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A Municipal Budgeting CITYOF CHANHASSEN 690 City Center Drive PO Box I47 Chanhasser4 Minnesota 55317 Phone 952.937.1900 General Fax 952.937.5739 Engineering Department Fax 952.937.9152 Building Department Fax 952.934.2524 Web Site www. ci. chanhassen, mn. us MEMORANDUM TO: FROM: DATE: Mayor City Council Bruce M. DeJong, Finance Director/~~. June 20, 2001 SUB J: Introduction to Municipal Budgeting I have attached a copy of the League of Minnesota Cities handbook section that discusses budgeting. Todd and I will present information regarding the current budget process and show how that compares with the guidance that other authoritative sources offer. The purpose of this discussion is to inform the council about our existing practices and receive feedback from Council members regarding what they would like to see as part of our process for this year. Il'we can get a clear understanding of the'information that Council members need to make a decision regarding the tax levy and budget up front, we can provide it right away in order to facilitate a smoother process and give staff more time to analyze the various scenarios that may come from the Council's deliberations. g:\user\bruce~council~2001~introducfion to municipal budgeting.doc Ct~t~r~ 23 Minn. StaL§ 275.065; Minn. StaL § 412.651, subd. 7; Mina. Stat- 412.701-.731. Budgeting Although budgeting is the first and most essential ingredient of any efficient system of administration, it has sometimes been a neglected, poorly implemented, and ignored fundamental of ,city government. All cities are required to prepare an annual budget, hold a property tax hearing, and give notice of the proposed budget adoption. Cities with the Plan B form of government also have additional budgeting requirements. Likewise, many home rule charter cities may have additional requirements in their charters. A budget is a comprehensive financial plan for a specific period of time. It outlines city activities and service levels, and contains estimates of probable costs and available revenues during the coming year. This chapter discusses some of the fundamentals of budgeting. More complete discussions of the subject, including detailed directions on budgeting procedures under the truth in taxation statutes, are discussed in the League publichtion, Guidelines for Preparing City Budgets, LMC 215b.1. The League sends one copy of this memo, free of charge, to each member city annually. This chapter covers the following topics: I. Review of revenue sources II. III' Role and purpose of budgeting Budget process IV. Long-term budget planning I. Review of revenue sources Before preparing the annual budget, the council should inspect the total city revenue. First, the council should determine whether the city is making the best use of its taxing powers. This includes deciding whether the tax rate, within any home rule charter tax levy limitations, if applicable, is adequate to meet the revenue needs of the city. A second advisable feature is a review of available intergovernmental grants and aids. Cities should seek to utilize these types of aids if this assistance is available. Finally, councils must give a regular, thorough study to the adequacy of other sources of city revenue. In particular, this review should attempt to answer three qUestions: Are license fees and charges for city services adequate to cover the city's costs and expenses for such programs? 497 HANDBOOK FOR MINNESOTA CITIES Should the city establish fees for other city service programs that are currently provided free of charge? When the city initiates a new program, such as a swimming pool, the council should decide whether or not to charge program users. It is always easier to begin charges when the city first provides the service, than it is to initiate fees at a later date. Are the council and other boards properly managing the city's fund balances? A regular review is the only way to ensure maximum and equitable use of present revenue sources. The revenue side of the city financial statement has become the chief concern of city councils. As governmental costs continue to increase, and as further demands for public services lead to new governmental programs, the strains on cities' pocketbooks have increased--particularly in small cities that often face decreasing or stagnant property values. The traditional way to meet this challenge has been to strive for greater efficiency in the present programs. !!. Role and purpose of bUdgeting Budgeting is critical for city finance and administration. Proper budgeting can assist the council in the performance of five vital functions: It is a vehicle through which the council can obtain estimates of the expected revenues for the coming year and plan city spending; Once the-council has allocated available money among the various city services, the budget can help control expenditures; Because budget preparation involves necessary decisions about the use of money, it facilitates important decision-making; At the conclusion of the budget year, the budget document can help the council evaluate the level and quality of city services provided during the year, and, By measuring the level and quality of services citizens received for each dollar spent, the council can measure the efficiency of providing each service. In this way, a budget serves as a check on administrative operations. 498 Minn. Stat. {} 412.651, subd. 7. See League memo, Guidelines for Preparing City Budgets, 215b.1. !!i. The budget process There are three basic steps involved in budgeting. Preparation consists of developing estimates of the needed and desired expenditures for the coming year, for each city activity, as well as developing the revenues available to pay for them. Consideration andfinal adoption of the budget constitutes the second stage of the process. Finally, the process ends as the expenditure controls established in the budget are implemented. Budget responsibility Ultimately, budgeting responsibility resides with the council. The council must accept or reject the budget and insist upon standards of budget enforcement. Generally, cities delegate budget execution or enforcement to the chief executive or administrative officer of the city. The statutes impose these duties on the manager in Optional Plan B cities. Although the law does not require it, the responsibility should logically go to the clerk-administrator in cities operating under'Plan A. In Standard Plan cities; the council might use either of two procedures. It might delegate the task of coordinating departmental budget requests to a council committee. It may make either this committee or an administrative officer responsible for budget execution. The council may also give the responsibility for both budget preparation and execution to the clerk, deputy clerk, or other official responsible for the supervision of all city activities. Budget format Two aspects of the budget format need consideration: the actual forms city officials use in preparing the budget, and the classification of accounts or account titles for summarizing data. The budget forms recommended by the League and explanations of them are included in the League publication, Guidelines for Preparing City Budgets. Uniform chart of accounts The Office of the State Auditor sets a standard chart of accounts that may be used for city budgeting. This "Classification of Accounts for Use by Fiscal Officers in Cities" can be used as the basis for most city budgets. Every city should consult this chart of accounts for maintaining financial records and for preparing the annual budget. Although cities may use a modification of this chart of accounts, it is the format required for the annual report to the state auditor. 499 This discussion was taken in part from Management Policies in Local Government Finance, 3rd edition (ICMA), pp. 153-156. See also, The Municipal Yearbook 199.5 (ICMA), pp. 42-52. HANDBOOK FOR MINNESOTA CITIES Budgeting techniques Generally, the purpose of any budget is as a policy document that sets goals and tracks performance. This policy helps city managers and other decision-makers make choices about allocating resources among competing needs. When dollars are scarce, decision-makers need a tool to assist them in making rational choices about how to distribute funds to particular services rather than just making across-the-board cuts. Decision-makers must find the budgeting techniques that work best for their city. City councils face peculiar problems: First, a city nearly always has limited resources due to rising costs and citizen demands. · Second,. city officials face uncertainty about which programs and what level of service to offer. · _Third, often no one is directly accountable for specific actions; therefore, it is hard to pinpoint exactly who or what caused financial problems~ . · Finally, cities face a problem of inefficient resource allocation. While cities cannot eliminate these problems, they can diminish their impact through sound budgeting. A budget system should outline priorities, conduct program evaluations, allow for management .implementation and reporting, and provide sound financial resource planning and management. There are many types of budgeting techniques. Some of these are: line item, performance, planned programming budget systems (PPBS), zero based budgeting (ZBB), and program performance budgeting (PPB). An analysis of each functional area for each budget type indicates the advantages and disadvantages of each system. Generally, there are seven functional areas to consider:. · Structure of the budget, or how it appears on paper; · Effectiveness of the budget for planning. To be effective, the budget must establish goals for future direction; · Evaluation--the budget must critically examine the past; · The budget must set forth the available resources; · The budget must provide control over the plan; 500 Ct~A~'F.~ 23 · An effective budget should establish program priorities; and, Finally, the tool should aid management by helping monitor and evaluate performance. Line item budgeting The line item budget is the most traditional type of budgeting for cities. This approach divides the city into departments and divisions. For instance, the parks and recreation department prepares its own line item budget. The budget lays out a one-year financial plan, detailing each individual expense category. This type of budget allows evaluation on the basis of expenditure trends. The council can compare last year's expenditures with the current year's projected expenses. Resources to fund a line item budget are usually supplied from the general fund. Typically, capital expenditures and major improvements are separate. Perhaps the strongest feature of a line item budget is its' high degree of control. The document details each line item expense. Management can monitor a line item budget by examining the financial reports. The degree of complexity of a line item budget varies according to a city's Size and needs. '- Performance budgeting Performance budgeting is an outgrowth of the line item budget. Its purpose is to help decision-makers analyze service production. A program budget, like a line item budget, has a structure consisting of departments and divisions; The performance budget includes a plan that defines the amount of service that can be produced for a given amount of resources. Evaluating a performance budget requires examining the amount of output produced at a defined workload based on some unit of production. To control the overall plan, this technique examines general expense categories and not individual line items. This tool helps set priorities and allows decision-making based on a more results-oriented approach. The performance budget is a useful managerial tool because it helps monitor workloads and can compare actual results against the plan. Performance budgeting assists in managerial decision-making. Its biggest shortcoming is that it only emphasizes output. Performance budgeting will show how much a department produced, but it will not show how well or poorly the department delivered the service. 501 Planned programming budget system The planned programming budget system (PPBS) helps councils compare programs and the services provided. The planning technique sets very high and general goals. A typical goal is to improve the public health, safety, and welfare, as opposed to hiring three, new pu. blic safety officers. A major weakness of a PPBS is that it is general rather than specific. Evaluation is a problem because a PPBS lacks objectives against which to measure performance. Control is also difficult because it usually gives a bottom line figure, for example: $200,000 budgeted to improve public safety. Prioritizing is difficult since the information is so general, therefore, priorities tend to depend on value judgments. Finally, a PPBS is of limited use for management analysis because it aims only at general annual goals. Zero based budgeting The theory behind zero based budgeting (ZBB) is to force each department to start from zero and justify its service. The structure of ZBB consists of decision units, which are not complete programs but pieces of programs. The ZBB method allows planning for incremental objectives starting from zero, but cities generally start at 80 percent below current funding because it is impossible to cut services altogether. Evaluation is on the basis of decision packages that define the resources needed to accomplish a given level of service. As with the other methods, it identifies only the general fund as a resource. Control through ZBB is similar to control in performanc, e budgeting. The method identifies expense objectives, rather than just bottom line figures. The city establishes priorities through incremental rankings, forcing managers to rank priorities by stacking up decision packages to determine need. This approach can create situations where decision-makers must choose between service levels that are difficult to compare. For example, how can the need for five new swingsets be evaluated against the need for an additional police officer? ZBB can be useful because of the forced annual rankings. Councilmembers will need to examine the rankings and finance the services the city needs to accomplish. The use of ZBB has several advantages: First, ZBB encourages organizational assessment by forcing department heads to critically assess their departments; Second, it allows for departmental involvement and, thus, more satisfied workers; and, 502 CH^PT~ 23 Third, ZBB forces decision-makers to come up with alternative implementation techniques and establish objectives. However, there are some disadvantages to ZBB: First, when using ZBB, the starting point is not zero, but probably about 80 percent below current funding due to statutory and contractual obligations; Second, ZBB increases paperwork and administrative workloads because of its many decision packages; Third, there is a possibility of misuse because each department manager decides exactly what goes into each decision package; Fourth, annual reassessment of service rankings may be too frequent. In some situations, review is necessary only every three to five years; and, · Ranking of. priorities is impractical in some cases. Program performance budgeting Another budgeting technique consists of a mix of the favorable parts of other budgeting techniques. A program performance budget (PPB) has a structure that shows programs and departments. Typically, there is a broad service area, and a general and specific program description. The planning technique lists specific service targets that are well-defined goals for the.city to accomplish. Evaluation is complete and provides information about the need for the service, the city's response, the cost, and the impact of each service or program. The PPB method differs from other budgeting methods in that it examines total resources, and not just the general fund. Control is strengthened because there is a summary of each program, along with a line item chart of accounts. The strongest factor is the PPB's ability to assist in setting priorities. The technique promotes rational choices by comparing a service-cost balance. The PPB is a useful managerial tool because it provides regular performance reports, as well as detailed financial reports. Program performance budgeting pleases the public and city officials because it provides an understandable document, and the service-cost balance shows the importance and cost of different services. The intent of a PPB is to provide an analysis of demand, workload, productivity, and effectiveness. 503 HANDBOOK FOR MINN'E~A CITIES Demand (need) can be measured by factors such as applications and requests for a service, complaints received, population changes, and external deficient conditions. Workload (response) is indicated by production of units, construction, maintenance, processing, people served, and time spent. Productivity (cos0 is measured by efficiency per unit. Ratios that are understandable and useful include dollars/units, units/dollars, time/units, or units/time. Effectiveness (outcome) is measured by qualitative factors, responsiveness, customer satisfaction, problem reduction, and achievement of objectives. Estimating revenues The first Step to estimating revenues is 'to identify and isolate the revenue sources. The city should then look at each source and its past performance and future expectations, taking into account any trends or institutional changes that might disrupt -the pattern. After estimating all other revenues and assessments, the city must determine the amount of money needed from property taxes. This sum should be an amount sufficient to balance the budget. The tax levy may not, Of course, exceed any tax levy limitations for various funds, nor may it exceed any home rule charter levy limitations. ' . No single formula is available for estimating city revenue. Each individual revenue estimate depends on individual, relevant factors. Estimating expenditures Cities must estimate several kinds of expenditures such as current expenses, capital outlay expenditures, and debt redemption. Certain current expenses, sometimes called basic expenditures, consist of relatively fixed charges and are comparatively easy to estimate. These are items such as rent, interest expense, salaries, contractual costs, and other charges the city establishes by agreement that cannot be reduced during the budget year. Budgetary estimates of these costs can be on the basis of past experience, plus necessary increases based on inflation. It is generally only these increases, and not the basic costs themselves, that the budget officer or the council can alter. The only manner in which the city can change such costs 504 See League memo, Guidelines for Preparing City Budgets, 215b. 1. CHAPTER 23 is to discontinue the program, reduce the program's quality, or look for opportunity to provide the service cooperatively with another unit of government. Other current expenses, sometimes called supplemental expenditures, are those related to new policy and administrative proposals, such as the costs of expanding an existing work program or starting a new city service. Supplemental expenditures entail important policy questions because they require the council's close scrutiny and careful consideration. Councils should ask for public opinion on such proposals during the development of the budget and at the Truth in Taxation public hearing. The distinction between basic and supplemental expenditures has a twofold importance in the budget process. It stresses that each city has a large burden of fixed costs that the council can manipulate to only a minor extent, and which cannot be substantially reduced without curtailing existing services. Also, it places special emphasis on the policy matters in the budget, and helps to relate the costs of government with the quality of government services. Excise and sales tax Cities must pay the state sales tax on the purchases of goods and. specific services. Vendors will generally be responsible for collecting the 6.5 percent tax. (See the League publication, Guidelines for Preparing City Budgets, for a more detailed discussion of the state sales tax.) Minn. Stat. § 168.012. Minn. Stat. § 297B.01; M/nm Stat. § 168.012. subd. I(b). Sales tax on motor vehicles The 6.5 percent sales tax on motor vehicles applies to most state government, city, county, and school district purchases of motor vehicles. Motor vehicles include every self-propelled vehicle not operated exclusively upon railroad tracks; any vehicle propelled or drawn by a self-propelled vehicle; or any device in, upon, or by which any person or property may be transported or drawn upon a public highway. The sales tax on motor vehicles does not apply to certain city vehicles, however. The definition of motor vehicles subject to the sales tax affects only vehicles for which registration is required. Municipal fh'e apparatus, police patrols, and ambulances (the appearance of which is unmistakable), shall not be required to register or display number plates. Thus, no tax is imposed on clearly marked emergency vehicles. The Department of Revenue has conf'u-med this interpretation. 505 Minn. Stat. §§ 297H.02, subd. 2 and 297H.03, subd. 2. M'mn. Slat. §§ 297H.02 and 297H.03. Minn. Stat. §§ 297H. 02, subd. 1 and 197H.03, subd. 1. HANDBOOK FOR MINNESOTA CITIES Solid waste management tax The solid waste management tax must be collected from both residential and commercial generators, and on collection bags and stickers, if the price includes mixed municipal waste services. The rate is 9.75 percent for residential generators and 17 percent for commercial generators. Cities are liable for the tax if they do any of the following: · Provide solid waste management services. · Directly bill on a property tax statement for private waste management services. · Subsidize the cost of waste management services through the sale of bags, stickers, or other indicia. Cities that provide solid waste management services must determine the market price of the service and apply the tax to the market price. The determination must be done by resolution. The Office of Environmental Assistance, the Minnesota Pollution Control Agency, and the Department of Revenue will review the market prices each year. State fuel'taxes Minn. Stat. § § 296A.07, subd. 3 and 296A. 16, subd. 2. Minn. Stat. § 296A.18, subd. 1. GaSoline tax Cities generally are subject to state gasoline and special fuel taxes; however, they are also eligible for a refund of the state excise tax on gasOline for non-highway uses of motor vehicles owned by the city. If a motor vehicle, such as a grass mower or a f'u'e pumper, is used both on and off highways, the city can claim a refund of the tax paid on gasoline or special fuel used for purposes other than driving the vehicle on highways. Gasoline tax refund claims must be supported by detailed records that accurately establish the ' amount of fuel used and the purpose for using the vehicle. Records to support a refund claim for gasoline tax on vehicles operated both on and off the highway should include some or all of the following kinds of information: type of operation, dates of operation, miles traveled on highways, age of equipment, and results of tests determining engine performance during off-highway use. "Off-highway use" does not include snowmobiles or motorboats; therefore, refunds are not available for gasoline that is purchased for use in these vehicles. 5O6 CH^~T.~ 23 To claim refunds for both the state excise tax on gasoline for non-highway uses of motor vehicles, a city must submit a PDR-1 form to the Department of Revenue, Income Tax Division. (The PDR-1 form is available from that office.) All claims must be submitted within one year of the purchase date. Minn. Stat. § 296A.08, subd. l(c). Also see section on federal gasolir~ taxes. Diesel fuel tax Both dyed and undyed diesel fuel are subject to state sales tax even though exempt from federal excise tax. Minn. Stat. § 296A.17. Aviation fuel tax A few cities may be eligible for a refund of the tax on aviation fuel or special fuel for aircraft use. Tax refund forms (Form PDR-1AV) are available from the Department of Revenue, Petroleum Division and must be submitted yearly, on or before April 30 following the year of purchase. Claims submitted after April 30 will not be considered. Refunds are determined on a graduated rate according to the amount'of gasoline used. Cities must meet specific regulations for some refunds. For more information on state fuel tax refunds contact the Minnesota Department of Revenue, Petroleum Division, at (651) 296-0889 or (800) 657-3596. Federal fuel taxes 26 U.S.C. § 6421 (c), (d).26 U.S.C. §{} 6416 (b)(2)(C) and 4081 (a)(2). See League memo, Guidelines for Preparing City Budgets, 215b. 1, for a sample form. Gasoline tax Cities are exempt from federal excise taxes on gasoline and most diesel fuels purchased for the exclusive use of the city. Cities may pay the gasoline tax at the time of purchase and apply for an IRS refund at the end of the year, or pay the tax quarterly if the taxes during the quarter are $1,000 or more. Refund claims must be filed on IRS Form 8849. Alternatively, the city can purchase the fuel tax-free by filing a certificate of ultimate purchase with the vendor. 26 U.S.C. 4082 (a). See League memo, Guidelines for Preparing City Budgets, 215b.1, for a sample Diesel fuel tax Cities may purchase dyed diesel fuel without paying the sales tax, but should be certain that a notice stating: "Dyed Diesel Fuel. Nontaxable use only. Penalty for taxable use." appears on all papers and receipts. Alternatively, undyed diesel fuel may be purchased from a registered ultimate vendor at a tax excluded price. Only a registered ultimate vendor may apply for a refund of the federal excise tax on diesel fuels. Most cities will no longer be able to apply for these refunds and should look for diesel fuel vendors who either 507 HANDBOOK FOR MINNESOTA Cfi[ES sell dyed diesel fuel, or who are registered ultimate vendors authorized to sell undyed diesel fuel tax free. State deed tax Cities are required to pay the state deed tax for every granting, assignment, transfer, or conveyance of land by deed. The tax rate is $1.65 for each $500 of value. Minn Stat. § 412.241; Minn. Stat. § 275.065. Minn. Stat. § 412.711. Budget checklist for councils After the budget officer has prepared the preliminary budget, the council must assume full responsibility for reviewing and approving it in its final form. In this review, the council should consider several questions: Does the budget meet the needs of the community? Are there some services the city should reduce or eliminate to provide funds for new programs, for the expansion of existing programs, or in order to reduce the property tax levy?~ Does the budget provide proper balance between activities, especially between more essential and less essential services? Will the level of service funded in the budget ensure adequate standards of service? Is the proposed budget sound and honest? Is the estimate of revenues realistic? Does it include all expenditures and conceivable contingencies? Does it contain a contingency appropriation for emergencies? · Is the budget economical, providing the greatest value per dollar? Is the budget consistent with the ability and willingness of the citizens to support it? Does the budget discharge a city's responsibility for the future? Is it consistent with the city plan and with other long-term policies for the development of the community? Whether or not a city is operating under Optional Plan B, approval of the budget in its final form should be as a resolution of the council. An ordinance is not necessary. A simple majority of the council will suffice to pass the resolution. The resolution, which Plan B cities must adopt by Oct. 1, should set forth the total amount budgeted for each purpose or fund. The resolution should also contain whatever detailed breakdown of expenditures the council deems necessary for adequate budget control. 508 CHAPTER 23 Budget execution The preparation of a budget is meaningless unless the council makes sure city employees follow it. The controls needed for an adequate system of budget execution depend on the size of the city and its government. Larger cities should use the system of allotments and encumbrance accounting, in which the money budgeted for any specific purpose (the police department, for example) is allocated to that purpose (the police department). Additionally, cities may wish to consider adopting a legal level of budgetary control based on categories of expenditures. This prevents exhaustion of the appropriation before the end of the calendar year, and places limits on the amount of expenditures that can be made by a department without seeking additional approval. There are two minimum controls every city shOuld exercise, regardless of size. While responsibility for these controls belongs to the council, either an administrative officer responsible to the council or a council committee may implement the controls in actual practice. The first of these controls is a requirement that no expenditure should occur until a designated person has checked to see whether or not adequate funds are available. In other words, no expenditure occurs unless the council authorized the expenditure in the original or a subsequent budget resolution. Once a city adopts a budget, only the council should authorize any deviations. The second essential control is a budget reporting system. The council should require a monthly or quarterly report that details for each budget item, the amount budgeted, the amount already spent, the amount not yet spent but committed for a particular budget item, and the budget amount that remains unspent and uncommitted. With this information, the council can scrutinize administrative operations, exercise greater control over future spending, and make any needed adjustments in the budget. A reporting system is the most important facet of any expenditure control program. Budget reports should include a summary of work accomplish- ments under the budgetary appropriation to-date. Only with this information in hand, can the council maintain an adequate check over the enforcement of the budget and the administrative activities of its subordinates. IV. Long-term budget planning While cities only prepare their budgets for the next 12 months, councils must be aware of the long-range f'mancial problems and demands facing the city. 5O9 HANDBOOK FX3R MINNESOTA ClTIF~ Long-term financial plan In addition to the annual budget, a long-term city financial plan includes the following: Public services program--a long-range pi.an for all public services, estimating future needs for recreation, fire protection, police protection, and so on. The plan measures the objectives and needs for each city department, the standard of services, and the impact of such services on the annual operating budget. Capital improvement program--a comprehensive list of projects and facilities the city needs or will need to carry out public services. Long-term revenue program--a tentative revenue policy that develops long-term plans for financing public services and capital improvements. Capital budget--this summarizes, on a five- or six-year period, the capital or money requirements for capital improvements or purchases. A capitol budget lists a priority for each anticipated investment in community facilities, and balances this with the availability of revenues. Although it is ultimately the council's responsibility, the city planning cOmmission could prepare and maintain the long-term financial plan. In the absence of a planning commission, a council committee might perform this responsibility. The council should review the plan and revise it prior to adopting the annual budget. Capital improvement budgeting Capital budgeting is a list of needed capital improvements, their order of priority, and the means of financing them. (This discussion was taken from Managing Small Cities and Counties (ICMA), p: 251). Besides being one of the major tools of planning, a capital budget can provide some or all of the following advantages: Keep the public informed of future needs and protect councilmembers from pressure groups seeking projects rated low on the priority list; · Often reduce or stabilize the tax rate; Establish an orderly capital improvement program, preventing the peaks and valleys in a community's debt retirement program; Frequently allow a community to move gradually to a pay-as-you-go program of capital expenditure financing for a considerable portion of its improvements; 510 CHAPTE~ 23 Capital improvements take place in a logical and orderly manner, rather than haphazardly; · .Help preserve the community credit rating by preventing an over-extension of credit and maintaining a credit reserve for emergencies at all times; · Integrate the plans and projects of ~tll city departments and agencies, eliminating conflicting and overlapping projects; and, · By insuring prior consideration for all capital improvements, it helps guarantee ample time for detailed and careful planning of the actual program. The responsibility for capital budgeting is usually the responsibility of the chief administrative officer, the clerk, clerk-administrator, or city manager. Aiding this person should be the council, a committee of the council, the city planning commission, and the treasurer or chief fiscal officer. Capital budgeting usuallY involves the following procedures: · The chief administrative officer makes up a priority list of anticipated capital improvements that the city will need within the next few years, usually five to 10 years. · A careful evaltiation follows with the elimination of those capital improvements that overlap or duplicate. · The end result is a priority list of capital improvements on the basis of need, considering the community's present and future program of public services. · The city then puts these improvement projects into a multiple year capital improvement program on the basis of the established priority. When the council reviews it in light of the community's financial situation, it may find the city should defer some of the projects beyond the improvement period and other projects indefinitely. · Following this, the budget officer recommends projects for the coming budget year. The recommendations, in effect, become the recommended program. · Priorities in the capital budget program for the following years remain tentative, and the council should review them annually. At that time, the council should consider the addition of new projects and the deletion of others. 511 512 HANDBOOK FOR MINNESOTA CITIES Although capital budgeting may appear cumbersome and unwieldy for the small city, this is actually not the case. A capital budget provides protection to the small city, helping it avoid commitments and debts that would limit its ability to later finance more important capital improvements. Signs of financial stress Financial analysts do not agree on how to predict future city financial problems. Certain indicators are useful in measuring any city's financial stress position. Periodic evaluations should allow the council to take steps to head off any developing financial emergency. The five most effective financial indicators include long-term debt, short-term debt, total interest payments, tax effort, and unfunded pension or other liability. Long-term debt. The amount of long-term debt varies greatly depending on the kind of community, its maturity, and the extent to which it has undertaken a consistent, long-term capital improvement program. However, cities may find it useful to compare their long2term debts outstanding with those of other similarly sized and composed communities. Short-term debt The dollar amount of short-term debt outstanding is usually less significant than the year-to-year trend of that debt. Most Minnesota cities must, by law, pay off each issue of tax or revenue anticipation debt by the end of the city's fiscal year. Such tax anticipation certificates or warrants, which the city retires by taxes and does not refinance by another short-term issue, present no real cause for alarm. However, if a city mak'es extensive purchases on open account, uses temporary improvement financing extensively, or uses any other obligations that force it to go into the money market at a particular time, consequences can be severe. When the only possible means of paying off such debt is to go into the money market, default is inevitable if the market rate is above the permissible statutory rate or, in the bond raters' and buyers' judgment, the city's financial position is so shaky as to make the city's bonds a bad investment. Total interest payments This index will not completely be a function of the outstanding debt. The mix of long- and short-term obligations, the timing of the various offerings, and the bond raters' and buyers' perceptions of the soundness of the community all influence this indicator. CHAIXrER 23 Tax effort The tax effort, or tax per capita of all the overlapping local governmental units, determines the amount of capacity to respond to a financial emergency. If the local tax rate in a city is high in comparison to other cities, and particularly in those cities in the same .state and region, any increase will likely result in a loss of tax base, resulting in a decrease in tax revenue. This can have a negative long-term effect on the ability of a city to maintain financial stability and current service levels. In such circumstances, there is little opportunity to meet local increased revenue demands. For a more detailed discussion of relief association pension plans, see Chapter 11. See also, League memo, Guidelines for Preparing City Budgets, 215b.1; League memo, Organization and Operation of the Relief Association, 220e.3. Minn. Stat. § 69.77, subd. 2h; Minn. Stat. § 424A.05, subd. 3; Minn. Stat. § 356.215, subd. 4. Unfunded local pension or other liability Cities must also budget to cover any shortfalls in the number of local pension plans, such as the pension plans for a volunteer firefighter relief association. There are also specific reporting requirements and actuarial surveys that must be done. Cities may need to budget for these costs as well. Such costs may sometimes be paid using money from the relief association's special fund, such as for the cost of an actuarial survey, an authorized administrative expense. This expense may also be paid using money from the relief association's general fund, if permitted by the relief association's bylaws. Cities will probably want to consider using these available funds before considering using money from the city's general fund, although the city may ultimately pay these costs because the cash requirements of the relief association's special fund will increase by the amount used to pay for the actuarial survey. Use of financial indicators Cities should use these five indicators (long-term debt, short-term debt, total interest payments, mx effort, and unfounded local pension or other liability) for comparing one community with other communities of similar size and maturity. For example, a suburb that has sprung from largely undeveloped land in the last 20 years should not compare itself to an old, free-standing community with a stable population. Comparisons should provide a good basis for evaluating the local financial health of a city. A high standing in any one of the five areas should not be particularly alarming if the other areas are low. However, even a single, high-standing index may provide reason to look carefully at that area, in 513 HANDBOOK FOR MINNESOTA CIT{ES order to see if changes might improve the city's prospects for economic stability. Statistical information for the purpose of making these comparisons is available in the report of the state auditor: Revenues, Expenditure and Debt of the Cities of Minnesota. Information on pension funding is available from the Legislative' Commission on Pensions and Retirement. Better budgeting guidelines The following six-steps are guidelines toward better budgeting. In processing their annual budgets, cities should: · Coordinate budgeting and accounting procedures; Devise good working papers for the preparation and execution of the budget; · Prepare a budget calendar; · Create an annual budget that considers all city operations from a long-range approach rather than a piecemeal, short-range approach; · Extend the budget-making process to include the mayor, the council, and citizens; and, · Establish effective methods to control expenditures in accordance with the budget plan. Budgeting, both as a long-term financial guide and as a short-term, annual plan of operation, is an indispensable part of city administration. 514 CITY OF CHANHASSEN, MINNESOTA FINANCIAL MANAGEMENT POLICIES Adopted May 8, 2000 !. PURPOSE The City of Chanhassen is responsible to its citizens to manage municipal finances wisely and properly account for public funds. The City must ensure that it is capable of adequately funding and providing local government services needed by the community. The City is also accountable for providing both short-term and long-term financial stability for the community. These financial policies provide the framework for the overall fiscal management of the City. Operating independently of changing circumstances and conditions, these policies assist the decision making processes of the City Council and Administration. These policies represent long standing principles, traditions and practices for City governments. These financial policies will be reviewed periodically to determine if changes are necessary. II. OBJECTIVES in order to achieve this purpose, this plan has the following objectives for the City's fiscal performance: 1. Promote sound financial management of the City by providing accurate, complete, and timely information to facilitate the City Council's decision making process. 2. Use conservative financial principles when estimating revenues, expenditures and tax revenues. 3. Minimize investment and financial risk by emphasizing principal preservation and liquidity over investment yield. 4. Use benchmarks and best practices to ensure that the City operates efficiently and effectively. 5. Employ policies which promote sustainable revenue sources. 6. Employ fair user charges where the direct benefit is identifiable and the cost is measurable. 7. Provide public facilities, infrastructure, buildings, and equipment through use of a five-year capital improvement program which identifies sources and uses of funds. 8. Establish and maintain open communication with credit rating agencies to protect and enhance the City's credit rating. 9. Provide sufficient maintenance to ensure that capital assets operate effectively to their full useful life expectancy. 10. Protect City assets through a sound system of financial and internal controls. 11. Maintain a risk management program that will minimize the impact of legal liabilities, natural disasters or other emergencies. !11. FINANCIAL MANAGEMENT POLICIES . . o Capital Improvement Budget Policies 4~ The City shall adopt a five year capital budget associated with all capital and operating funds. The City will project its capital needs for the next five years and will update this projection each year. In addition, the City will maintain its capital assets to minimize future maintenance and replacement costs. The City will coordinate development of the capital improvement budget with the development of the operating budget. Future operating costs associated with new capital improvements will be projected and included in operating budget forecasts. City staff will identify the estimated costs and potential funding sources, including possible joint ventures with other governmental jurisdictions, for each capital project proposal before the capital budget is submitted to the City Council for approval. The City will utilize the most advantageous financing method for the acquisition of capital goods. . . o . Revenue Policies The City will estimate its annual revenue by a conservative analytical process taking into account economic conditions, historical trends, and management estimates. Whenever user charges and fees are determined to be appropriate and the direct benefits are identifiable, the City will establish and revise annually, all user charges and fees at a level related to the cost of providing the service (operating, direct, indirect and capital). The City will set fees and user charges for each enterprise fund at a level which fully supports the total direct costs and capital costs of the activity. The City will consider the prior year's net proPerty tax delinquencies and abatements in setting the annual property tax levy. 1 o Debt Policies The City will confine long-term borrowing to capital improvements or projects which cannot be financed from current revenues. In addition, the City will not incur debt to support current operations. When the City finances capital projects by issuing debt, it will retire the instrument within a period not to exceed the expected useful life of the project. With most issues, the City will retire 50% of the principal amount issued within ten years. The City will generally attempt to keep the maturity of General Obligation Bonds and General Obligation Guaranteed Bonds at or below 15 years when deemed to be in the best interests of the city. o . Annual debt service for General Obligation Ad Valorem debt should not exceed ten percent (10%) of annual ad valorem tax revenues in the General Fund and Special Revenue Fund. Total General Obligation debt subject to statutory debt limits will not exceed two percent (2%) of the estimated market valuation of taxable property in the City according to Minnesota statutes. Where possible, the City will use special assessment, revenue or other self-supporting revenue streams instead of ad valorem taxes. The City will maintain open communications with bond rating agencies regarding its financial condition. The City will follow a policy of full disclosure in every financial report and bond prospectus. The Economic Development Authority will maintain a set of written policies concerning the use of Tax Increment Financing (TIF), tax abatement and other development incentives. , . General Fund Reserve Policies The City shall not use tax anticipation borrowings to cover operating expenses. The year end general fund balance shall be reserved in an amount adequate to cover 50% of the property taxes and Homestead and Agricultural Credit Aid (HACA) for the following year. The City will utilize fund balances in the best long term financial interests of the City. . Fixed Asset Policies The City will record and track the purchase, transfer and disposition of all assets with an expected life at least two years and an initial cost basis of at least $5,000. Other assets of less than $5,000 but with significant personal value, such as computers, will be tracked for insurance purposes. These items will not be reported on the financial statements. City of Chanhassen Investment Policy The purpose of this investment policy is to aid the City of Chanhassen in the appropriate management of its investments. The City of Chanhassen should use this policy as a guide to fit its needs and to comply with state and local laws, regulations, and other policies concerning the investment of public funds. Scope This policy applies to the investment of all funds, except for cash in certain restricted funds. The City will consolidate cash balances from all funds to maximize investment earnings. Investment income will be allocated to the various funds based on their respective participation and in accordance with generally accepted accounting principles. il. General Objectives The primary objectives, in priority order, of investment activities shall be safety, liquidity, and yield: Safety Safety of principal is the foremost objective of the investment program. Investments shall be undertaken in a manner that seeks to ensure the preservation of capital in the overall portfolio. The objective will be to mitigate credit risk and interest rate risk. The City will minimize credit risk, the risk of loss due to the failure of the security issuer or backer, by: · Limiting investments to the safest types of securities · Pre-qualifying the financial institutions, broker/dealers, intermediaries, and advisers with which the City will do business Diversifying the investment portfolio so that potential lOsses on individual securities will be minimized. The City will minimize the risk that the market value of securities in the portfolio will fall due to changes in general interest rates, by: Structuring the investment portfolio'so that securities mature to meet cash requirements for ongoing operations, thereby avoiding the need to sell securities on the open market prior to maturity Investing operating funds primarily in shorter-term securities, money market mutual funds, or similar investment pools. Liquidity The investment portfolio shall remain sufficiently liquid to meet all operating requirements that may be reasonably anticipated. This is accomplished by structuring the portfolio so that securities mature concurrent with cash needs to meet anticipated demands (static liquidity). Furthermore, since all possible cash demands cannot be anticipated, the portfolio should consist largely of securities with active secondary or resale markets (dynamic liquidity). A portion of the portfolio also may be placed in money market mutual funds or local government investment pools that offer same-day liquidity for short-term funds. Yield The investment portfolio shall be designed with the objective of attaining a market rate of return throughout budgetary and economic cycles, taking into account the investment risk constraints and liquidity needs. Return on investment is of secondary importance compared to the safety and liquidity objectives described above. The core of investments is limited to relatively Iow risk securities in anticipation of earning a fair return relative to the risk being assumed. Securities shall not be sold prior to maturity with the following exceptions: · A security with declining credit may be sold early to minimize loss of principal. · A security swap would improve the quality, yield, or target duration in the portfolio. · Liquidity needs of the portfolio require that the security be sold. I!1. Standards of Care Prudence The standard of prudence to be used by investment officials shall be the "prudent person" standard and shall be applied in the context of managing an overall portfolio. Investment officers acting in accordance with written procedures and this investment policy and exercising due diligence shall be relieved of personal responsibility for an individual security's credit risk or market price changes, provided deviations from expectations are reported in a timely fashion and the liquidity and the sale of securities are carried out in accordance with the terms of this policy. Investments shall be made with judgment and care, under circumstances then prevailing, which persons of prudence, discretion and intelligence exercise in the management of their own affairs, not for speculation, but for investment, considering the probable safety of their capital as welt as the probable income to be derived. Ethics and Conflicts of Interest ' Officers and employees involved in the investment process shall refrain from personal business activity that could conflict with the proper execution and management of the investment program, or that could impair their ability to make impartial decisions. Employees and investment officials shall disclose any material interests in financial institutions with which they conduct business. They shall further disclose any personal financial/investment positions that could be related to the performance of the investment portfolio. Employees and officers shall refrain from undertaking personal investment transactions with the same individual with which business is conducted on behalf of the City. Delegation of Authority Authority to manage the investment program is granted to City Manager and derived from Minnesota Statutes 412.141. Responsibility for the operation of the investment program is hereby delegated to the Finance Director, who shall act in accordance with established written procedures and internal controls for the operation of the investment program consistent with this investment policy. Procedures should include references to: safekeeping, delivery vs. payment, investment accounting, repurchase agreements, wire transfer agreements, and collateral/depository agreements. No person may engage in an investment transaction except as provided under the terms of this policy and the procedures established by the investment officer. The investment officer shall be responsible for all transactions undertaken and shall establish a system of controls to regulate the activities of subordinate officials. IV. Safekeeping and Custody Authorized Financial Dealers and Institutions A list will be maintained of financial institutions authorized to provide investment services. In addition, a list also will be maintained of approved security broker/dealers selected by creditworthiness (e.g., a minimum capital requirement of $10,000,000 and at least five years of operation). These may include "primary" dealers or regional dealers that qualify under Securities and Exchange Commission (SEC) Rule 15C3-1 (uniform net capital rule). All financial institutions and broker/dealers who desire to become qualified for investment transactions must supply the following as appropriate: · Audited financial statements · Proof of National Association of Securities Dealers (NASD) certification · Proof of state registration · Certification of having read and understood and agreeing to comply with the City's investment policy. An annual review of the financial condition and registration of qualified financial institutions and broker/dealers will be conducted by the investment officer. (See the GFOA Recommended Practice on "Governmental Relationships with Securities Dealers," in Appendix 3.) Internal Controls The Finance Director is responsible for establishing and maintaining an internal control structure designed to ensure that the assets of the City are protected from loss, theft or misuse. The internal control structure shall be designed to provide reasonable assurance that these objectives are met. The concept of reasonable assurance recognizes that (1) the cost of a control should not exceed the benefits likely to be derived and (2) the valuation of costs and benefits requires estimates and judgments by management. Accordingly, the investment officer shall establish a process for an annual independent review by an external auditor to assure compliance with policies and procedures. The internal controls shall address the following points: · Control of collusion · Separation of transaction authority from accounting and record keeping · Custodial safekeeping · Avoidance of physical delivery securities · Clear delegation of authority to subordinate staff members · Written confirmation of transactions for investments and wire transfers · Development of a wire transfer agreement with the lead bank and third-party custodian Delivery vs. Payment All trades where applicable will be executed by delivery vs. payment (DVP) to ensure that securities are deposited in an eligible financial institution prior to the release of funds. A third-party custodian as evidenced by safekeeping receipts will hold securities. V. Suitable and Authorized Investments Investment Types Consistent with the GFOA Policy Statement on State and Local Laws Concerning Investment Practices, the following investments will be permitted by this policy and are those defined by state and local law where applicable: U.S. government obligations, U.S. government agency obligations, and U.S. government instrumentality obligations, which have a liquid market with a readily determinable market value; Certificates of deposit and other evidences of deposit at financial institutions, bankers' acceptances, and commercial paper, rated in the highest tier (e.g., A-l, P-l, F'-I, or D-1 or higher) by a nationally recognized rating agency; Investment-grade obligations of state, provincial and local governments and public authorities; · Repurchase agreements whose underlying purchased securities consist of the foregoing; Money market mutual funds regulated by the Securities and Exchange Commission and whose portfolios consist only of dollar-denominated securities; and Local government investment pools, either state-administered or through joint powers statutes and other intergovernmental agreement legislation. Collateralization In accordance with state law and the GFOA Recommended Practices on the Collateralization of Public Deposits, collateralization of 110% of the total value of deposits will be required of all banks listed as authorized depositories. (See GFOA Recommended Practices, Appendix 3.) VI. Investment Parameters Diversification The investments shall be diversified by: o limiting investments to avoid over concentration in securities from a specific issuer or business sector (excluding U.S. Treasury securities), o limiting investment in securities that have higher credit risks, o investing in securities with varying maturities, and O~ continuously investing a portion of the portfolio in readily available funds such as local government investment pools (LGIPs), money market funds or overnight repurchase agreements to ensure that appropriate liquidity is maintained in order to meet ongoing obligations. (See the GFOA Recommended Practice on "Diversification of Investments in a Portfolio" in Appendix 3.) Maximum Maturities To the extent possible, the City shall attempt to match its investments with anticipated cash flow requirements. Unless matched to a specific cash flow, the City will not directly invest in securities maturing more than five (5) years from the date of purchase or in accordance with state and local statutes and ordinances. The City shall adopt weighted average maturity limitations (which often range from 90 days to 3 years), consistent with the investment objectives. Reserve funds and other funds with longer-term investment horizons may be invested in securities exceeding five (5) years if the maturity of such investments are made to coincide as nearly as practicable with the expected use of funds. The intent to invest in securities with longer maturities shall be disclosed in writing to the legislative body. (See the GFOA Recommended Practice on "Maturities of Investments in a Portfolio" in Appendix 3.) Because of inherent difficulties in accurately forecasting cash flow requirements, a portion of the portfolio should be continuously invested in readily available funds such as LGIPs, money market funds, or overnight repurchase agreements to ensure that appropriate liquidity is maintained to meet ongoing obligations. VII. Reporting Methods The investment officer shall prepare an investment report at least quarterly, including a management summary that provides an analysis of the status of the current investment portfolio and transactions made over the last quarter. This management summary will be prepared in a manner which will allow the City to ascertain whether investment activities during the reporting period have conformed to the investment policy. The report shall be provided to the City Manager, the City Council, and any pool participants. The report will include the following: o Listing of individual securities held at the end of the reporting period. Realized and unrealized gains or losses resulting from appreciation or depreciation by listing the cost and market value of securities over one-year duration that are not intended to be held until maturity (in accordance with Governmental Accounting Standards Board (GASB) requirements). o Listing of investment by maturity date. o Percentage of the total portfolio that each type of investment represents. Performance Standards The investment portfolio will be managed in accordance 'with the parameters specified within this policy. The portfolio should obtain a market average rate of return during a market/economic environment of stable interest rates. A series of appropriate benchmarks shall be established against which portfolio performance shall be compared on a regular basis. Marking to Market The market value of the portfolio shall be calculated at least quarterly and a statement of the market value of the portfolio shall be issued at least quarterly. This will ensure that review of the investment portfolio, in terms of value and price volatility, has been performed consistent with the GFOA Recommended Practice on "Mark-to-Market Practices for State and Local Government Investment Portfolios and Investment Pools." (See GF©A Recommended Practices, Appendix 3.) In defining market value, considerations should be given to the GASB Statement 31 pronouncement. VIII. Policy Considerations Exemption Any investment currently held that does not meet the guidelines of this policy shall be exempted from the requirements of this policy. At maturity or liquidation, such monies shall be reinvested only as provided by this policy. Amendments This policy shall be reviewed by the Finance Director on an annual basis. Any changes must be approved by the City Manager and City Council. IX. List of Attachments The following documents, as applicable, are attached to this policy: · Listing of authorized personnel, · Relevant investment statutes and ordinances, · Repurchase agreements and tri-party agreements, · Listing of authorized broker/dealers and financial institutions, · Credit studies for securities purchased and financial institutions used, · Safekeeping agreements, · Wire transfer agreements, · Sample investment reports, and · Methodology for calculating rate of return. Appendix 1: Glossary of Cash Management Terms .. . The following is a glossary of key investing terms, many of which appear in GFOA's Sample Investment Policy. This glossary has been adapted from an article, entitled "Investment terms for everyday use," that appeared in the April 5, 1996, issue of Public Investor, GFOA's subscription investment newsletter. Accrued Interest - The accumulated interest due on a bond as of the'last interest payment made by the issuer. Agency - A debt security issued by a federal or federally.sponsored agency. Federal agencies are backed by the full faith and credit.of the U.S. Government. Federally sponsored agencies (FSAs) are' backed by. each particular agency with a market perception that there is an implicit government guarantee. An example of federal agency is the Government National Mortgage Association (GNMA). An example of a FSA is the Federal National Mortgage Association (FNMA). Amortization - The systematic reduction of the amount owed on a debt issue through periodic payments of principal. Average Life - The average length of time that an issue of serial bonds and/or term bonds with a mandatory sinking fund feature is expected to be outstanding. Basis Point - A unit of measurement used in the valuation of fixed-income securities equal to 1/100 of 1 percent of yield, e.g., "1/4" of 1 percent is equal to 25 basis points. Bid - The indicated price at which a buyer is willing to purchase a security or commodity. Book Value - The value at which a security is carried on the inventory lists or other financial records of an investor. The book value may differ significantly from the security's current value in the market. ]0 Callable Bond - A bond issue in which all or part of its outstanding principal amount may be redeemed before maturity by the issuer under specified conditions. Call Price - The price at which an issuer may redeem a bond prior to maturity. The price is usually at a slight premium to the bond's original issue price to compensate the holder for loss of income and ownership. Call Risk - The risk to a bondholder that a bond may be redeemed prior to maturity. Cash Sale/Purchase - A transaction that calls for delivery and payment of securities on the same day that the transaction is initiated. Collateralization - Process by which a borrower pledges securities, property, or other deposits for the purpose of securing the repayment of a loan and/or security. Commercial Paper - An unsecured short-term promissory note issued by corporations, with maturities ranging from 2 to 270 days. Convexity - A measure of a bond's price sensitivity to changing interest rates. A high convexity indicates greater sensitivity of a bond's price to interest rate changes. Coupon Rate - The annual rate of interest received by an investor from the issuer of certain types of fixed-income securities. Also known as the "interest rate." Credit Quality - The measurement of the financial strength of a bond issuer. This measurement helps an investor to understand an issuer's ability to make timely interest payments and repay the loan principal upon maturity. Generally, the higher the credit quality of a bond issuer, the lower the interest rate paid by the issuer because the risk of default is lower. Credit quality ratings are provided by nationally recognized rating agencies. Credit Risk - The risk to an investor that an issuer will default in the payment of interest and/or principal on a security. Current Yield (Current Return) - A yield calculation determined by dividing the annual interest received 'on a security by the current market price of that security. Delivery Versus Payment (DVP) - A type of securities transaction in which the purchaser pays for the securities when they are delivered either to the purchaser or his/her custodian. Derivative Security - Financial instrument created from, or whose value depends upon, one or more underlying assets or indexes of asset values. Discount - The amount by which the par value of a security exceeds the price paid for the security. Diversification - A process of investing assets among a range of security types by sector, maturity, and quality rating. Duration - A measure of the timing of the cash flows, such as the interest payments and the principal repayment, to be received from a given fixed-income security. This calculation is based on three variables: term to maturity, coupon rate, and yield to maturity. The duration of a security is a useful indicator of its price volatility for given changes in interest rates. Fair Value - The amount at which an investment could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Federal Funds (Fed Funds) - Funds placed in Federal Reserve banks by depository institutions in excess of current reserve requirements. These depository institutions may lend fed funds to each other overnight or on a longer basis. They may also transfer funds among each other on a same-day basis through the Federal Reserve banking system. Fed funds are considered to be immediately available funds. Federal Funds Rate - Interest rate charged by one institution lending federal funds to the other. Government Securities - An obligation of the U.S. government, backed by the full faith and credit of the government. These securities are regarded as the highest quality of investment securities available in the U.S. securities market. See "Treasury Bills, Notes, and Bonds." Interest Rate - See "Coupon Rate." Interest Rate Risk - The risk associated with declines or rises in interest rates which cause an investment in a fixed-income security to increase or decrease in value. Internal Controls - An internal control structure designed to ensure that the assets of the entity are protected from loss, theft, or misuse. The internal control structure is designed to provide reasonable assurance that these objectives are met. The concept of reasonable assurance recognizes that 1) the cost of a control should not exceed the benefits likely to be derived and 2) the valuation of costs and benefits requires estimates and judgments by management. Internal controls should address the following points: · Control of collusion - Collusion is a situation where two or more employees are working in conjunction to defraud their employer. Separation of transaction authority from accounting and record keeping - By separating the person who authorizes or performs the transaction from the people who record or otherwise account for the transaction, a separation of duties is achieved. Custodial safekeeping - Securities purchased from any bank or dealer including appropriate collateral (as defined by state law) shall be placed with an independent third party for custodial safekeeping. Avoidance of physical delivery securities - Book-entry securities are much easier to transfer and account for since actual delivery of a document never takes place. Delivered securities must be properly safeguarded against loss or destruction. The potential for fraud and loss increases with physically delivered securities. Clear delegation of authority to subordinate staff members - Subordinate staff members must have a clear understanding of their authority and responsibilities to avoid improper actions. Clear delegation of authority also preserves the internal control structure that is contingent on the various staff positions and their respective responsibilities. Written confirmation of transactions for investments and wire transfers - Due to the potential for error and improprieties arising from telephone and electronic transactions, all transactions should be supported by written communications and approved by the appropriate person. Written communications may be via fax if on letterhead and if the safekeeping institution has a list of authorized signatures. Development of a wire transfer agreement with the lead bank and third-party custodian - The designated official should ensure that an agreement will be entered into and will address the following points: controls, security provisions, and responsibilities of each party making and receiving wire transfers. Inverted Yield Curve - A chart formation that illustrates long-term securities having lower yields than short-term securities. This configuration usually occurs during periods of high inflation coupled with Iow levels of confidence in the economy and a restrictive monetary policy. Investment Company Act of 1940- Federal legislation which sets the standards by which investment companies, such as mutual funds, are regulated in the areas of advertising, promotion, performance reporting requirements, and securities valuations. Investment Policy - A concise and clear statement of the objectives and parameters formulated by an investor or investment manager fOr a portfolio of investment securities. Investment-grade Obligations - An investment instrument suitable for purchase by institutional investors under the prudent person rule. Investment-grade is restricted to those obligations rated BBB or higher by a rating agency. Liquidity - An asset that can be converted easily and quickly into cash. Local Government Investment Pool (LGIP) - An investment by local governments in which their money is pooled as a method for managing local funds. Mark-to-market - The process whereby the book value or collateral value of a security is adjusted to reflect its current market value. Market Risk - The risk that the value of a security will rise or decline as a result of changes in market conditions. Market Value - Current market price of a security. Maturity - The date on which payment of a financial obligation is due. The final stated maturity is the date on which the issuer must retire a bond and pay the face value to the bondholder. See "Weighted Average Maturity." Money Market Mutual Fund - Mutual funds that invest solely in money market instruments (short-term debt instruments, such as Treasury bills, commercial paper, bankers' acceptances, repos and federal funds). Mutual Fund - An investment company that pools money and can invest in a variety of securities, including fixed-income securities and money market instruments. Mutual funds are regulated by the Investment Company Act of 1940 and must abide by the following Securities and Exchange Commission (SEC) disclosure guidelines: · Report standardized performance calculations. · Disseminate timely and accurate information regarding the fund's holdings, performance, management and general investment policy. · Have the fund's investment policies and activities supervised by a board of trustees, which are independent of the adviser, administrator or other vendor of the fund. · Maintain the daily liquidity of the fund's shares. · Value their portfolios on a daily basis. · Have all individuals who sell SEC-registered products licensed with a self-regulating organization (SRO) such as the National Association of Securities Dealers (NASD). · Have an investment policy governed by a prospectus that is updated and filed by the SEC annually. Mutual Fund Statistical Services- Companies that track and rate mutual funds, e.g., IBC/Donoghue,. Lipper Analytical Services, and Morningstar. National Association of Securities Dealers (NASD) - A self-regulatory organization (SRO) of brokers- and dealers in the over-the-counter securities business. Its regulatory mandate includes authority over firms that distribute mutual fund shares as well as other securities. Net Asset Value - The market value of one share of an investment company, such as a mutual fund. This figure is calculated by totaling a fund's assets which includes securities, cash, and any accrued earnings, subtracting this from the fund's liabilities and dividing this total by the number of shares outstanding. This is calculated once a day based on the closing price for each security in the fund's portfolio. (See beloW.) [(Total assets) o (Liabilities)]/(Number of shares outstanding) No Load Fund - A mutual fund that does not levy a sales charge on the purchase of its shares. Nominal Yield - The stated rate of interest that a bond pays its current owner, based on par value of the security. It is also known as the "coupon," "coupon rate," or "interest rate." Offer- An indicated price at which market participants are willing to sell a security or commodity. Also referred to as the "Ask price." Par - Face value or principal value of a bond, typically $1,000 per bond. Positive Yield Curve - A chart formation that illustrates short-term securities having lower yields than long-term securities. Premium - The amount by which the price paid for a security exceeds the security's par value. Prime Rate - A preferred interest rate charged by commercial banks to their most creditworthy customers. Many interest rates are keyed to this rate. Principal - The face value or par value of a debt instrument. Aisc may refer to the amount of capital invested in a given security. Prospectus - A legal document that must be provided to any prospective purchaser of a new securities offering registered with the SEC. This can include information on the issuer, the issuer's business, the proposed use of proceeds, the experience of the issuer's management, and certain certified financial statements. Prudent Person Rule - An investment standard outlines the fiduciary responsibilities of public funds investors relating to investment practices. Regular Way Delivery - Securities settlement that calls for delivery and payment on the third business day following the trade date (T+3); payment on a T+I basis is currently under consideration. Mutual funds are settled on a same day basis; government securities are settled on the next business day. Reinvestment Risk - The risk that a fixed-income investor will be unable to reinvest income proceeds from a security holding at the same rate of return currently generated by that holding. Repurchase Agreement (repo or RP) - An agreement of one party to sell securities at a specified price to a second party and a simultaneous agreement of the first party to repurchase the securities at a specified price or at a specified later date. Reverse Repurchase Agreement (Reverse Repo) - An agreement of one party to purchase securities at a specified price from a second party and a simultaneous agreement by the first party to resell the securities at a specified price to the second party on demand or at a specified date. Rule 2a-7 of the Investment Company Act - Applies to all money market mutual funds and mandates such funds to maintain certain standards, including a 13- month maturity limit and a 90-day average maturity on investments, to help maintain a constant net asset value of one dollar ($1.00). Safekeeping - Holding of assets (e.g., securities) by a financial institution. Serial Bond - A bond issue, usually of a municipality, with various maturity dates scheduled at regular intervals until the entire issue is retired. Sinking Fund - Money accumulated on a regular basis in a separate custodial account that is used to redeem debt securities or preferred stock issues. Swap - Trading one asset for another. Term Bond - Bonds comprising a large part or all of a particular issue which come due in a single maturity. The issuer usually agrees to make periodic payments into a sinking fund for mandatory redemption of term bonds before maturity. Total Return ~ The sum of all investment income plus changes in the capital value of the portfolio. For mutual funds, return on an investment is composed of share price appreciation plus any realized dividends or capital gains. This is calculated by taking the following components during a certain time period. (Price Appreciation) + (Dividends paid) + (Capital gains) = Total Return Treasury Bills - Short-term U.S. government non-interest bearing debt securities with maturities of no longer than one year and issued in minimum denominations of $10,000. Auctions of three- and six-month bills are weekly, while auctions of one-year bills are monthly. The yields on these bills are monitored closely in the money markets for signs of interest rate trends. Treasury Notes - Intermediate U.S. government debt securities with maturities of one to 10 years and issued in denominations ranging from $1,000 to $1 million or more. Treasury Bonds - Long-term U.S. government debt securities with maturities of ten years or longer and issued in minimum denominations of $1,000. Currently, the longest outstanding maturity for such securities is 30 years. Uniform Net Capital Rule - SEC Rule 15C3-1 outlining capital requirements for broker/dealers. Volatility - A degree of fluctuation in the price and valuation of securities. "Volatility Risk" Rating - A rating system to clearly indicate the level of volatility and other non-credit risks associated with securities and certain bond funds. The ratings for bond funds range from those that have extremely Iow sensitivity to changing market conditions and offer the greatest stability of the returns ("aaa" by S&P; "V-1" by Fitch) to those that are highly sensitive with currently identifiable market volatility risk ("ccc-" by S&P, '¥-10" by Fitch). Weighted Average Maturity (WAM) - The average maturity of all the securities that comprise a portfolio. According to SEC rule 2a-7, the WAM for SEC registered money market mutual funds may not exceed 90 days and no one security may have a maturity that exceeds 397 days. When Issued (WI) - A conditional transaction in which an authorized new security has not been issued. All "when issued" transactions are settled when the actual security is issued. Yield - The current rate of return on an investment security generally expressed as a percentage of the security's current price. Yield-to-call (YTC) - The rate of return an investor earns from a bond assuming the bond is redeemed (called) prior to its nominal maturity date. Yield Curve - A graphic representation that depicts the relationship at a given point in time between yields and maturity for bonds that are identical in every way except maturity. A normal yield curve may be alternatively referred to as a positive yield curve. Yield-to-maturity - The rate of return' yielded by a debt security held to maturity when both interest payments and the investor's potential capital gain or loss'are included in the calculation of return. Zero-coupon Securities - Security that is issued at a discount and makes no periodic interest payments. The rate of return consists of a gradual accretion of the principal of the security and is payable at par upon maturity. Appendix 2: Investment Pools 1. Definition In most states, there are provisions for the creation and operation of a government investment pool. The purpose of a pool is to allow political subdivisions to pool investable funds in order to achieve a potentially higher yield. There are basically three (3) types of pools: 1 ) state-run pools; 2) pools that are operated by a political subdivision where allowed by law and the political subdivision is the trustee; and 3) pools that are operated for profit by third parties. Prior to any political subdivision being involved with any type of pool, a thorough investigation of the pool and its policies and procedures must be reviewed. 2. Pool Questionnaire Prior to entering a pool, the following questions and issues should be considered: Securities: Government pools may invest in a broader range of securities than an entity may invest in. It is important to be aware of, and comfortable with, the securities a pool buys. The following is a list of questions an investment officer may wish to ask a prospective pool: o Does the pool provide a written statement of investment policy and objectives? o Does the statement contain: a. a description of eligible investment instruments? b. the. credit standards for investments? c. the allowable maturity range of investments? d. the maximum allowable dollar weighted average portfolio maturity? e. the limits of portfolio concentration permitted for each type of security? f. the poficy on reverse repurchase agreements, options, short sales and futures? o Are changes in the policies communicated to the pool participants? o Does the pool contain only the types of securities that are permitted by your investment policy? Interest: Interest is not reported in a standard format, so it is important to know how interest is quoted, calculated, and distributed in order to make comparisons with other investment alternatives. Interest Calculations Does the pool disclose the following about yield calculations: a. the methodology used to calculate interest? (simple maturity, yield to maturity, etc.) b. the frequency of interest payments? c. how interest is paid? (credited to principal at the end of the month, each quarter; marled?) d. how are gains/losses reported? factored monthly or only when realized? Reporting o Is the yield reported to participants of the pool monthly? (If not, how often?) o Are expenses of the pool deducted before quoting the yield? o Is the yield generally in line with the market yields for other investment alternatives? o How often does the pool report? What information does that report include? Does it include the market value of securities? Security: The following questions are designed to help safeguard funds from loss of principal and loss of market value. o Does the pool disclose safekeeping practices? o Is the pool subject to audit by an independent auditor at least annually? o Is a copy of the audit report available to participants? o Who makes the portfolio decisions? o How does the manager monitor the credit risk of the securities in the pool? o Is the pool monitored by someone on the board of a separate neutral party external to the investment function to ensure compliance with written policies? o Does the pool have specific policies with regard to the various investment vehicles? a. What are the different investment alternatives? b. What are the policies for each type of investment?- o Does the pool mark the portfolio t° its market value? o Does the pool disclose the following about how portfolio securities are ~alued: a. the frequency with which the portfolio securities are valued? b. the method used to value the portfolio (cost, current value, or some other method) ? Operations: The answers to these questions will help determine whether this pool meets the entity's operational requirements:. o Does the pool limit eligible participants? o What entities are permitted to invest in the pool? o Does the pool allow multiple accounts and sub-accounts? o Is there a minimum or maximum account size? o Does the pool limit the number of transactions each month? What is the number of transactions permitted each month? o Is there a limit on transaction amounts for withdrawals and deposits? a. What is the minimum and maximum withdrawal amount permitted? b. What is the minimum and maximum deposit amount permitted? o How much notice is required for withdrawals/deposits? o What is the cutoff time for deposits and withdrawals? o Can withdrawals be denied? o Are the funds 100 percent withdrawable at anytime? o What are the procedures for making deposits and withdrawals? a. What is the paperwork required, if any? b. What is the wiring process? o Can an account remain open with a zero balance? o Are confirmations sent following each transaction? Statements: It is important for (the designated official) and the agency's trustee (when applicable), to receive statements monthly so the pool's records of activity and holdings are reconciled by (the designated official) and its trustee. o Are statements for each account sent to participants? a. What are the fees? b. How often are they passed? c. How are they paid? d. Are there additional fees for wiring funds? (What is the fee?) o Are expenses deducted before quoting.the yield? Questions to Consider for Bond Proceeds: It is important to know (1) whether the pool accepts bond proceeds and (2) whether the pool qualifies with the U.S. Department of the Treasury as an acceptable commingled fund for arbitrage purposes. o Does the pool accept bond proceeds subject to arbitrage rebate? o Does the pool provide accounting and investment records suitable for proceeds of bond issuance subject to arbitrage rebate? o Will the yield calculation reported by the pool be acceptable to the IRS or will it have to be recalculated? o Will the pool accept transaction instructions from a trustee? o Are separate accounts allowed for each bond issue so that the interest earnings of funds subject to rebate are not commingled with funds not subject to regulations? Appendix 3: GFOA Recommended Practices and Policy Statements Related to Cash Management GFOA's Standing Committee on Cash Management has developed recommended practices and policy statements pertaining to the prudent investment of public funds. State and local governments should carefully consider the factors outlined in the GFOA recommended practices and policy statements when making investment decisions and entering into investment transactions. (A complete set of recommended practices and policy statements can be obtained from GFOA's Chicago office by calling 312/977-9700.) The following recommended practices and policy statements are attached: · Collateralization of Public Deposits (1984, 1987 and 1993) · Diversification of Investments in a Portfolio (1997) · Governmental Relationships with Securities Dealers (1986 and 1988) · Market Risk (Volatility) Ratings (1995) · Mark-to-Market Practices for State and Local Government Investment Portfolios and Investment Pools (1995) · Master Trust and Custodial Bank Security Lending Programs (1995) · Maturities of Investments in a Portfolio (1997) · Repurchase Agreements, Reverse Repurchase Agreements, Leveraging, and Prudent Investment Practices for Cash Management (1986 and 1995) · Selection of Investment Advisers (1992) · State and Local Laws Concerning Investment Practices (1997) · Use and Application of VolUntary Agreements and Guidelines and Support for Written Investment Policies for State and Local Governments (1995) · Use of Derivatives by State and Local Governments (1994) · Use of Various Types of Mutual Funds by Public Cash Managers (1987)