Local Government Finance: Capital Facilities Planning and Debt Administration by Alan Walter Steiss

Debt Administration

Debt administration was relatively routine task when long-term debt was a small part of the overall fiscal commitments of local government. The basic requirement was to ensure that sufficient funds were set aside each year from general revenue sources to cover debt service obligations, or, in the case of term bonds, to cover annual interest charges and build an adequate sinking fund. New and diverse bond offerings, however, have resulted in increased responsibilities for the administration of public debt.

Capital Project Funds

Capital project funds account for the resources required to build or buy specific capital facilities. These resources come from the issuance of bonds or other long-term obligations, from intergovernmental grants, or as transfers from other funds. The capital project fund is terminated when the project is completed. The accounting results are transferred to the debt service fund which is used to track the payment of interest and principal of the long-term debt on each capital project.

Bonds often are not sold on the date of issue. [6] Assume, for example, that bonds with an issue date of July 1, 19x3, were not sold until September 1, 19x3. The purchaser of these bonds receives semi-annual interest payments from the date of issue (that is, on January 1, 19x4, on July 1, 19x4, and every six months thereafter) and not from the date of purchase. Therefore, when the bonds are sold, the accrued interest is added to the purchase price--the buyer must pay the seller the equivalent of interest for the period from the issue date (or last coupon date) up to, but not including, the date of purchase. This accrued interest, in turn, will be included in the interest payment received by the buyer on January 1, 19x4. By convention, interest on municipal bonds is calculated on a 360-day year basis.

Accrued interest received by the issuing jurisdiction on the sale of bonds cannot be used in the capital project fund to pay for construction. It must be transferred to the debt service fund to be used as part of the resources for the first interest payment--that is, as a partial offset to the amount needed from the general fund for the first interest payment. Therefore, only funds sufficient to pay the interest from the purchase date to the interest payment date will have to be transferred from the general fund to the debt service fund.

At the time a bond issue is authorized, it often is difficult to determine exactly what the interest rate will be on the date the bonds are sold. The actual date of sale can seldom be predicted accurately. The possibility exists, therefore, that bonds will be sold at either a premium or a discount--that is, above or below the face value. [7]

Some states do not permit bonds to be issued at a discount (below face value, or par). This prohibition may force the issuing authority to pay a higher interest rate on the bonds to ensure their sale. When a discount is allowed, the full face value of the bonds is still required to complete the authorized project, and the difference may have to be made up from the general fund or the debt service fund. When bonds are sold at a premium (higher than face value), the difference is usually transferred to the debt service fund and used with other resources to pay off the bonds.

The capital project fund often receives proceeds from the sale of bonds or transfers of monies from other sources (such as, state or federal grants) before these resource are needed to acquire the capital asset. These resource should be invested to produce additional revenue. This investment revenue, in turn, is transferred to the debt service fund for payment of the principal or interest of the debt.

The administration of a capital project fund can be best understood by tracing a typical set of transactions. Assume that the City of Rurbania proposes to buy land and construct a new administration building at an estimated cost of $1,600,000. Matching grants of $300,000 from the state and $500,000 from the federal government are available for this project. The Rurbania taxpayers have approved a bond issue referendum for $800,000 to meet the local share of the project's financing.

Regardless of the method by which monies are transferred from one governmental unit to another, the results are the same: the capital project fund receives cash from the granting agencies. Assume that the grants are received at the outset of the project and are invested in short-term, sixty-day certificates of deposits at 4.0 percent interest. The resulting earnings of $5,260.27 ($800,000 x 0.04 x 60/365) should be deposited in the debt service fund.

Land is purchased for the building site. Two landowners agree to purchase prices, totalling $90,000. A third landowner cannot obtain his desired price; his land is condemned, with a court-ordered settlement of $35,000. These transactions are not encumbered because of the relative short time between purchase and payment.

In governmental fund accounting, capital assets are recorded as expenditures in the capital project fund and as fixed assets in the general fixed assets account group. The journal entry to record this transaction in the capital project fund is:

Payment for the land is recorded as:

The land sales and the judgment are paid on a proportional basis from three sources: the state grant (3/16), the federal grant (5/16) and the proceeds of the bond sale (8/16). The entry to record this transaction in the fixed assets account group is:

Grant funds are thus reduced to $737,500. This amount plus previously earned interest is invested in a thirty-day certificate of deposit, at 3.5%. The resulting earnings of $2,136.71 [($737,500 + $5,260.27) x 0.035 x 30/365] are deposited in the debt service fund.

The bonds, dated July 1, 19X3, are issued as 20-year general obligation bonds with an interest rate of 5 percent, payable semiannually on December 31 and June 30. For illustrative purposes, it will be assumed that the issue is for term bonds, wherein interest on the full amount of principal is payable over the twenty-year period to maturity.

On September 30, the bonds are sold at a premium of 2 percent, or $16,000, plus accrued interest of $10,000 ($800,000 x 0.05 x 3/12). Total receipts of $826,000 are recorded in the capital project fund as follows:

The accrued interest and premium on the sale of the bonds are trans-ferred to the debt service fund. From the sale of the bonds, $62,500 is paid toward land acquisition, and the balance of $737,500 is combined with the balance of the grant funds ($737,500 + $5,260.27 + $2,136.71), for a total of $1,482,396,98. This amount is invested in a ninety-day CD at 4.5%, yielding $16,448.51 on December 29, 19X1.

On October 1, 19X3, a construction contract is let for a building designed to be built for $1,300,000, including a contingency allowance of $100,000 to accommodate any necessary plan changes. The contract calls for completion of the building by November 1, 19X4. The Public Works Department will make the necessary land improvements and landscape the grounds at the completion of the construction phase. The estimated cost of $75,000 is encumbered at the outset of the project.

The Sunshine Construction Company is to receive quarterly payments on the basis of percentage of completion of the building and approval by the construction supervisor. During the first year of the project, the following payments are approved, based on invoices submitted by the company:

Individual entries are made to record each of these amounts when the invoices are received and approved. The balance of the grant funds and bond proceeds continues to be available for short-term investment in certificates of deposit or other securities.

Only $575,000 of the accounts payable is actually paid during the fiscal year (the June 30, 19X4, payment is made early in the next fiscal year). Closing entries as of June 30, 19X4, to close out the revenue, proceeds, and expenditure accounts, are as follows:

The capital project fund still has $900,000 in cash at the start of the second fiscal year (July 1, 19X2), offset by accounts payable of $225,000, a fund balance of $100,000, and reserve for encumbrances of $575,000 ($500,000 on the construction contract and $75,000 for site improvements). Thus, $675,000 is available for short-term investment.

On July 10, 19X4, a contract change is approved that increases the construction contract to $1,350,000. The third quarterly payment of $225,000 is also made on that date. On September 30, 19X4, another payment is approved for $400,000.

Exhibit 4. Interest Earning on Short-Term Investments

The project is not completed until December 1, 19X4, because of the addition to the contract. At that time, an invoice was received for the balance of the contract. The retained percentage on this project (pending final approval) is 5 percent of the contract price, or $67,500. Therefore, the December payment to Sunshine Construction is $82,500 ($150,000 - $67,500).

The Public Works Department completes its work at a cost of only $60,000, releasing $15,000 of the $75,000 encumbrance back to the fund balance. By February 28, 19X5, the corrections to the project needed for final approval are made by the contractors, and the retained percentage ($67,500) is paid. The fund balance account is then closed, and the balance of cash on hand--the $15,000 unused encumbrance plus $50,000 unused contingency allowance--is transferred to the debt service fund as a residual equity transfer.

Debt Service Funds

Debt service funds are used to account for: (1) the accumulation of resources from which the principal and interest on long-term debt is paid and (2) the investment and expenditure of those resources. Whenever possible, several debt issues should be accounted for in a single fund, since the fewer the number of funds, the less complicated the accounting for long-term debt. One fund needs only one set of financial statements; many funds need many sets of financial statements.

The money required for the repayment of debt, as well as the interest on the bonds, may come from several sources. If the locality or authority earmarks a special source for the repayment of bonds, then a special revenue fund may be set up to collect the money and transfer it to the debt service fund. Often revenue is collected from various sources in the general fund and then transferred to the debt service fund. Many bond indentures require that the money needed for servicing the bonds has first claim on the general revenue of the governmental unit.

Since the resources needed to service the principal and interest on serial bonds is received and expended each year, there is no accumulation of resources on which interest can be earned. The resources needed to service the principal on term bonds, however, are not needed until the debt matures and, therefore, can be invested. Thus, the assets and the fund balance increase annually, providing a sinking fund that eventually will be used for payment of the debt.

A sinking fund spreads the repayment costs over the life of the bond issue, thereby avoiding large, irregular demands on the annual budget. The amount that needs to be earmarked each year for the sinking fund is deter-mined by: (1) the dollar value of the bonds to be retired, (2) the number of payments to be made into the account, and (3) the anticipated rate of earnings on the invested funds. Sinking fund requirements should be recomputed each year. Should a surplus in excess of actuarial require-ments develop, it may be possible to lower future requirements. It is sound debt management practice, however, to absorb any significant surplus gradually over several fiscal periods rather than making a large reduction in payments in a single year. Should a deficit arise, adjust-ments should be made as soon as possible by increasing the level of payments into the sinking fund. New investment opportunities should also be sought to produce a greater return.

The same example used to explain the administration of a capital project fund can also be used to illustrate the operations of a debt service fund. Term bonds with a face value of $800,000 were issued at 5 percent for twenty years. Semi-annual interest payments on these bonds are $20,000 ($800,000 x 0.05 x 1/2). Since the bonds were sold three months after the date of issues, however, only $10,000 is needed for the first interest payment. The other $10,000 will come from the accrued interest received upon sale of the bonds. Often interest payments are made to bondholders by a fiscal agent on behalf of the locality. In that case, the handling charges made by such agents (usually 1 percent or less) must be included in the annual transfers to the debt service fund for interest payments.

The estimated amount needed to build up the sinking fund can be developed from an annuity table or from the annuity formula. For example, if the fund can earn 4.5 percent each year on its investments, then an annuity table shows that one dollar invested annually at the end of the year for twenty years at 4.5 percent will return $31.37. Thus it would take $25,502 added to the sinking fund each year, invested at 4.5 percent, to equal $800,000 at the end of twenty years ($800,000 divided by $31.37 = $25,502). No long-term investments are purchased in the first year because the payment, as an annuity, is generally not received until the end of the year. During the second and all succeeding years, however, the transfers as well as any earnings made in prior years will be invested.

Exhibit 5. Sinking Fund Requirements on 20-Year Term Bonds

The interest earned from short-term investments during the construction period is summarized in Exhibit 4. The $65,000 fund balance, transferred to the debt service fund when the capital project fund is closed, is added to the $56,635.16 in earned interest for a total of $121,635.16. These funds, invested on March 1 at 4.5 percent, earn $2,694.30 through June 30. The year-end balance of $16,960 from the first year of the sinking fund earns $752.40 during the second year.

At the end of the second year, the sinking fund has a substantial balance of $199,786.70. This fund balance invested at 4.5 percent would total $441,224.68 at the end of twenty years when the term bonds reach maturity. Therefore, the balance that must be accrued in the sinking fund is reduced to $358,775.32. Annual payments of $13,359.68, invested at 4.5 percent over the eighteen-year period, will yield the sum required in the sinking fund to cover the balance of the principal payment, as detailed in Exhibit 5. The net savings that accrue to the city of Rurbania through the rollover of the short-term investments is approximately $269,566

Long-Term Debt Control

Accurate debt records--including auditable ledgers as to the identity, purpose, and amount of debt commitments associated with capital projects and the debt service payments made--are vital to short-term and long-term fiscal operations. From these records, it should be possible to determine quickly and accurately the principal and interest requirements on the total debt over the full maturity of all issues. Such computations are needed to determine the financial capacity to meet the requirements for future capital improvement and to plan the retirement schedule for any new borrowing.

Long-term debt can best be controlled through a subsidiary ledger, such as a bond and interest register. By collecting in one place all pertinent information regarding individual bond issues, this ledger allows management to trace the complete history of each issue. It also assists in establishing a schedule of debt service requirements and in posting transactions to the general ledger, bonded debt ledger, and interest payable ledger.

A subsidiary bonded debt ledger contains a sheet for each bond issue, showing the project title and purpose, amount of bond originally out-standing, date of bonds, interest rates, amount retired to date, and balance outstanding. A separate sheet is maintained on each bond issue in an interest payable ledger. As interest payments come due, they are entered in the "credit" and "balance" columns. As payments are made, the amount is entered in the "debit" column, and the balance payable is reduced by a corresponding sum. An overall schedule of debt service requirements can be readily computed from these records, and a maturity and interest calendar for all debt can be compiled to monitor revenue needs for debt service on a month-to-month basis. The calendar must be adjusted and updated as new issues are marketed.

All fixed assets purchased, constructed, or obtained by contract are recorded at cost in the general fixed assets account group. Fixed assets obtained by gift should be recorded at the fair market value when donated. Assets obtained through foreclosure should be recorded at the appraised value of property or the total taxes or assessments plus costs, whichever is lower. Cash or liability transactions involved in the buying or selling of the asset are not recorded in the general fixed asset account group, however. Although not maintained for external reporting purposes, depreciation should be recorded in supplemental records for internal costing purposes.

An asset that is sold, destroyed, or otherwise rendered valueless is removed from the account group by debiting the general fixed assets account for the original amount recorded and crediting the particular fixed asset. Improvements to an asset--adding to its value--require an entry comparable to the original entry, but only for the amount of the improvement. General repairs--needed to keep the asset in the same operating condition--are not considered improvements and should not be added to the value of the fixed assets in the account group.

The long-term debt account group is used to maintain records of long-term liabilities, such as serial bonds, long-term notes, and long-term commitments arising from lease or purchase agreements. Separate records of long-term debt are maintained for special assessment funds, proprietary funds, and profit-type fiduciary funds.

Over the years, a sinking fund is built up by transfers from the general fund and interest on investments to an amount equal to that needed to pay off the bonds. The data in Exhibit 5 illustrate the final year transactions. At the beginning of the year 20, the fund balance should equal $752,765.86. This fund balance will earn $33,874.46 (at 4.5%), and a transfer of $13,359.67 will be made from the general fund at year-end to bring the total in the sinking fund to $800,000. Upon recording the matured bonds payable in the debt service fund, the amount in the general long-term debt account group would be closed out.

Financial Reporting

Financial analysts often point out that the annual financial reports concerning public debt is a major point of weakness in the management of government resources. Such reports are important to the basic credit rating of the governmental unit and are of major interest to bondholders, public officials, and and ordinary citizens. If adequate debt records are maintained throughout the year, the preparation of such annual reports can be a relatively simple procedure.

Annual financial reports concerning debt should cover several basic categories of information:

(1) A listing of all outstanding debt by type of issue (general obligation, special assessment, or revenue bonds). The following information should be provided for each bond issue: date of issue, original amount, date of maturity, coupon (interest) rate, total interest, amount of principal and interest presently outstanding, and the amount carried in sinking funds, if any. This information can be taken directly from the bond and interest register.

(2) For each broad classification of debt, information should be presented as to the annual schedule of debt service, including interest, amortization requirements, and total debt service requirements. This statement should also include data as to the level of unfunded debt, that is, short-term borrowing that constitutes an obligation payable out of current revenues

(3) The overlapping debt of the jurisdiction--that portion of the debt of the school district, county, township, or special districts payable from taxes levied by the reporting jurisdiction.

(4) A computation of the jurisdiction's legal borrowing status.

(5) If term bonds are outstanding, a sinking fund balance sheet should be included in the financial report to record the relation of sinking funds to actuarial requirements and a listing of current holdings.

Debt arising from the issuance of revenue bonds in proprietary funds must also be shown, including complete information on the facilities that support such debt. The report should include, as appropriate, the name of the corporate trustee, consulting engineers, and attorneys approving the legality of the issue. Revenue bond ordinances may require an annual report by an independent certified public accountant, including a current balance sheet and a statement of any contingent liabilities not shown on the balance sheet. Particular types of revenue bonds (e.g., for water or sewer utilities) often require supplemental information, such as average daily supply and consumption, storage capacity, number of customers, consumption per customer, method of billing, legal provisions, and so forth. Special assessment bonds guaranteed by the jurisdiction should also be shown in the schedule of debt.

Accurate and complete reporting on public debt develops confidence on the part of investors and the general public as to the fiscal manage-ment of a jurisdiction or public organization. In addition to the annual report, an interim report covering much of the same information should be prepared midway in each fiscal year for distribution to those interested in the financial status of the jurisdiction. The relatively small investment of time and expense in preparing such reports is often repaid many times over through lower interest rates.

Distribution of Revenues and Issuance of Additional Bonds

A reserve fund is established in most cases, into which all receipts and income derived from the operation of a self-supporting project are deposited. Monies in the reserve fund are then distributed monthly by the trustee or other handler of funds in the order established by the bond resolution or trust indenture (see Exhibit 6). Monies remaining in the reserve fund after the required distributions have been made may be placed in a surplus fund, to be divided among various categories such as:

o Redemption account to retire bonds in advance of maturity.

o Payment in lieu of taxes--When an authority purchases an operation that had been a corporate unit, payments may be made in lieu of taxes either by legislative requirement or to create good will.

o Other lawful payments, including improvements and extensions to the facility or support of other bond interest.

Exhibit 6. Distribution of Revenues from Self-Supporting Projects

(1) Operations and maintenance have first claim on the reserve fund. Without proper O&M funds, a facility may experience severe loss of income. Revenue bonds are commonly payable from net revenues--that is, gross receipts less operating and maintenance costs.

(2) Bondservice account should receive monthly payments sufficient to cover the next semiannual interest payment, as well as the next principal payment on serial bonds.

(3) A sinking fund is sometimes required in the case of term bonds, in lieu of principal pay-ments on serial bonds.

(4) Debt service reserve fund is gradually built up to equal a full year's maximum principal and interest in the case of serial bonds, or two year's interest in the case of term bonds.

(5) Renewal and replacement fund (sometimes called a replacement reserve) is established to replace equipment and provide necessary repairs beyond normal maintenance. Funds are paid into this account in amounts recommended by the consulting engineer and may be cumulative.

(6) Reserve maintenance fund may be established to meet unusual or extraordinary main-tenance charges that have not been budgeted. Some jurisdictions combine the reserve maintenance fund with the renewal and replacement fund.

(7) Working capital fund is established to cover unforeseen contingencies and should be equivalent to about one-tenth of the annual gross revenues.

When a facility is being constructed, it is not always possible to foresee just what the future will hold. It may be necessary to increase the size of the facility or to make other improvements that will require additional financing. Sufficient leeway should be provided in the bond indenture or resolution to permit the issuance of additional bonds.

If bonds of equal rank are permitted, safeguards must be established to prevent the undue dilution of the security of the original bonds. The two basic types of trust indentures are: (1) the closed-end indenture, which does not permit the issuance of parity bonds except as necessary to complete the project if initial financing proves insufficient; and (2) the open-end indenture, which permits the issuance of additional bonds but provides a formula prescribing the conditions to be met. In the first case, additional bonds must be junior in lien to the then outstanding bonds.

Debt Service and Retirement

Prompt payment of all principal and interest requirement is the most direct evidence of sound debt administration. Consequently, the way in which a jurisdiction administers its debt service is one of the most important factors in determining its credit standing for future borrowing. Even temporary defaults may adversely affect a municipality's ability to borrow at optimal interest rates. Well-defined administrative procedures--including advanced planning regarding the payment calendar and sound management of sinking funds and capital reserves--are essential to ensure regularity in the payment of interest and redemption of principal.

The first step is to establish an information system regarding interest and redemption requirements over the life of the issue. For this purpose, the bond and interest register and the ledgers for bonded debt and interest form a ready basis for the development of a payment calendar. Whenever a new issue is marketed, a schedule should be prepared showing the amount due on each principal and interest date, and this schedule should be incorporated into the consolidated payment calendar to show the timing of total cash requirements. If sinking funds or other debt service funds are involved, these must also be taken into account in the annual budget process.

The allotment of funds for principal and interest payments must be timed to provide cash when it is needed. Budget officials must plan ahead to ensure that early payments required in the following year can be met, that is, that a sufficient fund balance is carried over from the previous fiscal year and/or provision is made in the tax collection system to generate adequate funds in the early part of the new fiscal year.

Payment of all principal and interest requirements should be made through a single agency, for example, the City Treasurer's office or some other designated fiscal agent. In many cities, such payments also require authorization by the Director of Finance or the Controller. It is usually a good administrative practice to appoint a bank or trust company in the financial center in which a municipality's bonds are marketed to serve as its paying agent. Funds are deposited with the paying agent in advance of interest (and principal) due dates, and the agent oversees the payment of coupons and matured bonds as they are submitted. This arrangement is preferred by investors. It saves the municipality considerable routine work, and the paying agent is equipped to handle this function at a relatively low cost.

Sinking Funds

A major problem in the use of sinking funds (and one contributing to severe restrictions on this method of financing in many states) stems from the technical difficulties of managing the trust accounts. In most states, local governments are restricted by law as to the types of sinking fund investments that can be made--usually being limited to federal, state, and municipal bonds. Within these categories, investments should be limited to high-grade issues and should exclude revenue bonds on projects with unproven earning power. Bonds with equal security at times vary in terms of their yield, and the relationship of maturity to yield tends to vary with changes in market conditions. Analysis of the bond market, therefore, is essential to secure the maximum earnings for sinking funds compatible with the safety of investment.

While some controversy surrounds the practice, investment of sinking funds by a municipality in its own securities has certain advantages. It avoids the complex analysis required when selecting bonds of other jurisdictions, it simplifies the administration of the sinking fund and lowers costs, and it affords a ready market for a municipality's borrowing that may be particularly important when the general market is uncertain. The principal argument against this practice is that the sinking fund may become a dumping ground for excessive amounts of tax notes issued to offset inadequate administration. Under such conditions, the security for payment is little more than a collection of IOU's. With proper safeguards, however, this investment practice remains a viable alterna-tive to other forms of sinking fund investments. When a municipality invests in its own bonds, it does not increase its net debt any more than if it sold these bonds to outside investors. And when it buys in its out-standing bonds, it decreases its net debt just as much as if it invested in other municipals. In either case, the taxpaying capacity in relation to net debt is not affected.

In addition to security, sinking fund investments must have liquidity--the maturities of the various investments must be so timed that funds will be readily available to retire the term bonds when they come due. Without careful investment planning, it may be necessary to sell the holdings of the sinking fund in the open market, with the possibility of taking a loss. Greater flexibility often can be attained by investing in several different types and sizes of offerings.

To the extent permitted by state law, sinking funds should be consolidated to simplify transactions, to save time in putting the funds to work, and to secure a better investment position. Separate fund accounts should be maintained, however, for administrative purposes in calculating annual contributions. Since they are negotiable instruments, securities purchased from sinking funds should be kept in a safe deposit box, covered by fire and theft insurance, and with limited access by responsible officials. Whenever possible, sinking fund investments should be registered. An independent audit of the sinking fund should be made annually in addition to regular auditing by the controller of all sinking fund transactions.

It should be evident from this discussion that the management of a sinking fund is a complex task that should not be undertaken without ade-quately trained personnel and proper safeguards to protect the integrity of the funds. As has been noted, a number of states have legislated against term bonds secured by sinking funds insofar as general obligation borrowing is concerned. However, such funds remain as a viable means of financing many revenue-producing projects, whereby annual contributions to the fund are generated by the self-supporting facilities. In such cases, adherence to the guidelines outlined above is especially important since such debts often are outside the protection of the full faith, credit, and taxing power of the jurisdiction.

Recording and Cancelling Coupons and Bonds

The final step in servicing a municipal debt involves the recording and cancelling of coupons and bonds that have been paid. Following each scheduled payment, coupons and bonds must be checked to determine if any have not been redeemed. Some will always be slow in coming in, and occasionally, some may be missing permanently. Records must be maintained for several years after the final maturity date in most cases. Cancelled coupons and bonds usually are kept for several years, after which they are destroyed by shredding or burning.

Many commercial banks and trust companies that serve as paying agents for municipal bonds include as part of their services all phases of recording and cancellation. These banks and trust companies provide the municipality with a certified list of the cancelled and destroyed bonds and coupons. Many municipalities mandate that the disposition of these documents take place in the presence of the Director of Finance or the Controller and at least one other municipal official. The "mortgage burning" ceremony is one that still has considerable significance for many small communities.

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