CHAPTER TWO

Principles & Basis of Accounting for Government & NFP Entities

The following overview of the principles of government and NFP entities includes those
changed or added GAAP principles of GASB as indicated under GASB statement no, 34 that
afford an understanding of the unique nature and complexity of governmental accounting and
financial reporting which is termed as Generally Accepted Accounting Principles of
Government Accounting Standards Board. These principles are made up of twelve which are
discussed as depicted below.

Principle 1. Accounting and Reporting Capabilities

This principle explains the requirements for accounting records and reporting. It requires a
governmental accounting system to make it possible both:
A. To present fairly and with full disclosure the financial position and results of financial
operations of the funds and accounting groups of the governmental unit in conformity
with generally accepted accounting principles; and
B. To determine and demonstrate compliance with financial related legal and contractual
provisions. 
An important function of governmental accounting systems is thus to enable administrators to
assure, and report on, compliance with finance-related legal provisions (requirements). This
means that the accounting system—its terminology, fund structure, and procedures—must take
cognizance of and be adapted to satisfy finance-related legal requirements.

Principle 2. Fund Accounting System

Governmental accounting system should be organized and operated on a fund basis. A fund is
defined as a fiscal and accounting entity with a self-balancing set of accounts recording cash
and other financial resources, together with all related liabilities and residual equities or
balances, and changes therein, which are segregated for the purpose of carrying on specific
activities or attaining certain objectives in accordance with special regulations, restrictions, or
limitations.
The diverse nature of governmental operations and the necessity of assuring legal
compliance preclude recording and summarizing all governmental financial transactions
 and balances in a single accounting entity. Unlike a private business, which is accounted
for as a single entity, a governmental unit is accounted for through several separate fund
entities, each accounting for designated assets, liabilities, and equity or other balances.
Thus, from an accounting and financial management viewpoint, a governmental unit is a
combination of several distinctly (clearly) different fiscal and accounting entities, each
having a separate set of accounts and functioning independently.

Note that because a fund is an accounting entity, each fund has the following:
■ Its own accounting equation
■ Its own journals, ledgers, and other accounting records needed to account for the
effects of external transactions or inter fund activities on the net assets/activities accounted
for in the fund
■ Financial statements that report on the fund itself
Business-type activities are accounted for in a category of funds called proprietary funds.
General governmental activities are accounted for in governmental funds. There are two types
of proprietary funds and five types of governmental funds. Fortunately, accounting for each of
the two types of proprietary funds is quite similar, and accounting for each of the five types of
governmental funds is also quite similar. Thus, once you learn to account for one type of
proprietary fund, you will know most of what is needed to account for all other proprietary
funds. Likewise, once you can account for one type of governmental fund, you know most of
what is needed to account for all governmental funds.

Principle 3: Types of Funds

To facilitate the recording process, a grouping system has been devised with all funds being
placed in to one of the three broad classifications;
1. Governmental Fund
All governmental funds are expendable. They are meant to be used entirely used up, usually
in one accounting period. Expendable assets are assigned based on the purpose for which
they may or must be spent. Therefore, governmental fund is classified in to the following;
A. The General Fund -According to the definition given by the GASB, general fund is a
fund established to account for all financial resources except those required to be
accounted for another fund. This description seems to imply that the general fund
records only miscellaneous revenues and expenditures when, in actuality, this fund type
is used to account for money of a government’s most important services. Whereas the
other governmental funds account for specific events or projects, the general fund is
used to record a broad range of on going activities.
For example, the financial statements for a given city may disclose six major areas of
expenditure within the general fund: general government, public safety, physical
environment, transportation, economic environment, cultural and recreation.

B. Special Revenue Funds-This fund accounts for the proceeds of specific revenue
sources that are legally restricted to expenditure for specified purposes. As example, the
city council of a given city may specify that any money collected from the sale of zoo
animals may be spent to acquire new animals. Thus money received from this source is
monitored by inclusion in the special revenue funds until expended.

C. Capital Projects Funds -To account for financial resources to be used for the
acquisition or construction of major capital facilities (other than those financed by
proprietary funds and trust funds). As the title implies, capital project fund accounts for
costs incurred in acquiring or constructing major government facilities such as bridges,
high schools, roads or municipal office complexes (compound). Funding for this project
is normally collected from general revenues or from the sale of bonds. Capital project
funds exist only for the period of acquisition or construction of the fixed Asset. After
the acquisition or construction is completed the capital project fund will be abolished
(closed down). If the governmental unit has a number of capital projects going on at the
same time they might be accounted for together in one capital project fund. If the
governmental entity has capital projects going on continuously, the capital project fund
will be more or less perpetual.
 D. Debt Service Finds- Debt service fund accounts for the accumulation of resources for
and the payment of general long term debt principal and interest. These funds serve to
record money accumulated in order to pay long-term liabilities and interest as they
become due. Debt service funds maintain a record of the monetary resources available
to satisfy long-term liabilities as well as the eventual payments of principal and interest.
2. Proprietary Funds
Proprietary funds are non expendable. They are for a part of the government that is run like a
private business, where the income and fees for the services of the fund is expected to cover
at least a part of expenses. Accordingly, according to Governmental Accounting Standard
Board, the proprietary funds are used to account for a government’s ongoing organizations
and activities that are similar to those often found in the private sector. To facilitate financial
reporting the proprietary funds are broken down in to two major divisions that is Enterprise
fund and Internal service fund.

A. Enterprise Funds- enterprise fund accounts for operations:

(a) that are financed and operated in a manner similar to private business enterprises
where the intent of the governing body is that the costs (expense, including
depreciation) of providing goods or services to the general public on a continuing
basis be financed or recovered primarily through user charges; or

(b) Where the governing body has decided that periodic determination of revenues
earned, expenses incurred and /or net income is appropriate for capital maintenance,
public policy, management control, accountability, or other purposes. As an example
we can mention public transport organization involved in determination of income
such as Ethiopian air lines, Regional Bus transportation service organizations, Public
Telecommunication organization etc.

B. Internal Service Funds- accounts for the financing of goods or services provided
by one department or agency to other departments or agencies of the
governmental unit, or to other governmental units, on a cost reimbursement basis.
 A shared garage is a common example of an internal service fund,
particularly in NGOs. The garage would repair all NGOs vehicles,
regardless of which project or fund uses them. Charges are made to the
various funds for the repair costs. As non expendable fund, part of the
charge made to the various funds could be intended to be accumulated for
future years for the purchase of tools and equipment.
3. Fiduciary funds
Fiduciary funds are those funds that are used to account for assets held by a governmental unit
in a trustee capacity or as an agent for individuals, private organizations, and other
governmental units. These include:
A. Agency Funds- A fund Used to account for any resources held by a
government as an agent for individuals or other government unit's one body on behalf of
another occasionally collects tax etc.
B. Pension Trust Funds: A fund Used to account for an employee
retirement system because of need to provide an adequate benefit.

Principle 4: Number of Funds

Governmental units should establish and maintain those funds required by law and sound
financial administration. Only the minimum number of funds consistent with legal and
operating requirements should be established, however, because unnecessary funds result in
inflexibility, undue (unnecessary) complexity, and inefficient financial administration.

Principle 5- Accounting for Fixed Assets & Long term Liabilities

A. Fixed assets related to specific proprietary fund/trust fund should be accounted in those
funds. All other fixed assets of governmental unit should be accounted for in the
general fixed asset account group (GFAAG).
B. Long term liabilities of proprietary & trust fund should be accounted for through those
funds. All other un matured General Long Term Liabilities Account Group (GLTLAG).

Principle 6- Valuation of Fixed Asset

Fixed assets should be accounted for at cost, or if the cost is not practicable determinable, at
estimated cost. Donated fixed assets should be recorded at their estimated fair value (mkt) at
the time of receipt plus ancillary (additional) charges, if any.

Principle 7-Depreciation of Fixed Assets

Capital assets should be depreciated over their estimated useful lives unless they are either
inexhaustible (unlimited) or are infrastructure assets using the modified approach as set forth
(forwards) in GASB Statement No. 34. Inexhaustible assets such as land and land
improvements should not be depreciated.
A. Depreciation of governmental fixed assets should not be recorded in the account of the
governmental funds.
B. Depreciation of fixed assets accounted for in proprietary & trust fund should be
recorded in the account of those funds. Under GASB standards, the using up of the
assets doesn’t represent a use of financial resources, so depreciation is not recorded.
Instead the expenditures for the asset is recognized when it is purchased, i.e., when the
out flow of financial resources occurs.

Principle 8- Basis of Accounting

A- Governmental Fund- revenue and expenditure should be recognized on the modified
accrual basis of accounting.
 Revenues should be recognized in the accounting period in which they become
available and measurable. This means the designated person can place
monetary amount on the revenue when it is measurable and collects the revenue
when it is available. When these concepts are applied, there are revenues, which
are recognized on both cash basis and accrual basis. Revenues which are
collected on cash basis by gov’tal entities are like the following; fines, forfeits,
taxes fees etc. where as revenues which are collected on accrual basis are like
property taxes etc.
  Expenditures should be recognized in the accounting period in which the fund
liability is incurred, if measurable, except for un matured interest on general
long-term liabilities, which should be recognized when due.
Measurable means capable of being expressed in monetary terms; available is defined as
“collectible within the current period or soon enough thereafter to be used to pay liabilities of
the current period.”
The accrual basis is implicitly required to be measurable, just as under the modified accrual
basis. However, under accrual basis, revenues normally don’t have to be available. On the
expense side, the accrual & modified accrual basis of accounting has the same recognition
criteria; when the related liabilities are incurred. However, the modified accrual basis uses the
term expenditure rather than expenses, as is done under the accrual basis. Expenditure is used
because it relates to financial outflows, where as, expenses can be either outflows or using up
of assets, such as applied to fixed assets by taking depreciation.

Modified accrual basis of accounting recognizes revenue in the accounting period in which it is
both measurable & available to finance the expenditures of the period. Expenditures are
recognized in the accounting period in which the liabilities are both measurable & incurred.

B- Proprietary Fund- revenue and expenses should be recognized on accrual basis of

accounting. Briefly, accrual accounting means that
 revenues should be recorded in the period in which the service is given, although
payment is received in a prior or subsequent(following) period, and
 Expenses should be recorded in the period in which the benefit is received, although
payment is made in a prior or subsequent period.

In business organization accounting, the accrual basis is employed to obtain a matching of

costs against the revenue flowing from those costs, thereby producing a more useful income
statement. In governmental entities, however, even for government-wide financial reporting
and those funds that attempt to determine net income, the objective is to provide services to the
public, not to maximize economic gain or profit.
Most of the governmental fund types (general funds, special revenue funds, capital projects
funds, and debt service funds) are not concerned with income determination. These funds are
concerned with matching expenditures of legal appropriations, or legal authorizations, with
revenues available to finance expenditures.

Principle 9- Budgeting, Budgetary control and Budgetary reporting

A distinctive characteristic of governmental accounting resulting from the need to demonstrate
compliance with laws governing the sources of revenues available to governmental units, and
laws governing the utilization of those revenues, is the formal recoding of the legally approved
budget in the accounts of funds operated on an annual basis. Briefly, budgetary accounts are
opened as of the beginning of each fiscal year and closed as of the end of each fiscal year;
therefore, they have no balances at year end. During the year, however, the budgetary accounts
of a fund are integrated with its proprietary (balance sheet and operating statement) accounts.
The principle incorporates the following points.
 An annual budget should be adopted by every governmental unit
 The accounting system should provide the basis for appropriate budgetary control.
 Budgetary comparison should be included in the appropriate financial statement and
schedules for governmental funds for which an annual budget has been adopted.

The above first point that is, the annual budget concept is not an accounting or financial
reporting principle, but it is a necessary pre-condition to accounting system for appropriate
budget control and budgetary comparison.
Principle 10- Transfers, Revenues, Expenditures, & expenses account classification

1. To distinguish internal shifts of resources and long term borrowing from revenues,
expenditures and expenses. In general, the following summaries are provided as per the
governmental Accounting Standard Board (GASB) for Transfer, Revenue, and Expense
Account (or Accounting) classification.

 Inter fund transfers and proceeds of general long-term debt issues should be classified
separately from fund revenues and expenditures or expenses.
  Governmental fund revenues should be classified by fund and source. Expenditure
should also be classified by fund, function (or program), organization unit, activity,
character and principal classes of objectives.
2. Proprietary fund revenues and expenses should be classified in essentially the same manner
as those of similar business organizations, functions, or activities.

The statement of activities should present governmental activities at least at the level of detail
required in the governmental fund statement of revenues expenditures, and changes in fund
balances at a minimum by function. Governments should present business type activities at
least by segment.

The preceding principle is intended to ensure that account classifications provide for separate
financial statement reporting of transfers from revenues and expenditures (or expense) and for
appropriate level of detail in the basic financial statements.

Principle 11- Common Terminology and Classification

A common terminology and classification should be used consistently throughout the budget,
the accounts, and the financial reports of each fund. The common Terminology and
classification principles is simply a statement of the common sense proposition that if the
Budgeting, Budgetary control and Budgetary Reporting principle is to be implemented, persons
responsible for preparing the budgets and persons responsible for preparing the financial
statements and financial reports should work with the persons responsible for designing and
operating the accounting system. Agreement on a common terminology and classification
scheme is needed to make sure the accounting system produces the information needed for
budget preparation and for financial statement and report preparation.

Principle 12- Entry and annual financial reports

Financial report of governmental unit could be classified as interim financial reports,
comprehensive annual financial report (CAFR), and general purpose financial statement (GPFS).
a) Appropriate interim financial statements of financial position, operating results and other
pertinent information should be prepared to facilitate management control of financial
operations, and where necessary or desired, for external reporting purposes.
b) A comprehensive annual financial report covering all funds and the account groups of the
governmental unit-including appropriate combined, combining and individual fund
statements should be prepared and published. CAFR should contain introductory, financial
and statistical sections.
c) General purpose financial statements of the reporting entity may be issued separately from
the CAFR.