The User's Perspective

December 2013


A Plain-English Guide to Deferrals

An article in the December 2011 issue of The User’s Perspective attempted to describe some new items that were about to start appearing in the financial statements of state and local governments—deferred outflows of resources and deferred inflows of resources (for simplicity, we will call them “deferrals” throughout much of this article). The goal of the original article was to explain where these deferrals came from and why the GASB was requiring them to be reported separately from assets and liabilities. Perhaps the article was not plain-English-y enough because, now that deferrals are beginning to peek their heads above the soil, the GASB is hearing that constituents are attempting to better understand what they are.

So, we beg your indulgence to allow us to take another shot at explaining deferrals and why it is important that governments clearly identify them in the financial statements.

Understanding What Deferrals Are, and What They Are Not

Maybe the best place to begin is to say what deferrals are not: They are not assets or liabilities. An asset is a resource that a government controls at present that can be used to provide services. A liability is a requirement to give up resources that a government generally cannot avoid. In simpler words, assets are things that a government owns and liabilities are amounts a government owes.

Deferrals are not revenues or expenses (expenditures), either. Revenues represent resources coming into a government during a period (usually a fiscal year)—such as cash or receivables—that are related to that period. Expenses (or expenditures, in the governmental funds) represent resources leaving a government during the fiscal year—through a cash payment or promise to pay, or by being used up like inventory—that are related to that year. Stated differently, revenues are inflows, and expenses (expenditures) are outflows of resources related to a particular fiscal year.

Deferrals are not revenues or expenses and are not assets or liabilities, even though they have been reported among assets and liabilities until now. Consider their full titles—deferred outflows of resources and deferred inflows of resources. Like revenues and expenses, deferrals represent flows of resources into and out of a government during the fiscal year. However, unlike revenues and expenses, which are inflows and outflows of resources related to the period in which they occur, deferrals are related to future periods.

Admittedly, the terms “deferred inflow of resources” and “deferred outflow of resources” are potentially confusing. Their titles suggest that it is the inflow or outflow that has been deferred or delayed until later. But, as with revenues and expenses, the events associated with inflows and outflows related to deferrals have, in fact, already occurred. The thing that is being deferred is the recognition of those inflows and outflows as revenues and expenses. Recognition of revenues and expenses is deferred until the future period to which the inflows and outflows are related.

Net position is the difference between assets and deferred outflows, on the one hand, and liabilities and deferred inflows, on the other. Revenues increase net position—which makes a government look healthier financially, all other factors being equal. Expenses reduce net position—which makes a government look less healthy. If total revenues for the year exceed total expenses, then net position increases overall and financial health improves; the opposite is true if total expenses exceed total revenues. This relationship is key to the concept of interperiod equity—a government raising sufficient resources each year to cover that year’s costs. If a government does not raise sufficient resources during the year, it either must consume surplus resources accumulated in prior years or push some costs off to the future. Providing users with information to assess whether a government is achieving interperiod equity is an important objective of financial reporting by state and local governments.

To get a sense of whether interperiod equity has been achieved, any inflows or outflows that took place during the fiscal year, but which actually relate to future period, should not be included. Those inflows and outflows are kept out of the assessment of interperiod equity by being reported as deferred inflows and deferred outflows rather than recognized as revenues and expenses.

An Example: Property Taxes

This may be a good time to make these ideas concrete with an example. Consider a government with a fiscal year that begins on July 1. This government levies its property tax for the coming fiscal year and sends out tax bills on the preceding June 1. The government then starts to receive payments on property tax bills during the month of June, amounting to $100, before the next fiscal year has begun. (Obviously, $100 is not a realistic number; it is used because it is simple to illustrate.) How should the receipt of the property tax payments for the next year be accounted for in this fiscal year?

The government has received cash, which is recognized as an asset. If the payment was for this year’s property taxes, the government also would recognize property tax revenue, which would increase net position:



However, the payment is for next year’s property taxes. Instead of recognizing property tax revenue, the government should recognize a deferred inflow of resources. Rather than increasing net position, a deferred inflow offsets the asset and net position remains unchanged:



When the next fiscal year begins on July 1, the payments already received and recorded temporarily as deferred inflows would then be recognized as revenue:



The deferred inflow is reduced and the revenue is recognized.

If the property tax payments received in advance had been treated as revenue in the current year, when they were collected, the inflows related to the current year would have been overstated. That would make the government look like it had achieved interperiod equity when it might not have, or by not as much as it did.

Another Example: Grants

Most grants made and received by governments are expenditure driven. In other words, governments first spend money on a program or function and then qualify to receive a grant reimbursing them. Sometimes a government is required to meet certain conditions other than spending money before the grantor will provide the grant payment. Occasionally, though, grants are made before the recipient government has met all of the eligibility requirements. If a government receives a $500 grant payment but has not yet met all of the requirements necessary to be eligible for the grant, it technically owes that grant payment back to the grantor until it meets the requirements. For that reason, the recipient should report a liability and the provider of the grant (if it is a government) should report an asset until all of the eligibility requirements have been met (with the exception of time requirements; more on those below):



If a cash grant is received and all of the eligibility requirements have been met except for a time requirement—for example, the grant may not be used until next fiscal year—then the grant should be recognized as a deferred inflow:



As you can see, in both cases there is no effect on net position. Why are they not both reported as liabilities or as deferred inflows? In (d), the recipient government has not yet done what it has to in order to be eligible for the grant; if it never meets the eligibility requirements, the grant has to be returned. In (e), however, the government has to wait for the next fiscal year; the inflow is related to a future period and, therefore, should be reported as a deferral.

Where Have Deferrals Been All This Time?

Deferred outflows of resources have been reported among the assets. Deferred inflows of resources have been reported among the liabilities. They clearly are not, however, either assets or liabilities.

Consider the property tax example above in (b). Previously, the property taxes for next year that were received before the year started would have been reported as a liability called “deferred revenue.” But, does that amount represent an obligation on the government to make a payment? Theoretically, if the government were to close its doors before the start of the next fiscal year, you could argue that it would owe those property tax payments back to the property owners. What are the chances of the government going out of business?  Accounting traditionally has assumed that the entity is a going concern. Rather than an amount the government owes, those payments received in advance are inflows that are waiting to be recognized as revenue when the government reaches the period in which those inflows belong.

Why Is It Important to Report Deferrals Separately?

The GASB requires that deferred outflows of resources be reported in the financial statements apart from assets, and deferred inflows of resources apart from liabilities. The simplest reason is that deferrals are not assets or liabilities and not revenues or expense (expenditures), and reporting them as such risks distorting a government’s actual financial position.

If you are analyzing whether a government has sufficient resources to satisfy its liabilities, for instance, the ratios you calculate ought not to include deferred outflows of resources among the assets, because they are not resources that can be used to pay off a liability. Likewise, the ratios should not include deferred inflows of resources among the liabilities, because they are not amounts the government owes and will need resources to satisfy.

A second reason, already discussed, is interperiod equity. To get a reading of whether a government is raising sufficient resources each year—whether it is “making ends meet” or “living within its means”—you need proper measures of revenues and expenses. Reporting certain inflows and outflows as deferrals until the time is proper to recognize them as revenues and expenses avoids overstating actual current-period revenues and expenses.

Another important objective of financial reporting by governments is providing information about the cost of providing services. A key need for many users of governmental financial reports is a measure of how much it costs to provide services. This cost includes more than just cash paid out during the year; it also encompasses costs that were incurred but not yet paid, such as employee salaries earned prior to the next payday and interest accrued on outstanding debt. Cost of services also includes non-cash items such as depreciation on the capital assets that are used to provide services and operate the government. The reporting of deferrals helps to ensure that outflows of resources are not reported as costs until the period to which they belong; the cost of next year’s services should not be reported as expenses this year, which overstates the cost of services this year and understates it next year.

What Will Happen to the Deferrals Hiding among the Assets and Liabilities?

The GASB reviewed all of the balances that the accounting standards require governments to report as assets and liabilities and asked for each one, “Does it meet the definition of an asset or liability?” If the answer was yes, the balance will continue to be reported as an asset or liability. For example, prepayments in an exchange transaction—such as a government making a rental payment in advance—will continue to be recognized as assets. In this transaction, the government has simply changed the mix of its assets—it has less cash, but now it has an asset that represents the right to occupy a building or use a piece of equipment. If a government receives payments in advance—such as a deposit for future sales tax receipts—it reports those amounts as liabilities and will continue to do so.

Balances that did not meet the definition of an asset or liability were then compared with the definitions of deferrals. One example is revenue in the governmental funds that is not considered to be available. To be recognized as revenue under the modified accrual basis of accounting, which is used in the governmental funds, payment must be received during the year or soon enough thereafter to be “available” to finance current-period expenditures. If a portion of a government’s property tax levy is not expected to be collected until more than 60 days after the end of the fiscal year, for instance, it is not considered available. That portion is currently reported as a liability labeled deferred revenue. However, that amount is not owed to anyone; it just does not qualify to be recognized as revenue yet. Therefore, going forward it should be reported as a deferred inflow of resources and recognized as revenue when it is collected in the future.

If a balance previously reported as an asset or liability does not meet the definition of an asset, liability, or deferral, then it must actually be a current-period inflow or outflow of resources; in other words, a revenue, expense, expenditure, gain, loss, and so on. A prime example of this is bond issuance costs. Previously, bond issuance costs were reported as an asset and recognized systematically as expense (“amortized”) over the maturity of the related bonds. These costs are not a resource that can be used to provide service; they also are not an amount owed. They do represent an outflow of resources, but they are not related to a future period. Although they were incurred when issuing long-term bonds that are repaid over future periods, the costs themselves only relate to the period when the bonds were issued. As a result, from now on they should be reported as expenses when they are incurred.

What Should a User Do with Deferrals?

Deferrals are here to stay; now what?

Option 1: Treat them as if they are assets and liabilities


Pros: It would be simple to add the deferred outflows to the assets and the deferred inflows to the liabilities, as if they had never been moved to their own parts of the financial statements. This would maintain historical trends in ratios that are calculated as part of your analysis.

Cons: What is the value of a historical trend in ratios that are not accurate depictions of the resources a government has and the amounts it owes? Furthermore, this approach misses the value of deferrals when reported on their own. As revenues and expenses waiting to be recognized, deferrals are an indicator of future resources and costs and, therefore, of a government’s ability to continue to make ends meet. Although the financial report generally will not likely indicate when the deferrals will become revenues and expenses, that is a topic that can be pursued further with a government’s finance officials.

Option 2: Adjust ratios from prior years to remove deferrals

Pros: This is probably the preferable approach from an analytical standpoint because it produces a consistent historical trend that does not treat these items as if they are really assets and liabilities. However…

Cons: ...you may not be able to identify the items now reported as deferrals among the assets and liabilities in prior years. Some will be included among larger categories of assets and liabilities, such as receivables and payables, and are therefore indiscernible. Others may be buried within the prior category, deferred revenues—some of which will henceforth be reported as deferred inflows and others of which will continue to be reported as liabilities but with different labels (and may, consequently, be aggregated with other liabilities on the face of the financial statements).

Option 3: Adjust ratios and analysis to take into account that these items are not assets and liabilities

Pros: This is the most realistic approach, acknowledging deferrals for what they are. Going forward, ratios calculated using assets or liabilities alone will more accurately measure what they are intended to assess.

Cons: This requires working without a trend in the relevant ratios until governments have been reporting in this fashion for a few years. That is undoubtedly a loss of analytical information.

Some combination of options may be possible as well. For instance, one could continue to pursue Option 1 while beginning to build a new trend (Option 3), but with the awareness that the old ratios may be off to a degree based on how large the deferrals are relative to total assets and liabilities. The larger the deferred outflows and deferred inflows are as a percentage of assets or liabilities, respectively, the more inaccurate the ratios will be as long as they contain deferrals among the assets and liabilities.
 
Another potential boon to users should be mentioned in closing. At present, items such as deferred revenues are actually aggregations of both liabilities and deferred inflows. Some asset and liability items include deferrals. In both cases, it is difficult or impossible to sort them out on your own. The new standards for reporting deferrals should lead to more specificity about the nature of these deferred balances. The reasons why recognition of inflows and outflows as revenues and expenses is deferred vary. A deferred inflow related to a grant with time restrictions means something different than a deferred inflow resulting from an increase in the fair value of a hedging derivative instrument. It is likely that the reporting of deferrals in their own sections of the financial statements will provide greater detail about the nature of individual types of deferred inflows and outflows, which should be beneficial to the users of those financial statements.

 

Further Reading