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What is a Fund Balance? A Comprehensive Guide

A fund balance represents the net worth of a governmental fund at a specific point in time. Think of it as the difference between a governmental fund’s assets and its liabilities; essentially, it’s the residual equity available to finance future services. Unlike the concept of retained earnings in the for-profit world, a fund balance is specific to governmental accounting and represents resources that are legally restricted, committed, assigned, or unassigned for future use.

Understanding Fund Balance Classifications

Fund balances aren’t a monolithic block of available cash. Instead, they’re classified according to the level of constraint placed upon their use. This classification system is critical for understanding a government’s financial health and its flexibility in responding to future needs. The Governmental Accounting Standards Board (GASB) has established a hierarchy for these classifications, which provides a standardized way to report fund balances. This makes it easier to compare the financial health of different government entities. Let’s delve into these classifications in more detail:

Nonspendable Fund Balance

This category includes amounts that are not in a spendable form or are legally or contractually required to be maintained intact. Examples include:

Inventories: Physical goods held for consumption, such as supplies.
Prepaid Items: Payments made for services or goods that will be received in the future, such as insurance premiums.
Permanent Fund Principal: The original principal of a permanent fund, which must be maintained intact, with only the earnings being spendable.

Essentially, these assets are not readily available to be spent on the government’s day-to-day operations.

Spendable Fund Balance

This category is broken down further into restricted, committed, assigned, and unassigned classifications, each indicating a different level of constraint on how the funds can be used.

Restricted Fund Balance

Restricted fund balances are subject to externally enforceable limitations on their use. These limitations can arise from:

Constitutional Provisions: State constitutional requirements specifying how certain revenues must be used.
Enabling Legislation: Laws passed by a legislative body that mandate the use of funds for a specific purpose.
Grantors: External funding sources, such as federal or state grants, that specify how the funds can be spent.
Creditors: Debt agreements that require funds to be used for debt service or other specific purposes.

These restrictions provide the highest level of constraint outside the nonspendable classification, since the government does not have flexibility regarding these funds.

Committed Fund Balance

Committed fund balances represent amounts that are constrained for specific purposes, but unlike restricted funds, these constraints are internally imposed by the government itself. The key characteristic of a committed fund balance is that the commitment must be made by the government’s highest level of decision-making authority, typically the governing body (e.g., a city council or a board of supervisors).

The commitment must be formalized through a resolution or ordinance, and the funds can only be used for the specified purpose unless a similar action is taken to remove or change the commitment.
Example: A city council passes a resolution dedicating a certain amount of money for a future park improvement project.

Assigned Fund Balance

Assigned fund balances represent amounts that the government intends to use for a specific purpose, but the constraints are not as formal as those imposed on committed funds. These assignments are typically made by a body or official who has been delegated the authority to do so by the governing body.

This level of fund balance provides more flexibility than committed funds. An assignment signifies an intended use, but that intent can be easily modified by the designated authority.
Example: The finance director assigns a portion of the general fund balance to cover potential budget shortfalls in the upcoming fiscal year.

Unassigned Fund Balance

The unassigned fund balance is the residual classification for the general fund. It represents the portion of the fund balance that has not been classified as nonspendable, restricted, committed, or assigned. This is the most flexible portion of the fund balance, and it is available for any legally permissible purpose.

Only the general fund can report a positive unassigned fund balance. Other governmental funds can only report an unassigned fund balance if expenditures exceed the amounts restricted, committed, and assigned for those purposes.
This component is usually available to address unanticipated budget shortfalls or non-recurring expenditures.

Importance of Fund Balance Management

Effective fund balance management is crucial for the financial health and stability of any governmental entity. A healthy fund balance can:

Provide a cushion against unexpected revenue shortfalls or unforeseen expenditures.
Improve bond ratings, reducing borrowing costs.
Demonstrate fiscal responsibility to taxpayers.
Allow the government to fund capital projects without relying solely on debt.

Poor fund balance management, on the other hand, can lead to:

Budget deficits and financial instability.
Lower bond ratings and higher borrowing costs.
A loss of public trust.
Difficulty in responding to emergencies or unexpected events.

Fund Balance: Frequently Asked Questions (FAQs)

Here are some frequently asked questions about fund balances, designed to clarify key concepts and address common misconceptions:

1. How does fund balance differ from retained earnings?

Retained earnings are an equity account used in for-profit accounting, representing the accumulated profits of a company that have not been distributed to shareholders. Fund balance, on the other hand, is specific to governmental accounting and represents the difference between a governmental fund’s assets and liabilities, classified based on the constraints placed on its use. Fund balance emphasizes the restrictions and intended uses of governmental resources, while retained earnings reflect accumulated profitability.

2. What is a “rainy day fund” and how does it relate to fund balance?

A “rainy day fund” is a common term for a reserve set aside to cover unexpected expenses or revenue shortfalls. In governmental accounting, a rainy day fund is typically reflected within the committed or assigned fund balance classifications. The specific classification depends on the level of formality in establishing the fund (a resolution would be a commitment, while a budgetary designation would be an assignment).

3. What are some examples of restrictions on fund balance?

Restrictions on fund balance can arise from various sources. Common examples include:

Grant agreements: A federal grant that specifies how the funds must be used for a particular program.
Debt covenants: Agreements with bondholders that require funds to be used for debt service.
State constitutional provisions: Requirements that dedicated tax revenues be used for specific purposes, such as education or transportation.

4. How does the general fund relate to fund balance?

The general fund is the primary operating fund of a government, used to account for most of its day-to-day activities. The unassigned fund balance is a component of the general fund, representing resources that are available for any legally permissible purpose. A healthy unassigned fund balance in the general fund is a key indicator of a government’s financial stability.

5. What is the difference between a fund balance “commitment” and an “assignment”?

A commitment is a formal constraint on the use of funds, established by the government’s highest level of decision-making authority (e.g., the city council) through a resolution or ordinance. An assignment, on the other hand, is an intended use of funds that is designated by a body or official with delegated authority. Commitments are more binding and require a similar formal action to remove, while assignments are more flexible and can be easily modified.

6. How can a government increase its fund balance?

A government can increase its fund balance by:

Generating surplus revenues: Collecting more revenue than it spends in a fiscal year.
Reducing expenditures: Cutting costs and operating more efficiently.
Transferring funds from other funds: In some cases, funds can be transferred from other funds to the general fund, increasing its fund balance.

7. What are the dangers of having a negative fund balance?

A negative fund balance indicates that a governmental fund has more liabilities than assets. This can lead to:

Cash flow problems: Difficulty paying bills on time.
Increased borrowing costs: Higher interest rates on debt.
Potential for a fiscal crisis: Inability to meet financial obligations.

8. How is fund balance reported in a government’s financial statements?

Fund balance is reported in the fund financial statements of a government’s comprehensive annual financial report (CAFR). The fund balance section of the balance sheet presents the different classifications (nonspendable, restricted, committed, assigned, and unassigned) for each governmental fund.

9. Why is it important to monitor fund balance regularly?

Regular monitoring of fund balance allows governments to:

Track their financial health and stability.
Identify potential problems early on.
Make informed decisions about budgeting and spending.
Ensure compliance with legal and contractual requirements.

10. What role does the budget play in managing fund balance?

The budget is a critical tool for managing fund balance. By carefully planning revenues and expenditures, governments can ensure that they generate sufficient resources to maintain a healthy fund balance. A well-managed budget includes strategies for addressing potential revenue shortfalls and controlling spending.

11. Can a government use restricted funds for any purpose?

No, restricted funds can only be used for the specific purpose(s) for which they are restricted. Using restricted funds for other purposes would violate the legal or contractual requirements that govern their use.

12. What are some best practices for fund balance management?

Some best practices for fund balance management include:

Establishing a fund balance policy: This policy should outline the government’s goals for fund balance, including target levels for each classification.
Developing a multi-year financial plan: This plan should project revenues and expenditures over a longer period of time, allowing the government to anticipate future financial challenges and opportunities.
Monitoring fund balance regularly: Tracking fund balance throughout the year and taking corrective action as needed.
Communicating with stakeholders: Keeping the public informed about the government’s financial health and fund balance management strategies.

By understanding the nuances of fund balance and implementing sound management practices, governmental entities can ensure their financial stability and effectively serve their citizens.