Proprietary Funds Financial Statements

Proprietary funds account for government activities that operate similarly to private-sector businesses, providing goods or services to external customers or to other departments on a fee-for-service basis. They use the economic resources measurement focus and full accrual basis of accounting — the same model as commercial enterprises — and report capital assets, long-term liabilities, and depreciation directly on their fund-level statements.

Blueprint Coverage

This section maps to BAR Area III, Group A, Topic 3 – Proprietary funds financial statements. Representative tasks:

1. Identify and recall basic concepts and principles associated with proprietary fund financial statements (e.g., required funds, financial statements, financial statement components).
2. Prepare the statement of revenues, expenses, and changes in fund net position for the proprietary funds of a state or local government from trial balances and supporting documentation.
3. Prepare the statement of net position for the proprietary funds of a state or local government from trial balances and supporting documentation.
4. Prepare the statement of cash flows for the proprietary funds of a state or local government.

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Two Types of Proprietary Funds

Proprietary funds are divided into two categories based on who they serve:

Fund Type	Serves	Examples
Enterprise Funds	External users (the public)	Water/sewer utility, airport, parking garage, transit authority, municipal golf course
Internal Service Funds	Other departments or governments	Motor pool, IT services, central printing, self-insurance, central purchasing

Enterprise Funds — When Required

An enterprise fund must be used when one or more of the following criteria are met:

1. The activity is financed with debt backed solely by a pledge of the net revenues from fees and charges of the activity.
2. Laws or regulations require that the activity's costs (including capital costs such as depreciation) be recovered with fees and charges rather than taxes.
3. Management's pricing policy is designed to recover the costs of providing services, including capital costs such as depreciation.

Exam Tip

Remember the "debt, law, pricing" mnemonic for mandatory enterprise fund usage. If a question says bonds are secured solely by utility revenues, that activity must be in an enterprise fund.

Internal Service Funds — Key Characteristics

• Used when one government department sells goods/services to another department on a cost-reimbursement basis.
• Never required — always a management choice.
• If the internal service fund predominantly serves governmental activities, its assets and liabilities are typically reported within governmental activities in the government-wide statements.

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Measurement Focus and Basis of Accounting

Because proprietary funds mirror commercial accounting, they differ significantly from governmental funds:

Feature	Proprietary Funds	Governmental Funds
Measurement focus	Economic resources	Current financial resources
Basis of accounting	Full accrual	Modified accrual
Reports capital assets?	Yes (with depreciation)	No
Reports long-term liabilities?	Yes	No
Revenue recognition	When earned	When measurable and available
Expense vs. expenditure	Reports expenses	Reports expenditures
Bottom line	Net position	Fund balance

Critical Distinction

Proprietary funds report expenses (including depreciation and amortization), not expenditures. When you see "expenditures" on a proprietary fund statement, it is always wrong.

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Three Required Financial Statements

Proprietary funds must present three fund-level financial statements:

#	Statement	Purpose
1	Statement of Net Position	Reports assets, deferred outflows, liabilities, deferred inflows, and net position at a point in time
2	Statement of Revenues, Expenses, and Changes in Fund Net Position	Reports operating and nonoperating results for the period
3	Statement of Cash Flows	Reports cash inflows and outflows in four categories using the direct method

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Statement of Net Position

The statement of net position may be presented in either a classified (current/noncurrent) format or an unclassified liquidity format. Most governments use the classified balance-sheet format.

Net Position Categories

$$\text{Net Position} = \text{Assets} + \text{Deferred Outflows} - \text{Liabilities} - \text{Deferred Inflows}$$

Net position is divided into three components:

Component	Definition
Net investment in capital assets	Capital assets, net of accumulated depreciation, minus outstanding debt related to those assets (plus unspent bond proceeds)
Restricted	Resources with externally imposed constraints (creditors, grantors, laws) or constitutional provisions
Unrestricted	All remaining net position — may include board designations, but these are not restrictions

Example — Statement of Net Position

Bear City Water Utility Fund — Statement of Net Position — December 31, 20X5

	Amount
Assets
Current assets:
Cash and cash equivalents	$2,450,000
Accounts receivable (net)	1,380,000
Inventories	210,000
Total current assets	4,040,000
Noncurrent assets:
Capital assets (net of depreciation)	18,600,000
Total assets	22,640,000
Deferred Outflows of Resources	320,000
Liabilities
Current liabilities:
Accounts payable	680,000
Accrued salaries	140,000
Current portion of revenue bonds	500,000
Total current liabilities	1,320,000
Noncurrent liabilities:
Revenue bonds payable	7,500,000
Total liabilities	8,820,000
Deferred Inflows of Resources	180,000
Net Position
Net investment in capital assets	10,600,000
Restricted for debt service	850,000
Unrestricted	2,510,000
Total net position	$13,960,000

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Statement of Revenues, Expenses, and Changes in Fund Net Position

This statement distinguishes operating from nonoperating items:

Operating vs. Nonoperating Classification

Category	Examples
Operating revenues	Charges for services, water usage fees, sewer connection fees, parking fees
Operating expenses	Salaries, utilities, supplies, depreciation, repairs, contractual services
Nonoperating revenues	Interest income, grants not restricted to capital, gain on sale of assets
Nonoperating expenses	Interest expense, loss on sale of assets

Below the nonoperating section, report:

• Capital contributions (tap fees, developer contributions, capital grants)
• Transfers in/out
• Special and extraordinary items (if applicable)

Exam Tip

Interest expense on revenue bonds is always classified as nonoperating — even though the bonds finance the core operations of the enterprise fund. The GASB considers interest a financing cost, not an operating cost.

Example — Statement of Revenues, Expenses, and Changes in Fund Net Position

Bear City Water Utility Fund — Year Ended December 31, 20X5

	Amount
Operating revenues:
Charges for services	$8,200,000
Connection fees	340,000
Total operating revenues	8,540,000
Operating expenses:
Personnel services	2,800,000
Purchased water	1,950,000
Utilities	420,000
Supplies and materials	310,000
Depreciation	1,400,000
Repairs and maintenance	280,000
Total operating expenses	7,160,000
Operating income	1,380,000
Nonoperating revenues (expenses):
Interest income	85,000
Interest expense	(525,000)
Total nonoperating expenses	(440,000)
Income before contributions and transfers	940,000
Capital contributions	600,000
Transfers out	(150,000)
Change in net position	1,390,000
Net position — beginning of year	12,570,000
Net position — end of year	$13,960,000

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Statement of Cash Flows

The proprietary fund statement of cash flows has two unique features compared to FASB standards:

1. Direct method is required (FASB allows either direct or indirect).
2. Cash flows are classified into four categories (FASB uses three).

Four Categories of Cash Flows

Category	Description	Examples
Operating Activities	Cash from providing services and paying for operations	Cash received from customers, cash paid to employees, cash paid to suppliers
Noncapital Financing Activities	Borrowings/grants for operating purposes, interfund transfers	Operating grants received, transfers to/from other funds, short-term borrowings not related to capital
Capital and Related Financing Activities	Acquisition of capital assets and related debt	Purchase of capital assets, bond proceeds for capital, principal and interest payments on capital debt, capital contributions received
Investing Activities	Purchase/sale of investments and returns thereon	Purchase of investments, proceeds from sale of investments, interest and dividends received

GASB vs. FASB Difference

The GASB splits FASB's single "financing activities" category into two: noncapital financing and capital and related financing. Interest and dividends received go to investing activities under GASB (not operating). This is a frequent exam question.

Interest and Dividends Classification

Item	GASB Classification	FASB Classification
Interest received	Investing activities	Operating activities
Dividends received	Investing activities	Operating activities
Interest paid on capital debt	Capital and related financing	Financing activities
Interest paid on noncapital debt	Noncapital financing	Financing activities

Example — Statement of Cash Flows

Bear City Water Utility Fund — Year Ended December 31, 20X5

	Amount
Cash flows from operating activities:
Cash received from customers	$8,320,000
Cash paid to employees	(2,760,000)
Cash paid to suppliers	(2,890,000)
Net cash provided by operating activities	2,670,000
Cash flows from noncapital financing activities:
Transfers to other funds	(150,000)
Net cash used by noncapital financing activities	(150,000)
Cash flows from capital and related financing activities:
Capital contributions received	600,000
Acquisition of capital assets	(2,100,000)
Proceeds from revenue bonds	1,000,000
Principal paid on revenue bonds	(500,000)
Interest paid on revenue bonds	(525,000)
Net cash used by capital and related financing activities	(1,525,000)
Cash flows from investing activities:
Interest received	85,000
Net cash provided by investing activities	85,000
Net increase in cash and cash equivalents	1,080,000
Cash and cash equivalents — beginning of year	1,370,000
Cash and cash equivalents — end of year	$2,450,000

Required Reconciliation Schedule

A reconciliation of operating income to net cash provided by operating activities (similar to the indirect method) is presented as a schedule at the bottom of the statement:

	Amount
Operating income	$1,380,000
Adjustments to reconcile:
Depreciation	1,400,000
Increase in accounts receivable	(220,000)
Decrease in inventories	30,000
Increase in accounts payable	40,000
Increase in accrued salaries	40,000
Net cash provided by operating activities	$2,670,000

Exam Tip

Even though the statement uses the direct method, GASB still requires the reconciliation schedule. Think of it as getting both methods — direct in the body, indirect as a supplementary schedule.

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Enterprise Fund vs. Internal Service Fund Reporting

Feature	Enterprise Funds	Internal Service Funds
Presented in	Proprietary fund statements	Proprietary fund statements
Column presentation	May be reported as major funds (separate columns)	Always combined in a single column
Government-wide consolidation	Business-type activities	Usually governmental activities (if predominantly serving governmental funds)
Pricing basis	Market rates or cost recovery	Cost-reimbursement to internal users
Major fund determination	Apply 10%/5% test	Not subject to major fund criteria

Internal Service Fund Consolidation

When converting to government-wide statements:

• Internal service fund assets and liabilities are added to governmental activities (assuming the fund predominantly serves governmental departments).
• Any profit markup charged to governmental funds is eliminated to avoid double-counting.
• The internal service fund's revenue from billings to governmental funds is eliminated against the corresponding expense in those funds.

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Journal Entry Examples

Recording Enterprise Fund Revenues

Bear City Water Utility bills customers $680,000 for water usage in December:

Debit

Credit

Dec 31

Accounts Receivable

$680,000

Charges for Services

$680,000

Recording Depreciation

Bear City records annual depreciation of $1,400,000 on water treatment plant and equipment:

Debit

Credit

Dec 31

Depreciation Expense

$1,400,000

Accumulated Depreciation

$1,400,000

Capital Asset Acquisition

Pine County Airport Fund purchases baggage handling equipment for $850,000:

Debit

Credit

Equipment

$850,000

Cash

$850,000

Revenue Bond Issuance

Bear City Water Utility issues $1,000,000 in revenue bonds to finance a new pumping station:

Debit

Credit

Cash

$1,000,000

Revenue Bonds Payable

$1,000,000

Internal Service Fund — Billing Other Departments

Illini Township motor pool bills the police department $45,000 for vehicle maintenance:

Debit

Credit

Due from General Fund

$45,000

Charges for Services

$45,000

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Summary of Key Differences

Topic	Proprietary Funds	Governmental Funds	Government-Wide
Measurement focus	Economic resources	Current financial resources	Economic resources
Basis of accounting	Full accrual	Modified accrual	Full accrual
Capital assets	Reported with depreciation	Not reported	Reported with depreciation
Long-term debt	Reported	Not reported	Reported
Cash flow method	Direct (required)	Not applicable	Not applicable
Cash flow categories	4 categories	N/A	N/A
Bottom line	Net position	Fund balance	Net position

Exam Tip

The statement of cash flows is only required for proprietary funds — not governmental funds and not government-wide statements. If an exam question asks which statement uses the direct method, the answer is always the proprietary fund statement of cash flows.

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Practice Checkpoint

Use these questions to test your understanding:

1. What three criteria trigger mandatory use of an enterprise fund?
2. Name the four categories in a governmental proprietary fund statement of cash flows.
3. Where is interest received classified in a GASB statement of cash flows? How does this differ from FASB?
4. If an internal service fund primarily serves governmental departments, into which column does it consolidate in the government-wide statements?
5. Why does a proprietary fund report depreciation expense but a governmental fund does not?

Answers

1. (a) Debt backed solely by fees, (b) legal/regulatory requirement for cost recovery, (c) management pricing policy designed to recover costs including capital costs.
2. Operating, noncapital financing, capital and related financing, and investing.
3. GASB: investing activities. FASB: operating activities.
4. Governmental activities column.
5. Proprietary funds use the economic resources measurement focus (full accrual), which requires recognition of long-lived asset consumption. Governmental funds use the current financial resources focus, recording capital outlays as expenditures at purchase.