CAPITAL CONFUSION 12 Misunderstandings about …

1 BY STEPHEN J. GAUTHIERCAPITAL CONFUSION12 Misunderstandings about accounting for CAPITAL AssetsMany accounting and financial reporting issues affectsome governments, but not all stateand local governments, however, must confront theongoing challenge of accounting for CAPITAL assets. To helpgovernments meet this challenge, the Government FinanceOfficers Association (GFOA) recently released a new book, accounting for CAPITAL Assets: A Guide for State and LocalGovernments, that comprehensively addresses accountingand financial reporting for CAPITAL assets (the contents are list-ed in Exhibit 1).

2 This article will focus on 12 common misun-derstandings that the new publication should help No. 1If it s a parcel of land with a building on top,it must be a CAPITAL asked to provide the quintessential example of a capitalasset, most probably would reply land or buildings. Yet notevery parcel of land or building necessarily qualifies as a cap-ital asset. Some assets are acquired for use in operations ( ,fire truck), while others are acquired withthe intent of resale ( , foreclosure prop-erties). By definition, only the formerqualify as CAPITAL is, the cru-cial factor in determining whether agiven item should be classified as a capi-tal asset is not the form of the asset, but itsintended use.

3 Thus, a parcel of landacquired to serve as the site of a newschool would properly be classified as acapital asset, but not an identical parcel of land acquired foreventual resale to a private-sector business as part of a rede-velopment distinction between capitaland noncapitalis more thana question of terminology. Governmental funds ( , generalfund) do not report CAPITAL assets; they do, however, reportitems acquired for the purpose of resale, including items thatresemble CAPITAL assets. Also, CAPITAL assets are unaffected bychanges in fair value, whereas items held for resale cannot bereported at more than their net realizable No.

4 2 CAPITAL assets and fixed assets are really one and the same the private sector, CAPITAL assets are commonly describedas property,plant, and equipment. For many years, the equiva-lent term in the public sector was fixed assets. In both cases,the language suggests an asset that is both tangible andimmovable. Neither quality, however, is an essential character-istic of a CAPITAL asset. Rather, the essential features of a capi-tal asset are that it will be used in operationsand that it has auseful life extending beyond a single reporting period. Thus,intangibleitems such a legal rights ( , easements) and inter-nally developed computer software typically qualify as capi-tal assets.

5 Unfortunately, because intangible assets do not look like other CAPITAL assets, financial statement preparersoften overlook them when calculating the portion of netassetsclassified as invested in CAPITAL assets,net of related No. 3A CAPITAL asset should always be reported as an asset of the government that maintains the public sector, it is not uncommon for a higher level ofgovernment ( , county) to acquire or construct a capitalasset for a lower level of government ( , township), with thelatter assuming responsibility for maintenance. Under gener-ally accepted accounting principles (GAAP), the same itemcannot be reported as a CAPITAL asset of twodifferent two or more governments areinvolved with the same CAPITAL asset, it isthe government that owns it that shouldreport it.

6 If ownership of a CAPITAL asset isdifficult to establish ( , sidewalks), it isthe government responsible for managingthe asset ( , maintenance) that normallywould report last provision has led some to erro-neously conclude that responsibility for managing a capitalasset is the normal criterion for determining which govern-ment should report a CAPITAL the contrary,responsibil-ity for maintenance is only a factor if ownership cannot be deter-mined. Put differently, ownership always trumps managementfor this No. 4An infrastructure asset includes the land it is built assets ( , roads and sewer lines) typicallyare built on land that the government controls through own-ership or easement.

7 Since infrastructure is unimaginable with-out the underlying land, it is tempting to view the cost of theland or easement as an integral part of the cost of the accounting standards,however,requirethat land and easements associated with infrastructure betreated as separate CAPITAL assets in their own 2009 | Government Finance Review29 Virtually all state and localgovernments must confrontthe ongoing challenge ofaccounting for CAPITAL Finance Review| April 2009 Misunderstanding No. 5 The cost of a CAPITAL asset should include the cost of an associated feasibility often undertake a feasibility study prior to theacquisition or construction of a CAPITAL asset.

8 Accountantspresume that cost should be recognized as expense whenincurred, unless they have demonstrable future value at thattime. It is hard to argue that cost has demonstrable futurevalue before the feasibility of a project has been , the cost of a feasibility study associated with theacquisition or construction of a CAPITAL asset should not beincluded as part of the cost of the asset thus No. 6If you don t issue debt for a project you will have no interest to enterprise funds and business-type activities, interestincurred during the acquisition or construction of a capitalasset must be included as part of the cost of that asset.

9 Itwould be understandable to conclude that there would be nointerest to capitalize if the government did not issue debt tofinance a given project. However, GAAP often require thatinterest be capitalized even in situations where no new debtis theory, if a given enterprise fund or business-type activityhad both available resources and outstanding debt, it couldapply those resources to liquidate the debt. If this were done,of course, the resources would no longer be available tofinance acquisition or construction, thus necessitating a newborrowing. Consequently, GAAP take the position that if thereis any outstanding debt in a given enterprise fund or business-type activity,even though that debt may relate to a different proj-ect of a prior period, the government s decision not to pay offthe debt is equivalent to a new borrowing, and the relatedinterest should be capitalized during acquisition or construc-tion as part of the cost of the CAPITAL No.

10 7 The fair value of something is what you can sell it require that donated CAPITAL assets be recorded attheir fair valueas of the date of donation. For this purpose, fairvalue should be understood as referring to what it would havecost the government to acquire the asset, not the amount forwhich it could resell the , for example, that a developer donated the right-of-way for a is little market for the land under a road,so the right-of-way would have little or no resale , the cost of acquiring the land for the right-of-waycould have been substantial. Some have reasoned in similarcases that the minimal anticipated resale value of the donat-ed land justified its being reported at some nominal value( , $1 per acre).