Assessing municipal credits

Assessing Municipal Credits

William P. Kittredge, Ph.D.Research Director

Center for the Study of Capital Markets

DOI: 10.13140/RG.2.1.3209.8168

“If to do were as easy as to know what were good to do, chapels had been churches, and poor

men's cottage princes' palaces.

-William Shakespeare

Today’s Agenda Context Definitions Municipal Bonds and the Bond

Market Credit Ratings Local Government Accounting Financial Condition Analysis

ContextWhere Does Financing Fit?

Strategic Plan

Asset Management PlanCapital

Improvement Plan

Lifecycle Cost Analysis

Priorities

Capital Budget

Financing Options

Debt Financing

Current Revenues

Capital Inventory

Physical Inventory

Condition Assessment

Capital Maintenance Plan

ContextCapital Inventory

Physical inventory

Condition assessment

Government Accounting Standards Board (GASB) Statement 34 (S34)

ContextCapital Improvement Plan

Identify capital needs for next 4-6 years Separate one-time from recurring capital

projects (e.g. capital maintenance) Use realistic assumptions Reconcile to annual budget Update annually Fund the Plan

Example: Onondoga County, NY

ContextCapital Improvement Funding

Options Grants Capital contributions Subsidized loans Current own source revenues (pay-as-

you-go)

Joint Ventures Privatization

Debt Issuance

Definitions ‘Municipal Bonds’

Functional definition NYS legal definition

Functionally, refers to all agreements used to acquire capital goods that commit the borrower’s resources over time Used generically to refer to bonds, notes,

leases, and sundry complex instruments Municipal credits

NYS DefinitionsObligations

The term "obligations" shall mean bonds or notes and only “obligations” constitute “indebtedness”.

“Every municipality, school district and district corporation shall pledge its faith and credit for the payment of all indebtedness contracted by it.”

NYS Definitions Local Debt Limits

“No county, city, town, village or school district in a city shall contract indebtedness for any purpose or in any manner which, including existing indebtedness, shall exceed an amount equal to the following percentages of the average full valuation of such county, city, town, village or school district”.

NYS DefinitionsLocal Debt Limits

“Any county, other than the county of Nassau, for county purposes, seven per centum;

Any city, other than the city of New York, having one hundred twenty-five thousand or more inhabitants … for city purposes; nine per centum;

Any city having less than one hundred twenty-five thousand inhabitants …, for city purposes, excluding education purposes, seven per centum;

Any town, for town purposes, seven per centum;

Any village, for village purposes, seven per centum;

NYS DefinitionsLocal Debt Limits

The term "average full valuation" shall mean the valuation of taxable real estate … which is derived by dividing the assessed valuations of taxable real estate on the last completed and the four preceding assessment rolls by the equalization rates …”

A 5 year rolling average

NYS DefinitionsEqualization Rate

An equalization rate is a ratio of the locally determined assessed value of taxable real property to the Office of Real Property Office's estimate of market value.


Equalization rates are New York State’s independent measure of each municipality’s level of assessment.

For example, an equalization rate of 50 indicates that a town’s total assessed value of all real property is 50% of the town’s full (market) value determined for a specified date.


The state’s responsibility for “equalizing” local property assessments to a common full (market) value is important because the full values are used for a variety of purposes.


These include the allocation of various state-aid programs, the fair apportionment of county and school property taxes, and the determination of tax and debt limits for local governments.

One of the most important uses of the equalization rate is to apportion the tax burden among municipalities that are in the same school district.

NYS Definitions“Periods of Probable

Usefulness” “A municipality, school district or

district corporation may not contract indebtedness for any object or purpose for a period longer than the period of probable usefulness…”

NYS Definitions“Periods of Probable

Usefulness” Water and Wastewater Systems

40 years for “acquisition, construction or reconstruction of or addition”

20 years for water meter purchase and installation

10 years for voting machines

30 years for single story school buildings outside a city

20 years for brownfield remediation in the City of Buffalo

Definitions We will use ‘municipal bonds’ in the

more inclusive and generally accepted sense to include all municipal credits.

Although the technical difference under NYS law is the province of the bond counsel, it is important to an understanding of the issuer’s context.

Municipal BondsSecurity Classes

Notes General obligation bonds Revenue bonds

True revenue bonds Sophisticated instruments

Capital leases Certificates of participation

Special assessment bonds

Notes Short-term (less than 1 year)

Issued in anticipation of: Tax revenues Grant funds Bond proceeds

NotesManaging Cash Flow

Operating cash flow notes Tax anticipation notes (TANs) Revenue anticipation notes (RANs) TRANs

Capital project interim financing notes Bond anticipation notes (BANs) May not be issued without bond issuance authority

Grant anticipation notes Grant anticipation notes (GANs) May be issued for either operating or capital

purposes

Bonds Long-term obligations

Limited by useful life in NYS

Two broad categories General obligation (GO) Revenue While still used by the industry and U.S. Census, two

categories, in my opinion, no longer comprehensively describe the varieties of municipal bonds

Bonds are typically sold in $5000 dominations or multiples of $5000

Types of BondsGeneral Obligation

Pledge “full faith and credit” of the issuer

Usually require plebiscite under NYS law

Pledge may be limited by tax and expenditure limitation legislation – such bonds are referred to as GO limited tax (GOLT) Not to exceed a fixed percentage of average full

valuation

Lowest interest rate (Simonsen & Robbins 1996)

Types of BondsRevenue

Originally referred to bonds issued for improvements with independent revenue streams, e.g. water systems

Now a catchall term that includes anything not a GO True revenue bonds, e.g. for water systems

Lease-revenue bonds, e.g. COPS

Special district and authority issues, e.g. NYSTA

Revenue Bonds Debt service reserve

Provides additional security for investors Sources of funding:

Bond proceeds Cash on hand System revenue reserves Credit enhancement

Coverage covenant Formal, legally binding assurance to investors that revenues will

be maintained at levels sufficient to generate net revenues in excess of debt service requirements

Usually expressed as a percentage of debt service, e.g. 120% Commonly 105-150% range

Revenue Bonds Additional bond test

Legally binding assurance to investors that revenue and coverage pledges will not be diluted by future issues

Feasibility study Done by specialized consultants at

issuer’s expense ‘Criticality’ Reasonability

Special Assessment Bonds General characteristics

Secured by specified tax revenues Collection limited Project specific

Not general fund revenue May reduce demands on general fund revenues

Types: Property tax based Sales tax based

Special Assessment BondsProperty tax based

General characteristics Property owners in area receiving benefits pay

costs Often formed as limited duration districts Security may be tied to expected increases in

property value and/or decrease in other costs associated with improvements

Formation of a fire district lowers fire insurance rates Paving roads increases property values

Limitations: Not usually attractive is tax base is small Skewed incentives if used speculatively e.g.

bare land

Special Assessment BondsSales tax based

General characteristics Secured by incremental sales tax

revenues Collection limited to maturity period or

retirement of debt

Limitations: Requires voter approval Security more volatile than property tax

based

Leases ‘True lease’

AKA ‘tax lease’ or ‘operating lease’ Lowest payments Usually used for computers, copiers, etc. End of lease options

Replace equipment with newer technology Return to lessor Renew lease Purchase at fair market value

Leases Capital lease

AKA ‘financing lease’ or ‘lease-purchase’

‘Constructive sale’

Usually used for buildings, machinery and other long-lived assets

End of lease options Purchase at pre-agreed price

Leases All local government leases always

contain a fiscal funding or appropriation clause

Technically makes the lease ‘breakable’ if appropriation is not forthcoming

Sometimes called ‘subject to appropriation clause’

Usually counteracted by ‘non-substitution clause’

Certificate of Participation (COP)

A form of lease revenue bond that permits multiple investors (participants) to share a stream of lease payments

Tied to the acquisition or construction of specific equipment, land or facilities

Certificate of Participation (COP)

Re-payment by annual appropriation

COPs provide weaker security and carry ratings that are below an issuer's general obligation rating.

Risk premium

Selecting the Method of Sale

Sale methods Competitive sale Negotiated sale Private placement

Selection factors Debt policy Statutory considerations Market factors

Competitive Sale Issuer chooses size and structure of

issue

Solicits bids from underwriters

Awarded on the basis of lowest True Interest Cost (TIC) in Georgia

Competitive Sale Increased competition should put

downward pressure on interest costs

Cost advantage will increase with the number of bidders

Bonds are well understood, nearly commodities, with well functioning market

Negotiated Sale Underwriter selected prior to bond

structuring

Awarded directly to the underwriter or underwriting syndicate without bidding

Local officials “match wits” with underwriters

Negotiated SaleConditions Favoring

Some issues are too large or complex to sell through competition

Revenue pledges may not be well understood

Issues may not attract bidders under certain conditions

Volatile markets Periods with rapidly rising interest rates Poor issuer credit history, e.g. history of default

Negotiated Sale Underwriter Compensation -

Spread Discount from issue purchase price

Net bond proceeds less than par value Underwriter’s gross margin

Expressed as: Percentage per bond or of issue amount Dollars per thousand dollars of par value


Spread Take down

Sales staff commissions Should vary with maturities and issue characteristics

Management fee Investment bankers Structure and market issue Should vary with need for investment banker’s

involvement


Spread Expenses

Travel, lodging, meals, etc Should be itemized and reasonable

Underwriting fee Underwriter’s risk Should vary with pre-sale success

Private PlacementSpecial Form of Negotiated

Sale Small, infrequent issuers

Placed with local or regional bank – bank-qualified securities

Extremely complex and/or risky ventures Direct negotiation with “qualified

investors” Central City (CO) Business Improvement

District sale 2003

Structuring the Issue Match with purpose

Short-term – receipt of revenues or funds

BANs, TANs and GANs Long-term – useful life of asset

Match with fiscal capacity Overall financing goals Receipts pledged to debt retirement

Bond Structures Issue Structure

Serial Term Zero coupon

Debt Service Structure Fixed Variable rate bonds

Usually short-term Rate adjusted periodically according to a prescribed formula

Issue StructureSerial Bonds

The typical serial bond issue contains as many maturities as the years of the issue’s term

15 year serial issue retires (redeems) part of the principle (issue par value) each year (that year’s ‘maturity’)

Longer term increases interest rates on each maturity

A serial issue pays lower interest rates than a term issue of the same duration

See maturity schedule example in packet

Issue Structure Term Bonds

All bonds have one maturity Sinking fund requirement Similar to traditional corporate debt

Zero Coupon Bonds Pay no periodic interest or principal

payment to investor Sold at deep discount

Debt Service StructureFixed Rate

Equal principal

Level debt service

Graduated principal

Deferred principal


Equal principal Lowest total interest cost (nominal dollars) Annual debt service declines each year

Level debt service Total interest cost slightly higher (nominal

dollars) Annual debt service payments

approximately equal


Graduated principal May complicate marketing and require

feasibility study Increased total interest cost (nominal dollars) Allows redemption schedule to match

expected revenue increases attributable to asset


Deferred principal Interest only payments for some period of time

Total interest costs increase as a function of deferral period

Capitalized interest feature common

Provides flexibility to match redemption schedule to expected revenue increases attributable to asset

Municipal Market OverviewParticipants

Citizens Government Issuer

Elected officials Professional staff

Financial advisor Underwriter Specialized attorneys Rating agencies Bond insurers Trustees Investors

Issuer’s Team Citizens – Present and Future

Elected Officials Professional Staff

Independent Financial Advisor

Investor’s TeamInvestor

Underwriter

Underwriter’s Counsel

Rating Agency

Bond Insurer

Bond Counsel

Assembling the Financing Team

Financial advisor Bond attorney Underwriter Paying agent/registrar Official Statement printer Trustee Selecting outside professionals

Financial Advisor Identify funding sources and alternatives Issuance process, structure and document drafting Market expertise – issue timing Credit rating and/or credit enhancement Disclosure, arbitrage and other compliance matters Post-sale memorandum Competitive sale

Bid process Negotiated sale

Develop RFP Initial pricing negotiations

Financial AdvisorTypes

Independent FA

Investment banks underwriters

Commercial banks

Subsidiaries of commercial and investment banks

Financial AdvisorIndependence

Independence FA activities sole source of income Does not underwrite, buy or sell securities

Objectivity Opinions not compromised by conflicting incentives

Accountability Responsible to issuer alone

Appearance of impropriety and openness of the public process


“Unlike an underwriter, however, an independent financial advisor represents the interests of its issuer clients, acting as a business agent in the analysis, negotiation and structuring of financial transactions and in long-term capital planning and budgeting. Independent financial advisors function best as extensions of their issuer-clients’ staffs.”

Source: http://www.agfs.com/whyfinancialadvisor.shtml Accessed: September 30, 2002, 11:20 am EST

http://www.agfs.com/whyfinancialadvisor.shtml


“All else equal, having a debt policy provision that requires the use of an independent financial advisor results in lower TIC.” (Kittredge, 2002)

“When the financial advisor is also the underwriter, interest costs are increased.” (Clarke, 1998)

Financial AdvisorSelection Process

Identify qualified firms NAIFA website http://www.naipfa.com/ Commercial and investment banks

Competitive process – RFP Name and qualifications of advisors, including

availability commitment Firm resources and relevant experience Discussion of firm’s understanding of issuer,

including proposed issue structure Discussion of relevant funding sources and

innovative financing approaches References

Financial AdvisorCompensation Fixed fee

Can be experience based Capped hourly

Hourly basis Issue basis

$/$1000 issued or percent of issue Creates conflict of interest Not recommended

Bond Attorney Bond counsel

Underwriter’s counsel

Issuer’s counsel

Bond Counsel Opinion

Assures investors as to issuer’s legal authority Interest exempt from federal and state income

tax

Participates drafting offering statement and other issuance documents

Represents investor’s interests

Bond Counsel Method of selection

Similar to FA process (Tab 4) Legal specialty requires specialized firms

Compensation Flat fee (bid)

Customary in GO and true revenue sales Hourly basis

More common in complex issues

Underwriter Firm or group of firms (syndicate) Purchases issuer’s securities for

remarketing to investors Investment banks

Goldman, Sachs & Co. and Salomon Smith Barney (national)

Commercial banks Insurance company subsidiaries

Others Paying agent/registrar Bond Printer Official Statement Printer Trustee

Disclosure What is disclosure?

Disclosure, simply put, means that the issuer must provide investors with the information they need to make decisions about the bond issue. (Tab 9)

Who is responsible? It is the legal responsibility of the issuer

to ensure that disclosure is adequate, and reliance on outside experts is not a legal defense if the rules are violated.

Disclosure When must disclosure take place?

Pre-sale – initial disclosure Post sale – continuing disclosure (more in the After

the Sale section)

Required under SEC Rule 15(c)(2)-12 False or misleading disclosure subject to

penalties under SEC Rule 10(b)(5) including fraud enforcement and private damages

Initial Disclosure Offering documents are required for the

underwriting of municipal securities

Market offering documents notice of sale, preliminary official statement (POS) official statement (OS) bond resolution bond counsel’s opinion letter

Initial Disclosure Intended to ensure that investors are

clearly aware of all material facts and significant information relevant to the bonds or obligations

POS used by underwriters to market bonds to perspective investors

OS Amend POS to reflect changes Contains interest rates of the bonds issued

Continuing Disclosure Required under SEC Rule 15(c)(2)-12

Annual financial condition update for the investor community Promptly advise investor community of ‘material events’

False or misleading disclosure subject to penalties under SEC Rule 10(b)(5) including fraud enforcement and private damages

Any failure to comply could result in contractual liability to bondholders

Continuing Disclosure Issuer is responsibility to the investor

community Provide information needed to make decisions

about the bond issue

Reliance on outside experts is not a legal defense if the rules are violated

Applies to agency staff and governing boards

Continuing Disclosure Investor community

Rating agencies Bond holders Nationally Recognized Municipal Securities

Information Repository (NRMSIR) (Tab 10) Required to file information with all NRMSIR

Annual filing requirements Consolidated Annual Financial Report (CAFR)

Most common way to meet “continuing disclosure” requirements

Annual audited financial statement Other annual financial and operating data

Continuing Disclosure Promptly provide notification of failures

to meet these annual filing requirements

Promptly provide notification of certain designated material events as they occur

Major employer leaves town Tax limitation passed Bond defeasment IRS review of tax status?

Arbitrage Arbitrage is the profit earned from

the investment of tax-exempt bond proceeds in higher yielding taxable securities

All net earnings must be remitted to the federal government

Arbitrage Due to the tax-exempt status of most

municipal bonds (which results in a lower cost-of-funds than prevailing taxable rates)

Freedom from taxation by the federal government enjoyed by municipal entities

Municipal issuers can usually earn arbitrage by investing proceeds in US Treasury or Agency securities.

Arbitrage May occur when an issuer raises money

through the sale of a bond issue and invests the proceeds in instruments with a yield above the bond issue's cost-of-funds

Debt reserve sinking fund

Investment pending disbursement

Arbitrage The 1986 Tax Reform Act was passed, in

part, to address arbitrage earnings by municipal authorities

It places restrictions on the interest income earned on the investment of bond proceeds

Arbitrage In simple terms, income earned in excess of a

tax-exempt cost-of-funds must be returned to the federal government

This process is known as ‘arbitrage rebate’, Bond attorneys often refer to the cost of funds as the

‘rebate yield limit’

The federal government has the power to revoke the tax-exempt status of municipal bond issues that improperly earn arbitrage profits

Arbitrage The computation of arbitrage and the

appropriate application of investment techniques to maximize non-rebatable income are fields of specialization within municipal finance

Usually beyond the scope of both bond attorneys and underwriters

Arbitrage Arbitrage can be earned and legally

retained in certain circumstances Most common exception is for small issuers Government entities that issue less than $5 M

per year are usually exempt from arbitrage rules 26CFR1.148-8

Credit Ratings Credit rating is an evaluation of credit

quality – an assessment of the probability of timely repayment

People are willing to pay more for certainty Two assets with equal average returns

but with one greater variation have different prices

Investors are risk averse, so the more variable asset is more costly to the government

Credit Ratings 3 private companies

Moody’s Investors’ Service

Standard & Poor’s

Fitch

Credit Ratings

Ratings are paid for by the issuer

Ratings are not required or necessary, currently approximately 30% the issues coming to market do not have a rating.

Credit Ratings Unrated bonds generally get interest

rates marginally better than speculative grade bonds Some governments go unrated when

they feel they would not be well rated Unrated bonds don’t carry the premium

you might expect!

Credit RatingsHierarchy of Risk

Hierarchy of Risk

Risk Categorization Moody'sFitch S&P

Interest Rate

Least Prime Aaa AAA LowestExcellent Aa AA Upper Middle A, A1 ALower Middle Baa, Baa1 BBB

Most Speculative Ba BB Highest

Difference between Aaa and Ba typically exceeds 100 basis points or a 1% increase interest cost!

Credit Ratings During the last 20 years, cumulative

default rates for municipal bonds has been less than 1.5%

Credit Ratings However, this figure is the product of

averaging bonds that are arguably not equivalent and have very different default profiles:

GO 0.01-0.04% Health care, utility, and multi-family housing

1-4% Industrial development bonds ~15%

Source: FitchIBCA Public Finance Special Report “Municipal Default Risk” 9/15/99 at www.fitchibca.com

Credit Ratings Ratings are a signal to the market

Economic conditions

Amount of debt – all else equal most important factor in rating

Financial condition

Management ability

Mechanisms to Raise Bond Ratings

Managing well No statistically significant measures of

‘good management’ exist, so highly subjective

Managing poorly e.g. ‘budget crisis’ in Nassau County, NY

Mechanisms to Raise Bond Ratings

Selection of bond type

Multiple ratings are perceived as a credit enhancement Many governments purchase three

ratings!

Credit and Liquidity Enhancements

Credit and Liquidity Enhancements

Bank Enhancements Letters of Credit Line of Credit

Debt Service Reserve Fund

Surety Bond

Bond Insurance

Bank Enhancements Letters of Credit

Irrevocable pledge Strength and value tied to bank’s rating Critical liquidity enhancement for Variable Rate

issues due to redemption rights (put features) tied to interest rate changes

Line of Credit Less secure than Letter of Credit

Debt Service Reserve Fund Source of payment for principal and

interest in the event that revenues are unable to cover these obligations when due

The DSRF is to equal 10 percent of the value of the bond issue one year of debt service 125 percent of the average annual debt service

Debt Service Reserve Fund Three cash funding alternatives

Proceeds of the bond issue Issuer equity contribution (GF monies) Project revenues generated from the project

that the bonds were issued to finance

Should the DSRF fall below its mandated level, the issuer is required to bring the fund to the required balance

Debt Service Reserve Fund

Three fund management alternatives Purchase a Surety Bond/Letter of Credit in lieu

of investments Use special investment products: Guaranteed

Investment Contracts, Forward Purchase Agreements, and Repurchase Agreements

Actively manage marketable securities (e.g., US Treasury Notes, US Government Agency Securities)

Surety Bond Replaces or reduces debt service

reserve fund cash requirement Offered by bond insurance companies

May be used in avoid arbitrage problems associated with debt service reserve fund

Bond Insurance Purchased through a one time payment of a

premium at the time of the bond closing May be capitalized

Not all issues qualify for insurance

Governments with severe financial problems may not be able to purchase bond insurance

Methods Direct purchase Elective bidding

Bond Insurance Guarantees the payment of

principal and interest if the issuer defaults Assuming that the insurance

company doesn’t get overwhelmed by claims

Never been really tested by a serious crisis

Re-insurance spreads risk

Bond Insurance Resulting bond ratings are based

on the credit of the insurer rather than solely on the underlying credit of the issuer

May result in significant interest cost savings issuer's underlying credit market conditions at sale time

Bond InsuranceMoody's S&P

Fitch Insurer

Aaa AAA AAA AMBAC Assurance Corporation

Aaa AAA AAA Financial Guaranty Insurance Co.

Aaa AAA AAA Financial Security Assurance Inc.

Aaa AAA AAA MBIA Insurance Corporation

Aaa AAA AAA XL Capital Insurance

na AA AA Radian Asset Assurance Inc.

na A A ACA Financial Guaranty Corp.

Bond Insurance The ratings noted reflect the claims paying

ability of the bond insurer

Insured bonds do not automatically receive these ratings

The issuer is also responsible for paying the rating fee to each rating agency that assigns ratings to the bond issue

Bond Insurance Interest cost savings

Higher bond rating Enhanced liquidity

Emerged in 1971 1980 3% insured compared 40% in 2002

Unique Aspects of Accounting for State and

Local Governments[

A Third Basis of Accounting:Modified Accrual

Cash Accounting recognizes revenues when cash is received and expenses when bills are paid (focus on cash movement).

Accrual Accounting recognizes revenue when goods or services have been provided and recognizes expenses when resources have been used (focus on when revenues are earned or resources are consumed).

Governmental funds use Modified Accrual Accounting. Expenditures are recognized when resources are received. Revenues are

recognized when they are measurable and available within the accounting period or shortly afterwards (focus on financial resources).

– Financial resources are cash or assets that can be translated to cash, less current liabilities.

Inflow (Revenue) Recognition

CollectedMeasurable and Available

ModifiedAccrual Basis

Earned

AccrualBasis

CashBasis

Note: Governmental resource inflows are available if they are deemed to becollectable during or shortly after the end of the accounting period. This mayhappen before cash is received.

Payment has been received or will be received soon.

Service hasbeen provided.

Payment hasbeen received.

Outflow (Expense or Expenditure) Recognition

Appropriation

EncumbranceDelivery Payment Use

ModifiedAccrualBasis -

Expenditurenow.

CashBasis

Expensenow.

AccrualBasis

Expensenow.

Authorization to spend money.

Order hasbeen placed.

Order has been received.

Payment ismade.

Item isconsumed.

No expenseat this time -any basis.

No expense

at this time -any basis.

Implications of Modified Accrual Accounting

No long-term assets. - Long-term acquisitions such as buildings and equipment

are recognized as expenditures when acquired.- There is no recognition of depreciation.

No long-term liabilities. - Principal (repayment of debt) and interest are recognized as expenditures when paid.

Proceeds from borrowing are treated as a non-revenue source of fund balance rather than as a liability.

Differences BetweenBases of Accounting

Accrual Modified Accrual

Outflows(Expenses or Expenditures)

When resourceis used

When resource is acquired, legal obligation to pay exists and payment will come from available resources

Inflows(Revenues)

When resource is earned

When resource is legally owed, measurable and available

Assets Current and long term

Current

Liabilities Current and long term

Current

Governments and Fund Accounting

Governments use funds to account for separate sub-entities.

Governments have three major classes of funds:

- Governmental funds account for the operating activities of governments (Modified Accrual Accounting).

- Proprietary funds account for activities that are run on a business-like basis (Accrual Accounting).

- Fiduciary funds account for the government's activitiesas trustee and agent (Accrual Accounting).

The Governmental Funds

Governmental funds include:

- General Fund used for the bulk of the day-to-day revenuesand expenditures of the government.

- Special Revenue Funds for the revenues and expenditures of specific activities that are subject to legal or management-imposed restrictions.

- Capital Project Funds to account for major acquisitions of plant or equipment.

- Debt Service Funds to account for the accumulation of resources to pay for principal and interest on long-term debt.

- Permanent Funds, which are similar to endowment funds.

Proprietary Funds

Proprietary Funds are used for activities that are run on abusiness-like basis. Revenues come from fees, tolls, and other charges:

- Internal Service Funds are established to account for elements of the government that provide services to other

governmental units.

- Enterprise Funds are established to track the activities of governmental units which provide goods and services to

individuals and organizations outside of the government.

What are some examples of each type of fund?

Fiduciary Funds

Fiduciary funds are held for another. They are not the resources of the government.

- Trust Funds are established whenever money is given to a government under the terms of a trust agreement such as for an employee pension plan or an unemployment compensation fund.

- Agency Funds are used to account for money that a government is holding for some other operating entity like a volunteer fire department or another level of government.

Modified Accrual Transactions

The Town of Millbridge buys and receives some fireworks on January 15th that it intends to use on July 4th. It receives a bill from the manufacturer for $50,000. How would the transaction be recorded by the Town under modified accrual accounting?

Modified accrual accounting (purchase approach)

Assets = Liabilities + Fund BalanceNo Change = A/P + $50,000 - Expenditure $50,000

Governments generally record transactions using modified accrual, but have the option of using modified accrual or accrual for prepayments, materials, and supplies.

Property Tax Transactions

Millbridge issues $611,000 in property tax bills this year. Total collections for the year are $600,000 made up of $575,000 of this year's taxes and $25,000 from last year's tax bills. The remaining $36,000 from this year is expected to be

collected within 60 days of year-end. It is "available." How would these financial events be recorded?

Assets = Liabilities + Fund Balance

Recording the property taxes billed this year Taxes

Tax Receivable + $611,000 = No Change + Revenue

$611,000

Recording the receipt of $600,000 in collected taxesCash + $600,000

Taxes Receivable - $600,000 = No Change + No Change

Where are the $25,000 in last year’s collected taxes and the $36,000 in uncollected taxes from this year in these transactions?

Long-Term Liabilities Modified Accrual Accounting

When a government borrows money on a long-term basis:- no liability is created on the balance sheet.- cash is increased and the fund balance is increased.

This is how a $1,000,000 loan would be recorded: Assets = Liabilities + Fund Balance

Other Financing Cash + $1,000,000 = No Change + Sources $1,000,000

Note that the increase in the fund balance is not referred to as revenue.

An Interfund Transaction

During the fiscal year the general fund was legally required to transfer $100,000 to the debt service fund. Only $97,000 was transferred. How would this transaction be recorded?

Assets = Liabilities+ Fund Balance

General FundDue to

Other Financing Use Cash - $97,000 = DSF + $3,000 - Transfer to DSF

$100,000Debt Service Fund

Cash + $97,000 No Other Financing Source Due from GF + $3,000 = Change + Transfer from GF $100,000

Debt Repayment Transaction

The interest and principal due on Millbridge's debt during the year were $15,000 and $50,000, respectively. Payments were made from the debt service fund. How were the payments recorded?

Assets = Liabilities + Fund Balance Interest Principal

Cash = No - expenditure -expenditure

- $65,000 Change $15,000 $50,000

Both the interest and the principal were recorded as expenditures. Would the transaction have been recorded in the same way under accrual accounting?

Why was there no change in any liability account?

Acquiring a Building

Assume that a building is purchased for $270,000, with full payment in cash.

The acquisition of the building resulted in an asset decrease and an expenditure of $270,000. How would the acquisition of the building have been treated under accrual accounting?

What if the Town issued a bond for $270,000 to pay for the building? The proceeds of the bond issue were recorded as an increase in cash and an increase in the fund balance of the Town. How would the proceeds have been treated under accrual accounting?

Transactions forAcquiring a Building

Capital Projects Fund

Assets = Liabilities + Fund Balance

Acquisition Using Available Cash

Building acquisition

Cash - $270,000 = No Change - expenditure $270,000

Purchase of the Building by Issuing Bond

Other sources of Cash + $270,000 = No Change + financing $270,000

Building acquisition

Cash - $270,000 = No Change - expenditure $270,000

An Overview ofGovernment Reporting

Management Discussion and Analysis(Analysis of the Statements)

Government-Wide Financial Statements (Accrual Basis)

Governmental Funds (Modified Accrual Basis)

Reconciliation

Fiduciary Funds(Accrual Basis)

Other Required Supplemental Information Budget Comparison (Budget Basis) and

Other Information

Proprietary Funds(Accrual Basis)

Focus of Government Reporting

Keep government accountable.

Compare actual results to budgets.

Make sure of compliance with laws.

Monitor inter-period equity.

Provide information for decision making.

Allow analysis of the financial condition of the government.

Management Discussionand Analysis

Presented before the financial statement.

Provides an objective and easily understandable analysis.

Compares this year to last year and explains changes.

Provides an analysis of the overall condition of the government.

Discusses material events and their potential impact on financial condition.

Government-WideFinancial Statements

Prepared using Accrual Accounting

The Financial Statements- Statement of Net Assets- Statement of Activities

Both statements include a breakdown of:- Primary-Government units with columns for:

– Governmental Activities– Business-type Activities– Total

- Component units (legally separate entities)

Statement of Net Assets

Shows Columns for:- Primary Government (Governmental and Business Units)- Component Units

Assets and Liabilities are in order of Relative Liquidity- Encouraged, but not required

Capital Assets- Normally presented net of depreciation- Network Infrastructure may be presented at cost if it is maintained at some predetermined level

Net Assets - Invested in capital assets, net of related debt- Restricted by creditors, grantors, donors, law, or regulation- Unrestricted

Statement of Net AssetsPrimary Gov’t Primary Gov’t Primary

Governmental Business-Type Government ComponentActivities Activities Total Units

Assets: Cash and Cash Equivalents $ 375,050 $ 149,344 $ 524,394 $ 450,000 Receivables 743,343 25,118 768,461 199,456 Inventories 120,872 83,280 204,152 23,958 Capital Assets Net of Accumulated Depreciation

8,750,000 4,326,876 13,076,876 34,345,769

Total Assets $9,989,265 $ 4,584,618 $14,573,883 $35,019,183Liabilities Accounts Payable $ 825,443 $ 75,431 $ 900,874 $ 387,158 Deferred Revenue 380,000 18,500 398,500 34,946 Noncurrent Liabilities Due Within One Year 650,000 70,000 720,000 2,945,639 Due in More Than One Year 7,300,000 3,600,000 10,900,000 25,145,348 Total Liabilities $9,155,443 $ 3,763,931 $12,919,374 $28,513,091Net Assets Invested in Capital Assets – Net of Debt $ 800,000 $ 656,876 $ 1,456,876 $ 6,148,390 Restricted For: Capital Projects 15,000 15,000 Debt Service 18,000 18,000 Unrestricted 822 163,811 164,633 357,702Total Net Assets $ 833,822 $ 820,687 $ 1,654,509 $ 6,506,092

Statement of Activities

Includes Line Items and Summary Columns for: - Primary Government including

– Each Governmental Activity– Each Business-type Activity

- Each Component Unit

Shows details of:- Expenses (Area B), - Dedicated Revenues [excluding taxes] (Area C), and - Net Expenses or Revenues (Area D).

– Provides an indication of self-sufficiency or required subsidy.


ALine ItemFunctions

BExpenses

by Function

CProgram

Revenuesby Function

DNet

(Expenses)/Revenues

by Program

EGeneral Revenues,

Unrestricted Contributions, Transfers &

Changes in NA

FChanges in Net Assets

Revenues Not Related to Activities

Includes (E):- Taxes by type (property, sales, income, school, etc.)- Unrestricted Contributions- Special (one shot) Items - Transfers

Columns Summarizing Changes in Net Assets (F) for: - Total Government Activities

- Total Business-type Activities

- Total Primary Government Activities, and - Total Component Units


ALine ItemFunctions

BExpenses

by Function

CProgram

Revenuesby Function

DNet

(Expenses)/Revenues

by Program

EGeneral Revenues,

Unrestricted Contributions, Transfers &

Changes in NA

FChanges in Net Assets

Governmental Fund Statements

Required Statements- Balance Sheet- Statement of Revenues, Expenditures, and Changes in Fund Balances

Statements Show- The general fund- Other major funds (separate column for each)- Smaller funds may be aggregated in an other-funds column - Total of all Governmental Funds

Governmental Funds Balance Sheet

Under Modified Accrual Accounting there are no long-term assets or long-term liabilities.

Fund Balances are divided into reserved and unreserved amounts.

Reasons for reserves are shown.

Unreserved funds are specified by type of governmental fund.

Governmental Funds Balance Sheet

General New Town Hall

Project

Other Govern-mental Fund

Funds

Total Governmental

Funds

Assets: Cash $ 43,978 $ 5,000 $ 23,965 $ 72,943 Investments 832,190 128,345 67,000 1,027,535 Receivables, net 746,330 32,548 778,878 Due from other funds 186,000 25,000 211,000 Receivables from other governments

458,400

50,000 72,000 580,400

Total Assets $2,266,898

$183,345 $220,513 $2,670,756

Liabilities and Fund Balances Liabilities: Accounts payable $

28,988$ 42,385 $ 71,373

Due to other funds 75,000 75,000 Payable to other governments 12,000 35,089 47,089 Total Liabilities $

115,988$ 77,474 $ 193,462

Fund Balances Reserved for: Encumbrances $

45,000$ 45,000

Debt service 1,500,000 1,500,000 Unreserved, reported in General fund

605,910605,910

Special revenue fund $ 78,344 78,344 Capital Projects fund $183,345 64,695 248,040 Total Fund Balances $2,150,91

0$183,345 $143,039 $2,477,294

Total Liabilities and Fund Balances

$2,266,898

$183,345 $220,513 $2,670,756

Statement of Revenues, Expenditures,

and Changes in Fund Balances Interest, principal, and capital outlays are all shown as expenditures.

Proceeds from long-term debt are shown as a source of funds.

No depreciation.

Statement of Revenues, Expenditures, and Changes in Fund Balance

General Town Hall Other Funds

Total Funds

Revenues: Property taxes $ 8,435,674 --- $ 1,232,476 $ 9,668,150 Fees 1,234,746 --- 343,321 1,578,067 Permits 894,035 --- 43,984 938,019 Intergovernmental 2,089,994 --- 434,598 2,524,592 Charges for Services 1,542,959 --- 2,324,659 3,867,618 Investment Earnings 354,222 --- 390,712 744,934 Total Revenues $ 14,551,630 --- $ 4,769,750 $ 19,321,380Expenditures Current: General Government $ 7,535,980 --- $ 340,576 $ 7,876,556 Public Safety 3,999,745 --- 1,239,435 5,239,180 Sanitation 2,453,909 --- 784,445 3,238,354 Debt Service Principal 250,000 --- 2,000,000 2,250,000 Interest and Other Charges 15,000 --- 120,000 135,000 Capital Outlay: 2,150,000 --- 270,395 2,420,395 Total Expenditures $ 16,404,634 --- $ 4,754,851 $ 21,159,485Excess of Revenues Over Expenditures $ (1,853,004) --- $ 14,899 $ (1,838,105)Other Financing Sources (Uses) Proceeds from Long-term Capital Related Debt $ 2,000,000 $ 2,000,000 Transfers In 200,000 $ 45,000 $ 10,000 255,000 Transfers Out (85,000) (25,000) (110,000) Total Other Financing Sources & Uses $ 2,115,000 $ 45,000 $ (15,000) $ 2,145,000Net Change in Fund Balance $ 261,996 $ 45,000 $ (101) $ 306,895Fund Balances – Beginning 2,004,902 138,345 220,614 2,363,861Fund Balances – Ending $ 2,266,898 $183,345 $ 220,513 $ 2,670,756

Proprietary Fund Statements

Accrual Basis Accounting Statements (activities in columns)

- Statement of Net Assets - Statement of Revenues, Expenses, and Changes in Fund Net Assets - Statement of Cash Flows

– Uses Direct Method– Statement structure includes cash flows from:

Operating activities Non-capital financing activities Capital and related financing activities Investing activities

Financial Statementsof Fiduciary Funds

Financial Statements- Statement of Fiduciary Net Assets- Statement of Changes in Fiduciary Net Assets

Prepared on an accrual basis.

Other Required Supplemental Information

Budgetary Comparison

- Line Items show:– resource inflows by source of funds and– resource outflows by activity.

- Columns show:– original budget,– final budget - including legal changes authorized over the year,– actual amounts expended on a budgetary basis, and– variance from final budget (optional).

- Prepared on the same basis as the budget which varies by governmental unit.

Financial Condition Analysis

Assessing Municipal Credits

Best Practices Fund balance reserve policy/working

capital reserves – very significant

Multiyear financial forecasting - significant

Monthly or quarterly financial reporting and monitoring - significant

Contingency planning policies - influential

Best Practices Policies regarding nonrecurring revenue -

influential Debt affordability reviews and policies –

very significant Superior debt disclosure practices – very

significant Pay-as-you-go capital funding policies –

significant

Best Practices Rapid debt retirement policies (greater

than 65% in 10 years) – significant

Five-year capital improvement plan integrating operating costs of new facilities – influential

Financial reporting awards – influential

Budgeting awards – influential

Best PracticesAudits

Professional auditors Recognized CPA auditors Legislative audit not adequate

Annual GAAP compliant GASB S34 compliant

GASB S34 Inventory of capital assets

Current condition of capital assets

Depreciation

Capital Maintenance

Capital Improvement Plan (CIP)

After the Sale Investment of bond proceeds Arbitrage

26CFR1.148

Rating agency and investor relations Continuing disclosure Market monitoring

Investing Bond Proceeds Security

Robert Citron’s mistake

Liquidity Match investment maturities with

project cash flow needs

Return Maximize returns subject to arbitrage

rules

Investor Relations Timely and complete continuing

disclosure

Maintain periodic contact with rating agency analysts Direct transmission of continuing disclosure

documents may be appropriate

Contact with large holders of you bonds

Debt Policy “A debt policy is a set of principles and practices, which

guides and informs the debt issuance process.

Your debt policy may take the form of a charter provision or ordinance enacted by the legislative authority (e.g., council or commission).

It may be an administrative rule or set of rules formally

promulgated by your government’s administration.

A debt policy may also be unwritten. It could take the form of strongly held principles of good government.” (Simonsen & Kittredge 1997; Kittredge 2000)

Debt Policy Purposes Debt limits (legal and policy limits) Use of moral obligation pledges Types of debt permitted Issuance criteria Structural criteria Credit objectives

Debt Policy Sale method selection criteria Criteria and method for selection of

outside professionals Refunding policy Disclosure Legal compliance (e.g. arbitrage) Debt policy – CIP linkage Investment of bond proceeds

Debt Policy – Practical Benefits Lowers interest cost and improves credit

rating, especially when strongly linked to CIP (Kittredge 2000)

Provisions included in debt policy have greater impact on decision-makers’ actions (Simonsen, Robbins & Kittredge 2001)

Strong selection criteria for outside professionals lowers interest cost (Kittredge 2003)

Financial Condition Analysis

Assessing Municipal CreditsIn Practice

“Do not let what you cannot do

interfere with what you can do.”

-John Wooden

Financial Condition AnalysisReview Steps

Indicators of Short-Term Solvency

Indicators of Long-Term Solvency

Economic/Demographic Indicators

Internal/External Factors

Warning Signs Delaying or reducing payments to

pension funds Putting off preventive maintenance for

another year Using so-called "innovative" financing

methods that let you to pay for this year’s operating expenses in a later year

Reducing the amount of capital asset purchases formerly financed by current taxes

Seeking out "one-shot" revenue enhancements

Financial Condition AnalysisMajor Influences

Economic Conditions Demographics

population and its growth rate age, skills, wealth, employment levels, and

earning capacity of the population. Management

only factor under local control Measure of ability to cope with changes in

first two factors

Financial Condition Analysis‘Balanced Budget’

Many different possible meanings

Legally ‘balanced’ doesn’t necessarily indicate strong fiscal condition Use of one time revenues Inappropriate use of borrowing Fiscal gimmicks such as delaying

payments until ‘next year’

Financial Condition Analysis‘Balanced Budget’

‘Structurally balanced’ long-term view of the local economy’s ability

to pay recognizes revenues rise and fall with

economic swings identify a basic level of services that is

sustainable even during economic downturns uses surpluses built up during favorable

economic swings, personnel attrition and other expenditure reductions during unfavorable economic swings to support the basic level of services without causing fiscal stress.

Cash Solvency CS 1 — Cash Liquidity

CS 1A — Cash and Cash Equivalents as a Percentage of Current Liabilities

CS 1B — Cash and Cash Equivalents as a Percentage of Average Monthly Total Expenditures and Other Financing Uses

CS 2 — Current Liabilities CS 2 — Current Liabilities as a Percentage of Total Revenues

and Other Financing Sources

CS 3 — Real Property Tax Collections CS 3A — Real Property Taxes Receivable as a Percentage of Real

Property Tax Revenues CS 3B — Uncollected Current Year Real Property Taxes as a

Percentage of Total Current Real Property Tax Levy

Structural Budgetary Solvency

BS 1 — Operating Surplus or Deficit • BS 1 — Total Revenues and Other Financing Sources

less Total Expenditures and Other Financing Uses (Operating Surplus or Deficit) as a Percentage of Total Revenues and Other Financing Sources

BS 2 — Fund Balance • BS 2A — Total Unreserved Fund Balance as a

Percentage of Total Revenues and Other Financing Sources • BS 2B — Appropriated Fund Balance as a Percentage

of Total Revenues and Other Financing Sources BS 3 — One-Time Revenues and Other Financing Sources • BS 3 — One-Time Revenues and Other Financing

Sources as a Percentage of Total Revenues and Other Financing Sources

Long-Term Solvency

LT 1 — Capital Expenditures

LT 2 — Long-Term Debt

LT 3 — Pension Status

LT 4 — Other Long-Term Liabilities

LT 5 — Debt Service

Long-Term Solvency

LT 1 — Capital Expenditures LT 1 — Tax-Financed Capital Expenditures as

a Percent of Total Expenditures and Other Financing Uses

Often when a local government is starting to experience financial difficulties, one way it deals with the difficulties is to reduce or eliminate current tax-financed funding for capital investment.

Long-Term Solvency LT 2 — Long-Term Debt

LT 2A — Total Direct Long-Term Debt per Capita

LT 2B — Total Direct Long-Term Debt as a Percent of Taxable Full Value of Real Property Assessments

LT 2C — Total Direct Long-Term Debt as a Percent of Personal Income

LT 2D — Total Debt Subject to Constitutional or Charter Debt Limit as a Percent of Total Debt Allowed by Constitutional or Charter Debt Limit

Long-Term Solvency LT 3 — Pension Status

LT 3A — Pension Fund Assets Available for Benefits as a Percent of Pension Benefit Obligation (funded ratio)

LT 3B — Pension Fund Assets Available for Benefits as a Percent of Benefits Paid Last Year

LT 4 — Other Long-Term Liabilities LT 4 — Other Long-Term Liabilities per Capita

• LT 5 — Debt Service LT 5 — Debt Service as a Percent of Total Revenues

and Other Financing Sources

Economic & Demographics ED 1 — Population and Age Composition

Total Population and Proportion of Population Aged 65 and Over

ED 2 — Real Property Value Full Value of Taxable Real Property

ED 3 — Personal Income Per Capita Income (and/or Median

Household Income, Total Personal Income) ED 4 — Poverty

Percentage of Persons Living in Poverty

Economic & Demographics ED 5 — Unemployment

Percentage of Persons Unemployed

ED 6 — Revenue Behavior ED 6A — Change in Real Property Tax

Revenue Relative to Real Property Tax Base and other Bases

ED 6B — Change in Sales Tax Revenue Relative to Personal Income Base

Economic & Demographics ED 7 — Expenditure Behavior

Change in Governmental Expenditures Relative to Personal Income Base

ED 8 — Revenue Base Risk Portion of Real Property Tax Revenue

Provided by Largest Taxpayers

Management FactorsBudgetary Management

MA 1 — Regressive trends over a period of time

MA 2 — Maintaining year-to-year structural budget balance

MA 3 — Accuracy of original budget estimates

Management FactorsInternal Environmental

Indicators MA 4 — Managing for results, including

strategic planning and/or performance measurement

MA 5 — Long-term budgeting and capital planning

MA 6 — Timeliness, accuracy, and usefulness of the internal recordkeeping and reporting

MA 7 — Managerial environment

Management FactorsMiscellaneous Factors

MA 8 — Flexibility of local control over revenues and expenditures

MA 9 — "Political" environment, including

terms of office and cumbersome or difficult organizational structures

MA 10 — Ability and willingness to influence economic and land use development

Analysis Methods Comparisons over time

Comparisons to industry benchmarks Peer group comparisons

Comparison to statewide data

Comparisons Over Time trend may be more significant than

the actual current value six-year comparison used

any period between five and ten years is usually good.

longer periods will often be needed for analyzing the economic/demographic indicators

City of HarlanTax Financed Capital

Investment

City of Harlan has been reducing the level of its tax-financed capital expenditures over the last four years.

This demonstrates a pattern that management is either deliberately or inadvertently reducing the City’s tax-financed capital investment expenditures.

Which and why?

Year 1993 1994 1995 1996 1997 1998 Indicator LT 1 0.3% 0.6% 0.6% 0.5% 0.3% 0.2%

City of HarlanTax Financed Capital

Investment

City is getting smaller This is a long-term trend Raises concerns about sustainable levels

of taxation

1960 Census 1970 Census 1980 Census 1990 Census 1998 Estimate

20,129 18,653 18,144 16,825 16,333

1960 to 1970 1970 to 1980 1980 to 1990 1990 to 1998 1960 to 1998 -7.3% -2.7% -7.3% -2.9% -18.9%

Comparisons To Benchmarks

Choosing a peer group Government type Size Service mix

Type of Gov.

Proximity to City of Harlan

Size (Pop.)

Service Mix

Harlan City Same 16,825 Police, Fire, Highway, Water, Sewer, Parks and Rec., Planning and Zoning

Monty City 38 mi. 19,714 Police, Fire, Highway, Water, Sewer, Parks and Rec., Planning and Zoning

Dutch City 102 mi. 13,243 Police, Fire, Highway, Water, Sewer, Parks and Rec., Planning and Zoning

Chateau City 332 mi. 13,989 Police, Fire, Highway, Water, Sewer, Parks and Rec., Planning and Zoning

Fullerton City 55 mi. 15,656 Police, Fire, Highway, Water, Sewer, Parks and Rec., Planning and Zoning

Saratoga City 10 mi. 7,249 Police, Fire, Highway, Water, Sewer, Parks and Rec., Planning and Zoning

Alberta City 3 mi. 11,061 Police, Fire, Highway, Water, Sewer, Parks and Rec., Planning and Zoning

Tax-Financed Capital Expenditures

% Total Expenditures

tax-financed capital investment is extremely low and has been dropping over the last four years

is, and has been over the last six years, well below the peer group.

This is a potential indication of long-term fiscal stress

Year 1993 1994 1995 1996 1997 1998 City of Harlan

0.3% 0.6% 0.6% 0.5% 0.3% 0.2%

Peer Average

4.1% 6.7% 4.2% 3.9% 2.9% 2.3%

Questions About Trends Was there an awareness of the

trend?

If so, is there general agreement on what is causing the trend?

What plans have already been made to address the trend?

Special Considerations Municipal Lease

Guidelines

Municipal LeasesOverview

A typical lease financing involves the issuance of lease revenue bonds or certificates of participation (COPs).

The payment of debt service is derived from lease payments by a municipal entity for a particular asset or group of assets, such as a prison or government office

buildings.

The lessor, usually a municipal or not-for-profit financing shell, assigns the lease payments to the bond or certificate trustee.

Municipal LeasesOverview

Lease payments usually constitute lease purchase payments toward the ultimate ownership of the asset by the lessee.

Generally, the municipality’s obligation to make payments under the lease is subject to annual legislative appropriation.

The municipality, therefore, is not legally obligated to make rental payments in future years should it choose not to budget and appropriate the payments.

However, pursuant to the remedies under the lease and

other documents, the municipality would lose use and possession of and ultimate ownership interest in the asset, thereby providing an incentive to continue making rental payments until the underlying debt is paid.

Key Credit Factors Lessee’s credit quality Lessee’s recognition of lease as debt and its

intent to pay same Essentiality of the leased property and other

project considerations Structural provisions of the lease financing The factors are interrelated and their weighting of

importance may vary by individual situations.

Lessee Credit Quality/Financial Flexibility

A lease analysis begins with a general credit assessment of the lessee, considering the four major categories financial condition, and the issuer’s willingness to pay.

An analysis of a lease cannot simply categorize the obligation based on project essentiality or legal structure.

In addition to strong fundamentals and flexibility, a strong credit should have a demonstrated willingness to take the measures necessary to maintain financial health and meet its obligations.

Stronger credits may be more likely to be in a position to honor less viable or essential lease obligations than weaker entities, particularly if the magnitude of the exposure is not of great significance.

Accordingly, the context of the obligor’s overall credit standing

and financial flexibility, and the extent to which it asserts its commitment to support the financing (intent to pay), should also be considered.

Recognition as Debt/Intent to Pay

The intent to pay can be demonstrated in how the obligor recognizes the financing in its authorization and administrative processes.

These processes should be reviewed for consistency with the lessee’s regular legislative and administrative approval processes for issuing tax-backed long-term debt.

Optimally, specific executive and legislative participation in the approval of the lease financing is desirable.

Strong legislative voting outcomes are viewed favorably, particularly in instances where there has been extensive public discourse about the project being financed.

The administrative office that is normally responsible for debt issuance should be directly involved in the lease financing process. Central oversight of lease programs is important in the budgeting and payment process, particularly in those jurisdictions where lease payments are appropriated and paid through multiple departments and agencies.

Recognition as Debt/Intent to Pay High-level oversight indicates recognition of an obligation to pay

and administratively protects against inadvertent omissions of payment from the budgetary process.

Recognition of capital leases as long-term debt in the entity’s financial statements, inclusion of such leases in its capital improvement plan and other debt planning documents (such as debt affordability studies), and other disclosure of capital leases as financial obligations

Intent to pay can be further demonstrated through upfront equity contributions to the leased project or program.

Entities with a history of issuing and paying for lease debt are considered favorably. Certain states and localities severely restrict GO debt issuance through very low debt limits or difficult, super-majority voter approval requirements.

In such situations, use of lease debt as the principal means of finance is viewed more positively than, for instance, the first-time use of lease financing to avoid seeking voter approval for a particularly unpopular project.

Entities that have lease-backed debt as a major portion of their debt structure, such as the states of New York and Virginia, are, among other reasons, less likely to jeopardize access to this financing vehicle and existing credit standing by failing to appropriate lease rental payments.

Recognition as Debt/Intent to Pay

There are also situations where lease financing presents the best debt alternative. Certainly for equipment financings, a well-structured master lease program can be more flexible and economical than a bond issuance.

With a time-sensitive project, such as meeting court or

regulatory orders before financial penalties begin to accumulate, leasing may be used to avoid the time consuming bond election process.

Similarly, there are certain projects, such as prisons, that, while very critical to a government’s operations or court mandated, may not be popular with voters.

Leases also offer governments a way to avoid the sometimes more costly government procurement processes on construction projects, because the government lessee will not be the owner/builder of the project and the builder/lessor may not be subject to the same procurement codes.

Essentiality/Project Factors The function a particular asset will

serve is an important part of any lease analysis. The more integral the asset is to the core functions of a government, the less likely it is that the government will consider discontinuing the lease. For instance, a police headquarters would be considered much more essential to a municipality’s operations than would a neighborhood health clinic.

Financial Performance Risk Risks increase more significantly for leased projects that

carry financial performance risk, such as parking garages tied to economic development projects or entertainment projects, since failure to meet financial or other expectations may cause political pressure to discontinue rental payments, particularly if the lessee believed that the project would be self-supporting.

Accordingly, the reasonableness of the expectations concerning the project’s self-support and related economic benefits is important. This risk may be mitigated through the use of an asset transfer, whereby assets more essential to governmental functions than the asset being financed become the leased assets. For example, a city could sell and lease back a court building to finance the construction of a parking garage.

Technological Risk This risk can be a factor, particularly in

equipment leases. Operational problems in sophisticated equipment can render them unusable, and technological obsolescence is an inherent risk, particularly in the rapidly evolving computer and communications fields. Therefore, it is preferable that, where high-technology equipment is involved, amortization be appropriately short to offset this risk as it relates to non-appropriation.

Construction Risk Delays in construction and cost overruns are an

inherent risk in any building project and can increase appropriation and payment risks in lease financings. Certain municipalities, such as in California and Indiana, are not required to or are prohibited from making lease payments until the building is completed and occupied. This risk factor can be mitigated by: sizing the lease financing to include capitalized interest for a sufficient period beyond the project’s expected completion; the contractor’s experience, coupled with a guaranteed maximum fixed price contract; penalties for late construction; performance bonds; and sufficient contingency built into cost estimates and in certain situations, a guaranteed contract from a third party.

Structural Provisions Structural/legal provisions of the financing are closely analyzed and can

affect the rating outcome. As discussed earlier, strong lease structures, such as covenant to budget and appropriate leases, can compensate for project weaknesses, resulting in a higher rating than otherwise possible under a structure with a weaker requirement to make rental payments. Conversely, weak legal provisions can cause a lower rating. The following is a review of certain key provisions.

Length of Lease: The lease term should not extend beyond the useful life of the property but should equal or exceed the term of the debt. In many instances, long-term leases are not permissible, but must be renewed annually or biennially. If so, automatic renewal or the need for positive action to cancel is preferable.

Lease Purchase: Lease financings generally entail lease purchases, as opposed to true leases where the lessee does not build up equity ownership in the assets. Real property financing structures usually involve a sale/leaseback or lease/leaseback. The lessor, through purchase or long-term leasing for a nominal sum, gains long-term title to the fee or leasehold interest, usually from the lessee of the asset (land and improvements). It then leases or subleases the asset back to the lessee. Such lease payments, in substance, generally constitute payments toward the ultimate purchase and ownership of the asset by the lessee, as opposed to a true lease where lease payments are the equivalent of simple rent. This buildup of equity ownership over the lease term increases the likelihood of continuing appropriations. A variation to the basic lease/purchase arrangement is an asset transfer, whereby what is being leased is unrelated to the project being financed.

Master Lease Where equipment is involved, a master lease is

the preferable structure because the cross-collateralization avoids selective appropriation risk. Under this structure, there is a singular rent payment for all assets, preventing the lessee from choosing payments for specific items of equipment. Therefore, if the lessee decides that a particular item is not essential and consequently elects to not pay rent, it would stand to lose all of the equipment pursuant to the trustee’s security interest. A master lease can be used for real property as well, and the inclusion of real property can strengthen an equipment lease transaction.

Security Interest The debt holder, through the trustee,

should have a security interest in the assets — both equipment and real property. The trustee should have the right, in the event of non-appropriation or default, to repossess the property, evict the lessee, and sell or re-let the assets. While the rating is not based on the ability to raise sufficient moneys in the sale or re-lease of the property, the loss of use of the asset by the lessee is considered a significant incentive to continue to make lease payments.

Equity Contribution Upfront investment in a project

(either as cash or real property) is a positive factor, because the lessee has an early and ongoing incentive to continue making lease payment appropriations. Such investment also demonstrates willingness to pay.

Triple Net The lease should clearly state that, not

withstanding anything to the contrary, payments are “triple net” and are not subject to counterclaim or offset. This means that regardless of what has been said to the contrary elsewhere in the lease, if there is any dispute or litigation between the parties, the lessee must continue paying rentals and assume other cost, including taxes, insurance, and maintenance.

Seek Appropriation Where legally permissible, the lessee

should state its intent to use its best efforts to seek an appropriation from the legislative body on an annual basis. Also, declarations of essentiality and intentions to make appropriations for the full lease term are viewed favorably.

Risk of Loss Damage and destruction pose a risk to

lease transactions. If not repaired or replaced, loss of use of a leased asset increases the possibility of non-appropriation and can result in proportional reductions in rental payments where the lease has an abatement provision. Such risks can be offset through maintenance and insurance requirements. The lease should state that the lessee will maintain the property in good repair and insure it against loss.

Risk of Loss Property/casualty insurance coverage requirements

should cover replacement cost of the asset or the redemption value of the outstanding debt. Proceeds should be used for property repair or debt redemption; partial redemption is acceptable if the remaining property will support the remaining debt. Where leases contain abatement provisions, rental interruption insurance should be provided, generally one year for equipment and one-to-three years for real property. Self-insurance may be acceptable, provided that a qualified individual annually certifies to the trustee the adequacy of such coverage.

Title insurance, on a real property project, is desirable in that it provides protection against title defect or challenges to title that could jeopardize the true value or use of the property. Also, the due diligence undertaken by a title insurance company provides additional assurances that outstanding title issues have been identified.

Debt Service Reserve Where there is abatement or late budget

adoption risk, a debt service reserve should be funded at least at the level of the maximum semiannual debt service requirement.

Except for abatement leases, proper structuring can obviate the need for a reserve.

Late budget risks can be addressed by setting the first semiannual debt service payment date several months after the beginning of the fiscal year.

Even for entities with a strong record of timely budget adoption, it is preferable to avoid setting debt service payments earlier than two months into the fiscal year.

Other Considerations Lease financing debt structures usually take the

form of a lease revenue bond or a COP. Regardless of the debt instrument, financing

structures usually entail the lessee government to make payments directly to a trustee, pursuant to an assignment by a lessor or issuer.

The lessor is usually a financing shell, such as a municipal authority or corporation or not-for-profit corporation, created by the government lessee to carry out the lease arrangement. Such entities may file for bankruptcy only voluntarily and, in the case of municipal entities, only if authorized by state law.

Other Considerations If such entities can only issue non-recourse

debt, then their bankruptcy is generally viewed as remote. Where the lessor is an ongoing operating entity, legal counsel should provide an opinion that the assignment of rental to the trustee is absolute, for example, a sale as opposed to a pledge, and that bankruptcy of the lessor would not result in disruption or recapture of the lease payments to the bondholder.

Otherwise, a bankruptcy-proof lessor should be established. Such a lessor should be a not-for-profit, single-purpose corporation established solely to undertake the project at hand and restricted to issue debt only for that project.

Cash Solvency Our Cash Solvency analysis shows that,

while the City of Harlan has improved slightly from its virtual cash crisis situation in 1995, the cash liquidity indicators still point to a high level of stress at the end of 1998. The current liabilities indicator also points to a high level of stress at the end of 1998. The only bright spot in the cash solvency analysis is that, since the county where the City is located started buying the current-year uncollected real property taxes in 1996, this indicator shows no risk of stress.

Budgetary Solvency Our Budgetary Solvency analysis shows that, while the

operating surplus or deficit indicator trend and the related improvement in fund balances are positive, the City has experienced continuing fund deficits in its general fund and all its major special revenue funds.

In addition, much of the improvement in both operating surplus and fund balance has been financed with one-time revenues and other financing sources.

The City is growing and is a relatively heavy user of one-time revenues and other financing sources in the general and water funds.

Budgetary Solvency The City is growing and is a relatively heavy user of

one-time revenues and other financing sources in the general and water funds.

Lastly, the City has significantly added to its tax bite in the last few years, without making significant improvements to its short-term, budgetary solvency financial condition (see the Chapter 7 discussion of ED 6A Change in Real Property Tax Revenue Relative to Property Tax and Other Bases).

All these factors point indicate a high risk of budgetary insolvency and fiscal stress in the City of Harlan.

Therefore, both the Cash Solvency and Budgetary Solvency indicators point to a high risk of short-term fiscal stress in the City of Harlan at the end of the 1998 fiscal year.

Long-Term Solvency The City of Harlan’s long-term debt (LT 2), other long-

term debt (LT 4), and debt service (LT 5) indicators have been decreasing over the last three years.

In addition, the long-term debt (LT 2) and debt service (LT 5) indicators have been improving in comparison to the peer group average.

However, all these indicators are above the peer group average and in the high range in the statewide comparison at the end of 1998. The pension indicator (LT 3) has no current effect on the long-term financial condition analysis. However, the tax-financed capital expenditure indicator (LT 1) is troublesome.

Long-Term Solvency The drop in that indicator shows that the

City has been decreasing its tax-financed capital expenditures even though they were already at very low levels compared to the peer group cities and the statewide comparison.

The combination of the low and declining tax-financed capital expenditure indicators and the declining debt and debt service indicators is a bad one. It shows that the City is deferring needed infrastructure improvements. This could have significant long-term negative financial condition implications.

Long-Term Solvency First, it will probably cost the City more in the

future to catch up with its infrastructure and capital asset needs than if it had kept up with its needs.

Second, as the infrastructure deteriorates, the City probably will have a harder time attracting and keeping both necessary business and affluent population in the future.

Further analysis of the City’s capital needs and plans is required to reach a conclusion here. In the meantime, based on all the above, we assess the overall risk of long-term fiscal stress for the City of Harlan as high.

Economics & Demographics The economic and demographic

indicators for the City of Harlan are generally negative, indicating continued pressure on the City’s finances.

The City’s per capita income is relatively low compared with other jurisdictions in its county and state.

Economics & Demographics Population losses, increasing poverty

rates, and declining property values all have the continuing potential for straining the City of Harlan’s budget.

Therefore, the economic/demographic indicators for the City of Harlan have and will continue to show the pressure on the City of Harlan’s finances that could keep the City in fiscal stress.

Internal/External Factors In this step we look at the

Internal/External Factors Affecting Management’s Adaptability for the City of Harlan.

To summarize our analysis of the internal/external factors affecting management’s adaptability for the City of Harlan, indicators MA 1, MA 2, MA 4, MA 5, MA 6, MA7, MA 9, and MA 10 show a high level of risk of fiscal stress.

Internal/External Factors In addition, indicators MA 3 and MA 8

show a medium level of risk of fiscal stress. Of course we aren’t just counting the number of high-risk indicators, but the high risk indicators seem to be pervasive.

Therefore, based on the above analysis of all the management adaptability indicators, we assess the overall risk of fiscal stress for the City of Harlan as high.

Village of Fair Oaks

Date post:	11-Apr-2017
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