)

Fund Balance Other Financing Source: Bond Principal $10,000,000 Capital Outlay Expenditure: Golf Course ($10,000,000)

2.

Assets Cash $5,000,000

Capital Project Fund

=

Liabilities

+

Fund Balance Other Financing Source: Bond Principal $5,000,000

Cash $5,000,000

Transfer from Rainy Day Fund $5,000,000

Cash ($10,000,000)

Capital Outlay Expenditure: Golf Course ($10,000,000)

Assets Cash ($5,000,000)

Rainy Day Fund

=

Liabilities

+

Fund Balance Transfer to Capital Project Fund ($5,000,000)

3. d. $300,000

12-9.

1.

2.

b. decrease cash by $18,000 and increase equipment assets by $18,000. b. increase accumulated depreciation by $3,000 and increase expenses by $3,000.

Chapter 12: Unique Aspects of Accounting for State and Local Governments – Part I The Recording Process

12-10

12-10.

1. _f_ used to track resources earmarked for a specific purpose.

2. _a_ fund used to track resources available to pay interest and loans.

3. _d_ an enterprise or internal service fund 4. _c_ used to designate funds which are obligated under a legal contract 5. _g_ used for routine ordinary activities of government 6. _h_ a type of fiduciary fund.

7. _e_ business-type fund where the services are provided to other units of government.

12-11.

1. b. $67,000 2. b. $3,000 12-12. a. $100,000 b. $90,000 c. $90,000 d. On a full accrual basis, the PTO represents the consumption of resources in the current period and so the entire $100,000 would be recorded as an expense. On a cash basis, only $90,000 of PTO was paid for during the year, so only $90,000 would be recorded as an outflow. On a modified accrual basis, $90,000 was paid out from current financial resources and the remaining $10,000 will not be; hence, the $90,000 is recorded as an expenditure.

13-1

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Chapter 13

UNIQUE ASPECTS OF ACCOUNTING FOR STATE AND LOCAL GOVERNMENTS PART II: REPORTING FINANCIAL RESULTS

QUESTIONS FOR DISCUSSION 13-1. Governmental financial reporting attempts to keep the government accountable for its actions.

An element of accountability is to assure that information is provided that is helpful for making not only economic decisions, but also social and political decisions. Additionally, financial reporting by state and local governments should provide information that allows the user to determine if interperiod equity has been achieved. Interperiod equity refers to whether the government has used revenues from the current period to pay for services provided in the current period.

13-2. Many government bodies prepare an Annual Comprehensive Financial Report (ACFR). Included in that ACFR are the Basic Financial Statements, Management’s Discussion & Analysis (MD&A), and other Required Supplementary Information (RSI) including a budgetary comparison schedule. The information contained in the financial statements must serve not only the needs of lenders and vendors, but of the public as well.

13-3. According to GASB: MD&A should provide an objective and easily readable analysis of the government’s financial activities based on currently known facts, decisions, or conditions. MD&A should include comparisons of the current year to the prior year based on the government-wide information. It should provide an analysis of the government’s overall financial position and results of operations to assist users in assessing whether that financial position has improved or deteriorated as a result of the year’s activities. In addition, it should provide an analysis of significant changes that occur in funds and significant budget variances. It should also describe capital asset and long-term debt activity during the year.

MD&A should conclude with a description of currently known facts, decisions, or conditions that are expected to have a significant effect on financial position or the results of operations.1

1

Governmental Accounting Standards Board, Statement No. 34 of the Governmental Accounting Standards Board, Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments, (Norwalk, Conn.: Financial Accounting Foundation, 1999), Summary.

Chapter 13: Unique Aspects of Accounting for State and Local Governments – Part II: Reporting

13-2

To make the MD&A as useful as possible, the inclusion of graphs, charts, and tables would be appropriate. It is up to the managers who are preparing the document to include the most relevant information and to be creative in providing an MD&A that achieves the goals of the document rather than following a rigid format that might exclude important information.

13-4. Basic Financial Statements include government-wide statements and fund financial statements.

The government-wide statements include a statement of net position and statement of activities.

The governmental fund financial statements include a balance sheet and a statement of revenues, expenditures, and changes in fund balance. The fund financial statements that are required for proprietary funds are a statement of net position; statement of revenues, expenses, and changes in fund net position; and statement of cash flows. The fiduciary fund financial statements are the statement of fiduciary net position and the statement of changes in fiduciary net position. The statements will have notes and also have reconciliations.

13-5. Governments are often complex organizations. There may be housing agencies, school districts, recreational authorities, and so on. The BFS should include not only the primary government but also other entities for which the primary government appoints a voting majority of the governing body and provides financial benefits or burdens. All entities that are included but are not part of the primary government should be reported in the Component Units columns of the financial statements.

13-6. The government-wide funds are prepared on an accrual basis. This provides an entity-wide perspective of the government, using the basis of accounting common to other types of organizations. The proprietary and fiduciary fund financial statements are also reported on an accrual basis. The governmental fund financial statements report on the modified accrual basis.

The budgetary comparison schedule is prepared on the budgetary basis of accounting, which is often the cash basis.

13-7. No, because long-term assets are not recorded under modified accrual accounting. Long term assets are recognized as expenditures when acquired.

Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

13-3

PROBLEM 13-8. (Preparation of Financial Statements) Governmental Funds Balance Sheet Simonsen Village Balance Sheet Governmental Funds As of December 31, 2024 Debt General Service Fund

Fund

Capital Projects

Total Governmental

Fund

Funds

Assets and deferred outflows of resources Cash Real estate taxes receivable, net

$50,000 40,000

State grants receivable

90,000

90,000

Inventory

4,000

4,000

Due from other funds Total assets and deferred outflows of resources

$36,000

$

$86,000 40,000

—

6,000

$184,000

$42,000

$

$226,000

$10,000 10,000 8,000 6,000

$

$

$10,000 10,000 8,000 6,000

6,000

Liabilities, deferred inflows of resources, and fund balances Liabilities and deferred resources: Accounts payable Salaries payable Deferred tax revenue Due to debt service fund

inflows

of

Total liabilities and deferred inflows of resources Fund Balances: Unassigned Total fund balances Total liabilities, deferred inflows of resources, and fund balances

$34,000

$34,000

$150,000 $150,000

$42,000 $42,000

$184,000

$42,000

$192,000 $192,000 $

Chapter 13: Unique Aspects of Accounting for State and Local Governments – Part II: Reporting

13-4

Reconciliation: Amounts reported for governmental activities in the statement of net position are different because: Taxes receivable that are not current financial resources are not included in fund balances above, but are included in net position in the statement of net position.

8,000

Capital assets used in governmental activities are not financial resources and therefore are not reported in the funds.

180,000 Long-term liabilities are not due and payable in the current period and therefore are not reported in the funds.

Net position of governmental activities

(170,000) $210,000

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Governmental Funds Statement of Revenues, Expenditures, and Changes in Fund Balances Simonsen Village Statement of Revenues, Expenditures, and Changes in Fund Balances Governmental Funds for the Year Ended December 31, 2024 Debt Capital General Service Projects Fund Fund Fund Revenues Real estate taxes Intergovernmental—grants Total revenues Expenditures Current: General government Education Public Works, Safety, & Sanitation Debt service: Principal Interest Capital outlay: Total expenditures Excess of revenues over expenditures

$292,000 100,000 $392,000

$292,000 100,000 $392,000

$202,000 142,000 62,000

$202,000 142,000 62,000 $30,000 8,000

Net change in fund balances Fund balances—beginning Fund balances—ending

30,000 8,000 200,000 $644,000

$406,000

$38,000

$200,000 $200,000

($14,000)

($38,000)

($200,000)

($252,000)

$200,000

$200,000

Other Financing Sources (Uses) Proceeds from long-term capital related debt Transfers in Transfers out Total other financing sources and uses

Total Governmental Funds

$60,000 ($60,000) ($60,000)

$60,000

$200,000

60,000 (60,000) $200,000

($74,000) 224,000 $150,000

$22,000 20,000 $42,000

$0 0 $0

($52,000) 244,000 $192,000

Chapter 13: Unique Aspects of Accounting for State and Local Governments – Part II: Reporting

13-6

Reconciliation Simonsen Village Reconciliation of the Statement of Revenues, Expenditures, and Changes in Fund Balances of Governmental Funds to the Statement of Activities for the Year Ended December 31, 2024 Net change in fund balances—total governmental funds

($52,000)

Amounts reported for governmental activities in the statement of activities are different because: 1

2

3

Long-term note proceeds provide current financial resources to governmental funds, but issuing debt increases long-term liabilities in the statement of net position.

Repayment of principal is an expenditure in the governmental funds, but the repayment reduces long-term liabilities in the statement of net position. This is the amount by which proceeds exceeded repayments.

(170,000)

Governmental funds report capital outlays as expenditures. However, in the statement of activities, the cost of those assets is allocated over their estimated useful lives as depreciation expense. This is the amount by which $200,000 capital outlays exceeded the $20,000 depreciation expense in the Public Works department for current period.

180,000

Governmental funds only report revenues if they are measurable and available.

However, in the statement of activities, revenues will be reported even if they do not represent current financial resources. This is the amount that tax revenues on the statement of activities exceed revenues in the governmental funds.

Change in net position of governmental activities

8,000

($34,000)

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Government-wide Statement of Net Position Simonsen Village Statement of Net Position December 31, 2024 Primary Government Governmental Activities

Total

Assets: Cash Real estate taxes receivable (net) State grants receivable Inventories Capital assets, net Total Assets

$86,000 40,000 90,000 4,000 180,000 $400,000

$86,000 40,000 90,000 4,000 180,000 $400,000

Liabilities: Accounts payable Salaries payable Long-term notes Total Liabilities

$10,000 10,000 170,000 $190,000

$10,000 10,000 170,000 $190,000

Net Position Net investment in capital assets

$10,000

$10,000

42,000 158,000 $210,000

42,000 158,000 $210,000

Restricted for: Debt service Unrestricted Total Net Position

Chapter 13: Unique Aspects of Accounting for State and Local Governments – Part II: Reporting

13-8

Government-wide Statement of Activities Simonsen Village Statement of Activities December 31, 2024 Program Revenues

Net (Expense) Revenue and Changes In Net Position Primary Government

Expenses Functions Primary government Governmental activities General government Education Public works, safety, & san.

Interest on long-term debt Total governmental activities Business-type activities Total business-type activities Total primary government Component units None

Operating

Capital

Charges

Grants and

Grants and

Govern-

Business-

for

Contribu-

Contribu-

mental

type

Services

tions

tions

Activities

Activities

$202,000 142,000 82,000 8,000 $434,000

$0 0 0 0 $0

$0 0 0 0 $0

$0 0 0 0 $0

$0 $434,000

$0 $0

$0 $0

$0 $0

Component Total

($202,000) (142,000) (82,000) (8,000) ($434,000)

($202,000) (142,000) (82,000) (8,000) ($434,000)

($434,000)

$0 ($434,000)

General revenues—real estate tax

$300,000

$300,000

General revenues—State grants Total general revenues and special items Change in net position

100,000 $400,000 (34,000)

100,000 $400,000 (34,000)

Units

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Net position—beginning Net position—ending

Note that Public Works Expense includes $20,000 of depreciation on the firetruck.

244,000 $210,000

244,000 $210,000

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Chapter 14

FINANCIAL STATEMENT ANALYSIS

QUESTIONS FOR DISCUSSION 14-1. The CPA issues an opinion letter, providing expert opinion about whether the financial statements provide a fair representation of the organization’s financial position and the results of its operations in accordance with GAAP. As an outsider, the auditor provides an independent review of the financial statements. The discovery of fraud is an occasional by-product, but is not the primary focus of the audit.

One of the major functions of an audit is to review systems. It is too expensive to review every single transaction and find every error that has been made. Instead, auditors use sampling of transactions to determine how often errors are occurring and how large they tend to be. If an unacceptable level of errors is occurring, the auditor works with the organization to improve its internal control systems to try to prevent errors and fraud.

14-2. The first paragraph of the audit letter points out that although the auditor can provide an expert opinion, management holds primary responsibility for the contents of the financial statements. In some organizations, the auditors, in practice, provide a substantial amount of help in compiling the financial statements. It is important for managers to bear in mind that if there are later problems with the information contained in the financial statements, it is the organization’s management, rather than the auditors, who bear the primary responsibility for their content.

14-3. The first, introductory, paragraph explains what type of work was done by the auditor and provides a disclaimer. The paragraph indicates that an audit was performed and the specific financial statements that were included in the audit process. It also indicates that the organization’s management holds primary responsibility for the contents of the financial statements.

The second, scope, paragraph of the audit letter explains the type of work the auditor did. It tries to make clear the fact that not every transaction was examined and that immaterial errors are not necessarily found and corrected.

The third, opinion, paragraph gives the auditor’s opinion or whether or not the financial statements provide a fair representation of the financial position, results of operations, and cash flows of the organization, in accordance with GAAP. 14-4. When routine operating activities generate a surplus of cash, the organization is more financially stable and viable than if they consume more cash than they generate. It is preferable for cash decreases to result from either repayment of loans or purchases of investments.

Chapter 14: Financial Statement Analysis

14-2

14-5. Financial statements, in themselves, do not provide a complete picture of the organization’s finances. Financial statements are limited in their ability to convey information. For example, fixed assets are recorded based on their historical cost, adjusted for depreciation. Therefore, the balance sheet does not convey the value of the fixed assets. Inventory may be valued on the financial statements based on a LIFO (last-in, first-out), FIFO (first-in, first-out), or weighted average cost assumption. There may be commitments to make lease payments or there may be outstanding lawsuits. There are many types of information that do not fit neatly into the financial statements, but are needed for the financial statements taken as a whole to provide the user with a fair representation of the organization’s finances.

Given the wide range of possible ways to report information, it is vital to examine the notes in order to gain an understanding of which choices were made and the likely impact of those choices. A good understanding of financial position and results requires more information than the financial statements themselves can convey. For example, “what contingent liabilities are there and are they material in amount? How old are the organization’s buildings and equipment?”

14-6. Ratios are used because the comparison between two numbers generates information that is more useful than either or both of the numbers separately. Ratios can be grouped in a variety of different ways. The chapter grouped them into the following six principal types: (1) common size (2) liquidity (3) asset turnover (4) leverage (5) coverage, and (6) profitability.

A common size ratio compares all the numbers on a financial statement to one key number.

For example, each asset on the balance sheet is compared to total assets. One of the difficult aspects of comparing different organizations is that they may be substantially different in size. A common size ratio attempts to make the numbers on the financial statement more comparable by stating them terms of a key number such as total assets or total revenue.

Liquidity ratios focus on whether the organization has enough cash and other liquid resources to meet its obligations in the near term. At the same time, we can use liquidity ratios to assess whether the organization is wastefully maintaining too much liquidity. If liquidity is excessive, long-term investments with high relevance to the organization’s mission and perhaps high profit potential may be lost.

A set of ratios called asset turnover ratios (sometimes called efficiency ratios) can help assure that resources are being used efficiently. The ratios in this category are related to timely collection of receivables, appropriateness of inventory levels, and appropriate amounts of fixed assets and total assets.

Leverage refers to the extent to which an organization supports its activities by using debt.

The greater the debt, the riskier the organization becomes. In contrast to the liquidity ratios, which seek to assess short-term risk, the leverage ratios provide insight into the ability of the organization to meet its long-term obligations.

Some would argue that coverage ratios are even more critical. They examine the organization’s capacity to make debt service payments (interest and/or principal) as they come due.

Virtually all organizations need to earn a profit to be financially healthy—to be able to replace equipment, acquire new technologies, and expand services and to be able to meet the challenges of the future. At the same time, it might be inappropriate for many not-for-profit organizations to make an excessive profit. Profitability ratios can help the manager and outside users assess whether the organization is making an adequate, but not excessive, profit.

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Ratio analysis is a field that was developed primarily to serve for-profit organizations.

Managers in public service organizations should be pro-active in developing additional useful ratios. For example, the not-for-profit industry in recent years has started to actively report the program services ratio.

14-7. 1. Review of the auditor’s opinion letter 2. Review of the financial statements 3. Review of the notes that accompany the financial statements 4. Calculation and review of ratios with comparisons to the industry and other specific organizations 5. Overall assessment of the financial status of the organization being reviewed 14-8.

To get a sense of the implication of a ratio we need to make comparisons. We can compare a ratio to the same ratio for the organization at different points in time, to close competitors, or to the industry. By looking for points of comparison, the organization can determine benchmark standards that it wants to use as targets or goals.

14-9. Although ratios are powerful analytical tools, they do have certain weaknesses. These fall into four major categories. First, no one ratio is adequate. Second, ratios are generally drawn from financial statement information, which is subject to many GAAP imposed limitations. Third, one should not become overly concerned with the precise value of a ratio. And finally, one cannot assume that we desire to maximize or minimize the value of the ratio.

Ratio analysis requires a mosaic approach. When one looks at a picture made up of individual mosaic tiles, you cannot really learn anything about the picture from looking at one tile. If the tile is blue, it could be sky, water, or almost anything else. Similarly with ratios, a value for a ratio means little by itself. For example, the current ratio may be very high. This would seem to imply robust financial health. However, often a failing organization will sell off its fixed assets in desperation to raise money to pay its creditors. As of the moment the ratio is calculated, current assets may be high. However, ongoing losses may soon wipe out the liquid resources. One must look at the entire picture to get a more realistic understanding of the organization’s financial situation.

Ratios are often generated by using numbers for the audited financial statements. However, we know that financial statement data is limited. For example, fixed assets are reported at historical cost, adjusted for depreciation.

We can calculate ratios to many decimal places. In the current ratio calculated in the chapter for Save the Children, the true ratio value is 2.385294. Is that a useful number? Do you know more or less about Save the Children if you use the full number shown here, or if you simply know that Save the Children has about $2.39 of current assets for every dollar of current liabilities? In other words, don’t become overly concerned with the exactness of the ratio’s value.

When we look at ratios, it would simplify analysis if a particular ratio could be as low as possible, or as high as possible. A problem with that desire is the fact that many times ratios need to be somewhere in between. If a current ratio is too low, it implies that the organization may not be able to meet its obligations. That would be a sign of weak financial status. On the other hand, if the ratio is very high, then an unduly large amount of resources are being tied up in current assets.

Chapter 14: Financial Statement Analysis

14-4

A final note of caution relates to the specific definitions of ratios. Not everyone calculates ratios using the same definitions.

14-10.

1. Does LFC have an endowment? How do you know?

It is unclear from the financial statements alone. LFC’s Statements of Financial Position report net assets without donor restrictions and also net assets with donor restrictions. Without the notes to the financial statements, though, we cannot ascertain whether these restrictions are permanent or not.

2. How much of LFC’s net assets with donor restrictions were reclassified as without donor restrictions in 2024? Where can this be found in the Statements of Financial Position and Statements of Activities? $274,016 in net assets with donor restrictions were reclassified as without donor restrictions in 2024. On the Statements of Financial Position, this is shown in the decline in net assets with donor restrictions from 2023 ($538,530) to 2024 ($264,514) in the amount of $274,016. On the Statements of Activities, this is also shown as “Net assets released from restrictions.”

3. Calculate the four profitability ratios presented in Chapter 14 for LFC for 2024 and 2023, as well as the percent change in each from 2023 to 2024. By which measure did LFC’s deteriorate the most, and by how much?

Profitability Ratios Return on Net Assets = Change in Net Assets Net Assets Return on Assets = Change in Net Assets Assets Operating Margin = Change in NA w/o Donor Restrictions Revenue & Other Support w/o Donor Restrictions Total Margin =

Change in Net Assets Revenue & Other Support w/o Donor Restrictions

2024

Ratio

(680,212) 9,042,44 8

-7.52%

(680,212) 10,339,0 98

-6.58%

(406,196)

4,129,254

Ratio

% Change

42.47%

-117.71%

40.54%

-116.23%

73.88%

-113.92%

51.65%

-133.33%

9,722,660 4,129,254 10,184,708 -10.28%

3,950,70 6 (680,212) 3,950,70 6

2023

5,905,832 7,993,932

-17.22%

4,129,254 7,993,932

The Total Margin, by -133.33%.

4. LFC’s total expenses grew by over 100 percent from 2023 to 2024, while its total revenue and other support declined by over 50 percent. Looking at the theater’s Statements of Activities:

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

a. Excluding interest/investment income and the one-time sale of tax credits, which three revenue or support categories declined by over 50% from 2023 to 2024?

Special events, grants, and contributions b. Which expense category grew by over 100 percent?

Program services 5. Calculate LFC’s program services ratio for 2024 and 2023 as well as the percent change from 2023 to 2024. Is LFC’s program services ratio for 2024 higher than the commonly accepted benchmark?

Program Services Ratio

2024

Program Services = Program Service Expenses Total Expenses

Ratio

3,640,634 4,356,902

2023

Ratio

% Change

66.02%

26.58%

1,378,472 83.56%

2,088,100

Yes, LFC’s program services ratio exceeds 75 percent.

6. Given your answers to question 4 and 5 above, would you recommend that LFC reallocate some of its spending from program services to fund raising in 2025? Why or why not?

Yes, because while special events revenue, grants, and contributions declined from 2023 to 2024, program services expenses increased, increasing the program services ratio by more than 25 percent from just over 66 percent to over 83 percent. Because LFC’s program services ratio exceeds the commonly accepted benchmark, it can reallocate some of its spending to fund raising in an effort to increase special events revenue, grants, and contributions in 2025.

7. What was LFC’s depreciation expense in 2023 and 2024? Which financial statement(s) provide this information? $107,900 in 2023, and $624,356 in 2024. This information is provided in the Statements of Cash Flows. It is also disclosed in the Analysis of Expenses by Nature and Type.

8. Now that receivables constitute a much larger proportion of LFC’s assets than in the past, the Executive Director has asked you to calculate the receivables turnover ratio and average collection period for 2024. a. Which revenue items will you exclude from the ratio? Why?

Chapter 14: Financial Statement Analysis

14-6

Theater admissions, Concession and café sales, and Memberships are excluded because they are cash sales. b. What is LFC’s receivables turnover ratio and average collection period for 2024? Are they favorable or unfavorable? Why?

Turnover Ratios

2024

Receivables Turnover = Revenue & Support w/o Donor Restrictions Average Collection Period =

Ratio

1,599,762 2.67

Total Receivables

598,868

365

365

Receivables Turnover

2.67

136.64

Unfavorable, as LFC’s average collection period is far greater than the typical 30-60 day range. c. Would you recommend recalculating the receivables turnover ratio using the average of beginning-of-year and end-of-year receivables in the denominator? Why or why not?

Yes, because it may be the case that the substantial increase in grants receivable in 2024 overstates the typical level of total receivables for LFC. 9. Calculate the quick ratio and debt to equity ratio for LFC for 2024 and 2023, as well as the percent change in each from 2024 to 2023. Are these trends favorable or unfavorable?

Which presents the greater area of concern for 2024, and why?

Liquidity and Leverage Ratios

2024

Quick Ratio = Cash + Short-term Investments + Current Receivables

674,450

Current Liabilities

Ratio

1,296,650

Total Net Assets

9,042,448

Ratio

% Change

0.94

-42.92%

0.05

201.74%

350,144 0.54 373,410

1,260,054

Debt to Equity = Total Liabilities

2023

0.14

462,048 9,722,660

These trends are unfavorable, as LFC became both less liquid and more highly leveraged from 2023 to 2024. However, liquidity is a greater area of concern, as the quick ratio changed from just under the commonly accepted benchmark of 1.0 to just 0.54, a decline of over 40 percent. Despite LFC’s 200 percent increase in debt to equity, the ratio of 0.14 remains well below the commonly accepted benchmark of 1.0.

10. Given your answers to the questions above and an overall review of LFC’s financial statements, would you characterize LFC’s financial position as weak, neutral, or strong?

Why?

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

There are many possible answers to this question. LFC’s profitability declined greatly from 2023 to 2024, and this was driven by a substantial decline in revenue and other support in combination with a substantial increase in expenses. At the same time, LFC’s total assets remained fairly constant between 2023 and 2024, while its total liabilities more than tripled and its total net assets declined considerably. Though LFC is not highly leveraged, its liquidity position has declined to just half of the commonly accepted benchmark. The Statements of Cash Flows further reveal that whereas LFC’s operating activities contributed a net of nearly $6 million in cash in 2023, they absorbed a net of $227,842 in 2023, while the theater also took on a net increase in debt in the form of a line of credit. Because LFC’s program services ratio is greater than the commonly accepted benchmark, the theater has the opportunity to focus on fund raising in 2025 in the hopes that it can garner grants and contributions at 2023 levels or greater. In its current state, however, LFC’s financial position is weak.

14-11. (Financial Statement Analysis)

Chapter 14: Financial Statement Analysis

14-8

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

PART A continued CODE 4 CHANGE Statements ofActivities Common Size Ratios December 30, 2024 % $

December 30, 2023 % $

SUPPORT AND REVENUE: Contributions Contributions of charitable gift annuities Bequests Investment income — net

59.96% 4,771,172 3.03% 241,245 27.38% 2,178,924 9.63% 766,580

7.44% 2,654,400 0.50% 178,626 90.98% 32,436,803 1.08% 384,670

Total support and revenue

100.00% 7,957,921

100.00% 35,654,499

EXPENSES: Program services Management and general Fundraising

76.07% 6,053,675 1.08% 85,933 2.25% 179,277

97.48% 34,754,236 0.21% 75,499 0.47% 168,316

Total expenses

79.40% 6,318,885

98.16% 34,998,051

CHANGE IN NET ASSETS BEFORE CHANGE IN UNREALIZED APPRECIATION OF INVESTMENTS

20.60% 1,639,036

1.84%

656,448

CHANGE IN UNREALIZED APPRECIATION OF INVESTMENTS

4.08%

324,779

1.20%

428,159

CHANGE IN NET ASSETS

24.68% 1,963,815

3.04%

1,084,607

NET ASSETS — Beginning of year

91.51% 7,282,098

17.38%

6,197,491

NET ASSETS — End of year

116.19% 9,245,913

20.42%

7,282,098

Chapter 14: Financial Statement Analysis

14-10

2024

2023

$2,360,882 --------------------$4,059,893

$1,480,774 -----------------$3,851,715

0.58

0.38

$1,909,606 --------------------$17,312

$1,044,193 -----------------$95,885

110.31

10.89

$4,059,893 --------------$13,305,806

$3,851,715 --------------$11,133,813

Part B Current Ratio

Current Assets -----------------------Current Liabilities =

Part C Days Cash on Hand

Cash + Short-term Investments -----------------------(Operating Expense - Deprec.)/365 =

Part D Debt Ratio

Total Debt ----------------Total Assets =

0.31 or

0.35 or

30.51%

34.59%

$4,059,893 --------------$9,245,913

$3,851,715 --------------$7,282,098

Part E Debt to Equity

Total Debt ----------------Total Net Assets =

0.44 or

0.53 or

43.91%

52.89%

$1,963,815 --------------$7,957,921

$1,084,607 --------------$35,654,499

Part F Total margin

Increase in Net Assets ----------------Total Operating Revenues =

0.25 or

0.03 or

24.68%

3.04%

$6,053,675 --------------$6,318,885

$34,754,236 --------------$34,998,051

Part G Program Services

Program Service Expense ----------------Total Expense =

0.96 or

0.99 or

95.80%

99.30%

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

Chapter 15

FINANCIAL CONDITION ANALYSIS

QUESTIONS FOR DISCUSSION 15-1. Berne has defined financial condition as “the probability that a government will meet both (a) its financial obligations to creditors, consumers, employees, taxpayers, suppliers, constituents, and others as they become due and (b) the service obligations to constituents, both currently and in the future.”1 The ACFR with its Basic Financial Statements (BFS), auditor’s report, Management’s Discussion & Analysis, and other Required Supplementary Information (RSI) is an excellent source of information for financial condition analysis.

The BFS discloses details on revenues, expenses/expenditures, net assets/fund balances, assets, and liabilities, and the notes further explain items such as pensions. The RSI presents budgetary and economic and demographic information as well as trends in revenues.

Berne has indicated with respect to financial condition analysis that “there is considerable agreement over its major components, including the economy and demographics, revenue base, revenues, current and capital expenditures, debt, pensions, internal resources, management capabilities, infrastructure, willingness to raise revenues to provide necessary public services, and idiosyncratic factors. Comparative analysis is the dominant measurement methodology, which includes time series analyses, comparisons with other jurisdictions, and, occasionally, comparisons with industry standards.”2 15-2. The reason that financial condition differs from financial statement analysis is that many external factors become part of the evaluation of financial health for a governmental body. The wealth of the citizenry, the employment rate, and the general economy are all critical factors.

Also, the use of fund accounting by governments substantially increases complexity in the analysis of financial health. For example, should ratios be computed based solely on the general fund, or based on the governmentwide financial statements as well?

15-3. Some degree of creativity in data collection is clearly required. However, much data is available from public sources. For example, population statistics can be obtained from the U.S. Census Bureau; per capita personal income by city and retail sales by city can be obtained from the U.S. Department of Commerce, Bureau of Economic Analysis; and the U.S. Department of Labor, Bureau of Labor Statistics issues reports on employment rates. And, of course, many governments issue ACFRs.

1

2

Robert Berne, The Relationships between Financial Reporting and the Measurement of Financial Condition, (Norwalk, Conn.: Government Accounting Standards Board, 1992), vii.

Ibid., xvi.

Chapter 15: Financial Condition Analysis

15-2

15-4. Bowman and Calia argue that it makes sense to employ five tests to evaluate the quality of reporting. These are the use of GAAP for financial statements, use of GAAP for budgeting, use of a ACFR (annual comprehensive financial report) format, receipt of an unqualified3 CPA audit opinion, and timeliness of information (issuance of ACFR within six months of fiscal year-end).4 15-5. A problem that must be addressed is determination of which information to use in calculating ratios. Which columns should be used? Which statements should be used? It is extremely critical to consider why the analysis is being performed. The analyst must carefully consider the question at hand and which statements and which columns in the statements provide the best information to address that question.

15-6. Liquidity ratios are quite applicable to governmental financial condition analysis. Many of the standard liquidity ratios can be calculated for governments, even though current assets and current liabilities will not always be clearly segregated.

15-7. No. Even with accrual based governmentwide statements, the use of leverage and coverage ratios has limitations. Most governments are not able to sell their infrastructure or many other key long-term assets to meet their obligations. One might argue that the government’s ability to repay debt rests less in its assets and more in its ability to tax and borrow resources to pay obligations as they come due.

15-8. To focus on longer term solvency of governments, analysts frequently consider per capita debt, debt as a percentage of full value of property, or debt service expenditures as a percentage of total expenditures or revenues.

15-9.

Total general revenues, contributions, special items, and transfers Capital assets, net Total general revenues, contributions, special items, and transfers Total asset turnover = Total assets

Fixed asset turnover =

Analysts might differ on what to include in these asset turnover ratios. Some would argue that the assets of the government are used to support all of its functions. Therefore, the revenues directly associated with those functions should be included. The ratio could therefore include not only total general revenues, contributions, special items, and transfers in the numerator, but also the charges for services and operating and capital grant and contribution revenues from the top part of the statement of activities. Others might argue that special items are often unusual and cannot be expected to recur. Therefore, they should be excluded from the numerator. These create reasonable alternatives to the ratios as defined above.

3

4

As opposed to a qualified opinion. A qualified opinion expresses some problem with the financial statements that requires particular attention by the reader.

Woods Bowman and Roland Calia, Evaluating Local Government Financial Health: Executive Summary, (Chicago, Ill.: The Civic Federation, 1997), 3.

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

PROBLEMS 15-10. (Common Size Ratios)

Chapter 15: Financial Condition Analysis

15-4

15-11. (Current Ratio)

15-12. (Solvency Ratio) There are two possible interpretations for this exercise. One approach would include solely the noncurrent liabilities, whereas the other would include the current portion of the long-term debt as well.

($9,563,600 + $110,449,256) / $147,660,052 =

0.81

$110,449,256 / $147,660,052

0.75

15-13 (Interest Coverage Ratio)

=

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Instructor’s Manual for Financial Management for Public, Health, and Not-for-Profit Organizations, 7E

15-14 (Pension Analysis)

Funded Ratio

Benefits Coverage

Investment Earnings

Plan Fiduciary Net Position Total Pension Liability

Plan Fiduciary Net Position Total Benefits and Refunds

Net Investment Income Total Benefits and Refunds

2022

2021

145,117,814 153,390,284

136,363,265 150,405,544

94.61%

90.66%

145,117,814 10,740,272

136,363,265 9,240,901

13.51

14.76

15,194,567 10,740,272

2,412,908 9,240,901

141.47%

26.11%

The funded ratio is above the benchmark. The benefits coverage ratio is below benchmark, but is close. Investment earnings in 2022 were above benchmark, but below the prior year.

Both funded ratio and investment earnings improved.

Pension fund is still underfunded, and investment earnings may be volatile. Exposes plan sponsor to potential increased funding needs.