Financing Capital Projects—Part I: "Saving" through Fund Balance and Capital Reserve Funds

UPDATE August 2013: For more information on capital reserve funds, click here. Blight City has fallen on hard times. Its population has declined significantly since the 1990s, due in large part to the shuttering of two large manufacturing plants. Emblematic of the city’s decline is its central downtown area. Once a vibrant community center, it is now comprised mainly of run-down, vacant buildings. Recently, however, a mid-sized micro-brewed root beer company purchased one of the old manufacturing plants (located just outside the city’s downtown) and began operations. It employs 200 people and plans to double its workforce over the next two years. The company wants to capitalize on a recent resurgence in root beer “connoisseurs” by expanding the plant to include a tasting facility. And the company has expressed interest in opening a restaurant and root beer bar in the city’s downtown. City leaders want to support the company’s efforts. They view the company’s investment in the city as a cornerstone for the city’s resurgence. In fact, the root beer company’s recent investment in the city has sparked the interest of at least one developer. She has approached city officials about plans to help revitalize downtown. The developer intends to purchase several of the vacant buildings and refurbish them to attract a mix of small commercial entities, restaurants, bars, and residential tenants. Both the root beer company and the developer have requested (among other incentives) that the city invest in some infrastructure improvements and upgrades in the central downtown area to complement the private development. Specifically, the private entities would like the city to make road improvements, widen the sidewalks, install street lights, upgrade water and sewer lines, and demolish a city-owned structure to construct a parking lot. Assuming that the city councilmembers are willing to make these public infrastructure investments, there are several available funding options, which fall into five general categories: (1) Current Revenues; (2) Savings; (3) Grants/Donations/Partnerships; (4) Special Levies; and (5) Borrowing Money. This is the first in a series of posts discussing these funding options. It focuses on “Savings”—describing two ways in which the city may accumulate revenues over time to fund a portion or all of the costs of these (and other) capital projects and assets.

Capital Planning Most local governments expend moneys on capital projects and assets each year (collectively capital projects). And many units engage in a formalized process to project capital expenditures over a period of years. Some of these capital expenses easily can be funded from current revenues and are appropriated in the unit’s annual operating budget. Examples include routine maintenance and repair items on existing infrastructure, equipment, and sometimes even vehicles. Larger capital projects and acquisitions typically cannot be financed this way, though. Instead, a local government has to accumulate funds over time, identify additional revenue sources, or borrow money to pay for these capital expenses. There are two methods by which a unit of government may accumulate revenue over time to fund capital projects—(1) using fund balance; and (2) establishing a capital reserve fund. Fund Balance What is fund balance? Local governments use fund accounting to track assets and liabilities. An accounting fund is a separate fiscal and accounting entity, with its own set of self-balancing accounts. Thus, a fund has its own assets, liabilities, equity, revenues, and expenses. There are eleven types of funds—the most common is the general fund, which accounts for most general government revenues and expenditures. The equity associated with a fund is referred to as “fund balance.” In the simplest terms, fund balance is an accumulation of revenues minus expenditures. Fund balance generally serves three purposes. First, it provides the unit with cash flow. A local government’s fiscal year begins on July 1. Most units, though, do not receive the majority of their operating revenue (in the form of property tax proceeds) until late December/early January. Because of this delay, a local government typically must rely on cash reserves (fund balance) from the prior fiscal year to cover up to several months of expenditures. The second purpose of fund balance is to provide a unit with an emergency fund. It is difficult for a local government to raise money quickly during the fiscal year. Thus, fund balance can provide available cash to cover unexpected operating or capital expenses. Some units use fund balance for a third purpose—to facilitate saving money over time for anticipated capital expenditures. If a unit knows, for example, that it needs to engage in a capital project in the next several years, it might allow its fund balance to grow each year and then appropriate the accumulated moneys to finance the project. The Local Government Commission (a state agency with oversight responsibility for local government financial management practices) has set a minimum fund balance target for counties and municipalities at 8 percent of general fund expenditures. This is roughly equal to one month’s operating expenditures. Many counties and municipalities maintain fund balances well in excess of this level, though, to provide needed cash flow and to save moneys for future expenditures. The benefit of using fund balance to save money for future capital projects is that it provides a local governing board maximum flexibility. A governing board may use the accumulated moneys to fund either operating or capital expenditures. Generally a board is not locked in to spending the money on a particular project or asset. (Sometimes fund balance includes moneys that are restricted to certain purposes.) For example, assume that a county board of commissioners wishes to expand its solid waste disposal facility in approximately five years. The county board begins to purposefully accumulate fund balance towards this goal. In year three, a major economic recession hits the county. The county board is free to divert the accumulated fund balance to pay for operating expenses or more pressing capital expenses. The only exception is if a portion of the fund balance includes earmarked moneys (by grant or state statute) such that they only may be used to pay for the solid waste disposal facility expansion. Using fund balance as a savings account for future capital expenditures can be politically controversial. Citizens may question why a local unit continues to raise revenue (through taxes and fees) when the unit has significant cash reserves. They may not trust that the governing board ultimately will spend the accumulated fund balance appropriately. Capital Reserve Funds There is a second option available to local governments to facilitate saving money over time. Instead of accumulating fund balance, a unit’s governing board may establish a capital reserve fund and periodically appropriate money to the reserve fund. G.S. 159-18 authorizes a local government to establish and maintain a capital reserve fund for any purpose for which the unit may issue bonds. And a unit may issue bonds for any capital project in which it is authorized to engage. See G.S. 159-48. To establish a capital reserve fund a unit’s governing board must adopt an ordinance or resolution which states the following:

1. The purposes for which the fund is being created. A board may accumulate moneys for multiple capital projects within a single capital reserve fund, but it must list each project separately.
2. The approximate periods of time during which the moneys will be accumulated for each purpose. A board must provide a rough estimate of when moneys will be expended from the capital reserve fund for each capital project.
3. The approximate amounts to be accumulated for each purpose. A board must provide a rough estimate of the total amounts it intends to save for each capital project.
4. The sources from which moneys for each purpose will be derived. A board must indicate the revenue sources it intends to allocate to the capital reserve fund to finance each project (e.g. property tax proceeds, utility fees, local sales and use tax proceeds, grant proceeds, etc.).

Establishing a capital reserve fund affords a unit’s governing board a more formalized mechanism to save moneys for future capital expenditures. It also provides greater transparency than using fund balance because the board must indicate how it ultimately intends to expend the moneys. It is a less flexible savings option, though. Once moneys are appropriated to a capital reserve fund, they must be used for capital expenditures. The moneys may not be used to fund operating expenses, even in an emergency situation. Note that a governing board must list specific capital projects in the capital reserve fund. It may not simply establish the fund to raise money for general capital expenditures. A governing board, however, may amend its capital reserve fund at any time to add new capital projects, delete capital projects, or to change the nature of the capital projects. G.S. 159-19. The board is not required to expend the accumulated moneys for the capital projects initially identified in the reserve fund. For example, assume that a city is growing fairly rapidly. The governing board anticipates needing a water system expansion within the next eight to ten years to accommodate new growth. The board establishes a capital reserve fund and allocates moneys to the fund each year for the water system expansion project. Five years later a major recession hits the city. Growth slows significantly. It now appears that a water system expansion will not be necessary. The governing board could amend the capital reserve fund to delete the water system expansion project and substitute a new project(s), such as road improvements, building maintenance, vehicle acquisition, or a new recreation building. The board could not divert the accumulated revenues in the fund to cover operating expenses. How are moneys expended from a capital reserve fund? The governing board must adopt an ordinance or resolution authorizing the withdrawal of moneys from the fund, the transfer of the moneys to another fund (such as the general fund or an enterprise fund), and the expenditure of the moneys for one or more of the capital projects or assets identified in the capital reserve fund. Using Savings for Blight City Projects Saving money over time is one of the funding options available to local governments. But is it an appropriate option for Blight City? (Recall the Blight City is looking to make road improvements, widen the sidewalks, install street lights, upgrade water and sewer lines, and demolish a city-owned structure to construct a parking lot in its central downtown area.) Legally the city may save money using fund balance or a capital reserve fund to finance all or a portion of each of these projects. Practically, however, the city may not be able to delay the projects until it accrues enough funds. This is particularly true if the public infrastructure projects are being used as an incentive for private investment. The root beer company and developer may insist on completion of the public improvements before (or at least contemporaneously with) the private development. The city might be able to negotiate with the developers to phase the projects over a period of years, giving the unit time to raise additional revenue. In general, however, using savings to fund capital projects is a more effective option for routine capital expenditures or those expenditures that are anticipated years in advance.