N.C. Local Government Finance Policy Manual

3.0 Introduction

Fund balance represents the financial equity of governmental funds, which is calculated by subtracting total liabilities from total assets as shown on the respective fund’s balance sheet. Available fund balance represents the portion of fund balance that can legally be used to balance, if needed, the annual balanced budget ordinance. [G.S. 159-8(a)]. The Local Government Commission (LGC) staff considers the amount of fund balance available as a percentage of expenditures calculated for the general fund to be one of the key indicators of the financial condition of a tax-levying unit of government. As part of the process of reviewing audited financial statements each year, the staff calculates the amount of fund balance available in the general fund. This calculation is used primarily to identify units that could have cash flow problems.

This policy begins with the primary reasons for fund balance, including cash flow, emergencies, pay-as-you-go financing, and balancing the budget. It then presents the statutory calculation for identifying the amount of available fund balance that can be appropriated for balancing the annual balanced budget ordinance before providing an overview of the generally accepted accounting principles (GAAP) presentation of fund balance on annual financial statements. The methodology used by the LGC for calculating fund balance as a percentage of expenditures is also presented, including how the financial indicator is compared against other local governments for interpreting the financial condition of the respective local unit’s general fund.

See Sample Ordinances and Policies under the Resource List for four examples of fund balance policies.

3.1 Reasons for Fund Balance

The first reason for the general fund to maintain a healthy fund balance is cash flow, responding to the timing of how the primary revenue source of property taxes is collected for this fund. G.S. 159-8(b) states that the budget ordinance of a local unit shall cover a fiscal year beginning July 1 and ending June 30. While there may be initiatives for taxpayers to pay according to the due date in September or shortly thereafter (discount rates, federal tax laws, etc.), a significant portion of the property taxes are not collected until the beginning of January. Paying before the deadline in January still allows taxpayers to avoid interest and penalties on this fundamental revenue source of local units in North Carolina. Local units must have healthy fund balances to cash flow payroll and accounts payable for the first six months of operations while waiting for their cash accounts to be replenished from the collection of property taxes.

The second reason for the general fund to maintain a healthy fund balance is emergencies. The annual threat of natural disasters that disrupt critical services for local units across the state of North Carolina is commonly cited as an example in support of this reason. While local units may receive emergency relief from federal and state agencies after natural disasters occur, they rely on their cash reserves to immediately restore services while waiting on these reimbursements. The ability of local units to restore services in a timely fashion and to repair the infrastructure that supports the tax base is fundamental to the quality of life of the respective community.

The third reason for the general fund to maintain a healthy fund balance is pay-as-you-go financing. Local units invest in capital assets annually, including the need for ongoing maintenance and infrastructure expansion. This is why local units commonly adopt capital improvement programs to guide these critical community investments. However, local governments should rely on a balance between debt financing and pay-as-you-go financing when making these investment decisions. The ability of pay-as-you-go financing requires cash reserves accumulated in fund balance of the general fund. G.S. 159-18 also allows local units to use separate capital reserve funds to accumulate cash for capital investments, recognizing the importance of pay-as-you-go financing from the perspectives of community sustainability and of bond rating agencies. Rating agencies value the balance between debt and cash financing of capital assets and use fund balance levels to establish credit risk, directly impacting interest rates on debt financing.  

The fourth reason for the general fund to maintain a healthy fund balance is balancing the annual budget ordinance. G.S. 159-8 requires that local units adopt and operate under an annual balance budget ordinance. A budget ordinance is balanced when the sum of estimated net revenues and appropriated fund balance is equal to appropriations. While local units possess the flexibility to use cash reserves to balance their annual budget ordinances when needed, there is a limitation on the amount of available fund balance that can be used for this purpose, as discussed in Section 3.2.

Of course, this is not an exhaustive list of reasons for local units to maintain adequate cash reserves. It is common for local units to maintain and invest these cash reserves according to the limitations of G.S. 159-30 for income generation, with the proceeds being used to help balance the annual budget ordinance. Cash reserves also allow local units to respond to unexpected opportunities. Such opportunities may include the ability to appropriate funds for grant matching or unexpected economic development opportunities. In other words, cash reserves give local units decision-making flexibility. 

3.2 Statutory Calculation of Available Fund Balance

G.S. 159-8(a) states that appropriated fund balance to balance the annual budget ordinance shall not exceed the sum of cash and investments minus the sum of liabilities, encumbrances, and deferred revenues arising from cash receipts as those figures stand at the close of the fiscal year next preceding the budget year. Therefore, this calculation is going to be an estimate given that it is based on June 30 before the beginning of the new fiscal year rather than on audited financial statements from the previous fiscal year. It is common for the budget officer or the finance officer to make this calculation during the budget season to understand the amount available for appropriation regardless of the final decision on using part of fund balance to balance the annual budget ordinance. It should be noted that this is the maximum amount available for the coming fiscal year. Although the actual amount of fund balance will change during the year as revenues are received and expenditures are made, the maximum legally available amount will remain the same for the entire budget year.

The first part of the equation is the sum of cash and investments, stated on the balance sheet of the general fund. This amount includes restricted cash and investments. The second part of the equation is the sum of liabilities, which are amounts owed by the fund either to outside vendors of the organizations or to other funds of the same local unit. The third part of the calculation is encumbrances, which represent the amounts needed to pay any commitments related to purchase orders and contracts that remain outstanding at the end of the fiscal year. An outstanding amount is found in the notes of the financial statements. The final part of the equation is deferred revenues arising from cash receipts. The most common example of this category is when citizens pay property taxes in the fiscal year before they are due. Because these revenues are not legally available until the following fiscal year, prepaid taxes are reported as part of deferred inflows of resources on the general fund’s balance sheet. 

After this calculation is made, the amount of fund balance available for appropriation is divided by projected expenditures plus projected transfers out as those figures stand at the close of the fiscal year immediately preceding the budget year. The result is the financial indicator of fund balance as a percentage of expenditures. The reason for this extra step is local units would not want to violate their fund balance policies. For example, a local unit with a fund balance policy of 35 percent or more would not want to appropriate an amount of available fund balance to balance its annual budget ordinance that may compromise this threshold. A common question regarding the percentage is how to identify the appropriate threshold for a given local unit. While it is ultimately a policy decision made by the governing board, beginning with the average fund balance as a percentage of average expenditures for local units in the same expenditure category represents an excellent starting point before adjusting for circumstances unique to the respective local government. Stating the financial metric in terms of a percentage also allows for trend analysis over time, given the annual changes in both the numerator and denominator, and for benchmarking against other local units.  

3.3 GAAP Financial Presentation of Fund Balance

There is the budgetary perspective of fund balance and the financial reporting perspective. The financial reporting perspective is defined in GAAP by the Governmental Accounting Standards Board (GASB) in GASB Statement No. 54, Fund Balance Reporting and Governmental Fund Type Definitions. Another approach to identifying fund balance available for appropriation is by evaluating the elements, or categories of fund balance as they stand at the end of the fiscal year. Partially due to the ease in the calculation, the staff of the Local Government Commission evaluates available fund balance for municipalities and counties using this approach as described in Section 3.4.

Fund Balance Categories. There are five potential categories of fund balance:

• Nonspendable
• Restricted
• Committed
• Assigned
• Unassigned

In identifying what categories of fund balance exist for a governmental entity as of the end of the fiscal year, the evaluation must be performed in this order. It should also be noted that non-spendable and restricted portions of fund balance are considered outside the scope of management control, while committed, assigned, and unassigned amounts are within the scope of management control. Also, a negative amount should not be reported in any governmental fund for restricted, committed, or assigned amounts.

3.3.1 Nonspendable Fund Balance

Nonspendable fund balance represents a portion of fund balance that is either not in a spendable form or is legally required to remain intact. The most common portions of fund balance that are not in a spendable form would be inventory or prepaid assets remaining at the end of the fiscal year. These occur most commonly in the general fund. Amounts legally required to remain intact include endowments or the principal amount of a permanent fund. While uncommon for governmental funds, long-term notes or receivables and property held for resale would also be part of nonspendable fund balance (assuming the proceeds of the collection of the receivables or of the property sale have not been deemed to be restricted, committed, or assigned).

3.3.2 Restricted Fund Balance

In governmental GAAP, the term restricted indicates a limitation imposed by an external party or imposed by law. Examples of external restrictions could include but are not limited to, grants, donations, or debt covenants. Impositions by law most commonly include statutory requirements, constitutional provisions, or enabling legislation (an example of the latter would be a tax or charge authorized by the citizenry). While many of the elements of restricted fund balance may be in a spendable form, the use is limited by the external party or law.

A unique element of restricted fund balance in North Carolina is stabilization by state statute. This calculation is made at the end of the fiscal year and reflects the amount of fund balance that, by state statute, is not available for appropriation. The amount is determined as follows:

Total fund balance – (minus) Available fund balance (see Section 3.2) – (minus) Nonspendable fund balance = (equals) Stabilization by state statute reported as part of restricted fund balance

3.3.3 Committed Fund Balance

Committed fund balance represents the portion of fund balance “set aside” by formal action of the governing board for specific purposes, which is typically defined as the adoption of an ordinance in North Carolina. The action may only be taken by the governing board and must occur before the end of the fiscal year. However, the final amount may not be determined until after the end of the fiscal year. These commitments remain binding until the resources are used for their intended purpose or the governing board takes an equivalent formal action to remove the commitment.

3.3.4 Assigned Fund Balance

Assigned fund balance is intended to represent less formal fund balance designations for specific purposes. Assignments may be determined at any time before the external financial statements are issued. For the general fund, assigning fund balance for these purposes may occur by formal or informal action of the governing board. Alternatively, the governing board may confer the authority to determine assignments, if any, on management. In contrast to committed fund balance, limited or no action is taken to remove an assignment. If the assignment was created formally by the governing board, formal action is required to modify or remove the assignment if such action is taken during the same fiscal year. Otherwise, the assignment automatically lapses at the end of the fiscal year. In any situation, assignments may not create or increase a negative unassigned amount.

It should be noted that the way assignments are reported slightly differs for the other governmental fund types (i.e., special revenue, debt service, capital projects, permanent). Each of these fund types have very specific definitions and purposes. Thus, once nonspendable, restricted, and committed amounts are determined for each of these funds, if any positive amount is remaining, it is automatically assigned to the purpose of that fund type. If what remains is a negative amount, it would be reported as unassigned fund balance.

3.3.5 Unassigned Fund Balance

For the general fund, after the previous categories of fund balance are evaluated and identified, as applicable, the unassigned amount is determined. Whatever amount remains (positive or negative) would be reported as unassigned. However, the negative amount would lessen or eliminate the assigned amount. If there is still a negative unassigned amount after the assigned amount is eliminated, then it would be reported as such.

3.4 LGC Calculation of Available Fund Balance

Local units are required to send their audited financial statements to the LGC annually. The deadline for submission is October 31. It should be noted that amended audit contracts are required by the LGC when audits are received on or after December 1. While the LGC staff conducts a financial review of all funds, this section of the policy focuses on how the LGC staff members calculate the financial indicator of fund balance as a percentage of expenditures for the general fund. Again, this is a fundamental indicator for determining the financial condition of a tax-levying unit of government. However, the calculation is different from the statutory calculation presented in Section 3.2 of this policy for two reasons. The first is that the LGC leverages the GAAP financial presentation of fund balance discussed in Section 3.3, which allows the calculation to be made with financial data obtained directly from the financial statements rather than the statements and respective notes. The second is that the calculation used by the LGC, which is used for trend analysis and for benchmarking against other local units, results in approximately the same amount as the statutory calculation.

The calculation begins with total fund balance as found on the balance sheet of the general fund before subtracting the nonspendable category of fund balance and the restricted fund balance element of stabilization by state statute. The nonspendable portion of the fund balance represents resources that are physically or legally in a nonspendable form, such as inventory. Stabilization by state statute represents nonspendable resources as defined in Section 3.33. After this calculation is made, the resulting amount is divided by total general fund expenditures plus transfers out to produce the financial indicator of fund balance as a percentage of expenditures for the general fund. While the LGC staff members continue to track this indicator from the perspective of trend analysis, they no longer use population averages for benchmarking this metric against other local units. They now use general fund expenditure averages to create comparison categories, which place local units into categories based on their service provision as captured by total general fund expenditures rather than population.

The LGC considers being in the bottom quartile of an average expenditure group for tax-levying units to be an orange flag, which represents 50 percent of the average fund balance as a percentage of average expenditures for each expenditure category. For example, if the average fund balance as a percentage of average expenditures in a selected expenditure category is 60 percent, the bottom quartile would be 30 percent and below. The LGC often places local units on the Unit Assistance List (UAL) when they are in the bottom quartile and their respective percentages decline for three consecutive fiscal years.

The best line of defense against encountering cash flow problems or being placed on the UAL is to begin with a fund balance policy and to ensure compliance on an annual basis. This includes discussing the policy with the elected officials after the annual audit of the financial statements is complete. However, there are other lines of defense. The LGC, for example, encourages local units to avoid interfund transfers, which often occur between the general fund and the water and sewer fund. Therefore, local units should monitor the cash reserves in all funds to decrease the risk of transfers from the general fund. Local units must also follow the preaudit requirement of G.S. 159-28, a statutory, internal control fundamental to preventing budget violations and improving cash reserves.