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12/11/1984 - City Council SpecialSPECIAL CITY COUNCIL MEETING TUESDAY DECEMBER 11, 1984 5:00 P.M. I. ROLL CALL II. ARTHUR YOUNG STUDY III. UTILITY FUND BUDGET IV. OTHER BUSINESS V. ADJOURNMENT MEMO TO: HONORABLE MAYOR S CITY COUNCILMEMBERS FROM: CITY ADMINISTRATOR HEDGES DATE: DECEMBER 7, 1984 SUBJECT: SPECIAL CITY COUNCIL WORKSHOP FOR DECEMBER 11, 1984 ARTHUR YOUNG STUDY A special City Council workshop is scheduled for 5:00 p.m. on Tuesday, December 11, 1984. We are planning a working "light dinner" so the meeting can adjourn at approximately 7:30 p.m. There are two (2) items that are planned for the agenda. The first item is consideration of the Arthur Young study for the non-union positions. Mr. Mark Christianson, representing Arthur Young S Associates, will be present and present results of the position evaluation, discuss the evaluation of an on- going performance appraisal system and provide some general salary information concerning all these positions. During December, 1983, equity adjustments were not given consideration once a decision was made to carry out the study that has now been performed. As a part of that discussion, retroactivity to May 1 in 1984 for positions that were substantially underpaid was a consideration once the salary results were accepted by the City Council. It was the intention of the City Administrator to complete this study during the late summer/early fall. However, due to external factors (mainly the Minnesota race track proposal), development of the RFP was delayed until May of 1984 and consequently, the study has been pushed back accordingly. Mr. Christianson will present salary information relative to each of the grades and bands that have been established through the study for the purpose of comparing internal equity. In addition, salary information for comparable cities and the private sector will be available to make an external comparison, which is desirable for a market comparison. Mr. Christianson and the City Administrator will' -explain how this all relates to comparable worth at the meeting. UTILITY FUND BUDGET At the special workshop meeting held on November 13, the City Administrator and Director of Finance were directed to review the operating income, retained earnings, and the net income before operating transfers to provide justification for the proposed transfer that is being considered in the 1985 public enterprise budget. It is difficult to analyze what this transfer represents without discussing the difference in general fund and public enterprise fund budgeting. Also, some history as to how the "transfers" were treated in previous years is important to review. The Director of Finance has prepared a rather comprehensive memorandum addressing these issues. The memorandum is detailed and may be difficult to interpret because of the some of the accounting language and examples. However, the framework and explanation is in the memorandum. Once you have read and attempted to digest the report that is given by the Director of Finance, it will allow the verbal presentation by the City Administrator and the Director of Finance to be meaningful on Tuesday. After you have read the Director of Finance's memorandum, it might help you to review the following in more simplified terms. Consider in 1983 that the public enterprise fund realised a net income or operating transfer of $900,619. What this figure represents is an operating income of $248,446 of which approximately $157,000 was earmarked for the water treatment plant. Also, $259,045 was received from interest on investments and that money is available for maintenance and working capital for the public enterprise fund. The remaining amount, $367,370, was collected from connection charges and that money is specifically earmarked toward water source supply and storage or, in other words, expansion of the system. With the amount of construction that is occurring with our rapid growth, the connection charges have not been high enough or numerous enough to keep up with the total cost obligated to capital improvements. The breakdown of the transfer that was originally recommended by the City Administrator and which has been revised by the Director -of Finance in his memorandum relates to the comparison I have just illustrated. The City Administrator and Director of Finance have discussed the possibility of changing the budget format for 1985 to include a budgeting procedure that is more parallel with public enterprise fund auditing and financial operations. Frankly, this type of change should occur and would better reflect the specific use of operating funds that are available. This can be further discussed at the meeting on Tuesday. This kind of change would not require any additional meetings or work effort on the part of the City Council; however, it would provide a more accurate accounting of the dollars the "transfer" is being planned for in the public enterprise fund budget. s/Thomas L. Hedges Attachment 1) MEMO TO: CITY ADMINISTRATOR HEDGES FROM: FINANCE DIRECTOR VANOVERBERE DATE: DECEMBER 4, 1984 SUBJECT: UTILITY FUND BUDGET As you recall, at the special City Council meeting held on November 13, 1984, we were asked to review the status of various reserve and transfer accounts within the sewer and water departments individually and in the combined fund. Before attempting to address the particular questions I would like to provide some general background material relating to the budgeting and accounting process. I think a comparison of these processes between the general fund and the enterprise fund would be helpful. A general fund is used to account for most of the current operating expenditures of a government, certain capital outlays and, in certain cases, some debt service amounts. Accounting principles require the preparation of a budget for a general fund, thereby providing legal authorization for spending. Comparisons of approved budgeted amounts with actual results of operations are required to be included in the governmental financial reports of a general fund. The resources of the general fund are ordinarily largely expended and replenished on an annual basis. Consequently, the annual differences between sources and uses of resources which is closed to fund balance can be viewed as available spendable resources. The appropriate level of fund balance is typically determined by cash flow requirements to pay for subsequent operations prior to the receipt of new revenues and by the need to provide a cushion against unforeseen requirements, the latter being referred to as a "rainy day" fund. The accounting focus of the general fund is on sources and uses of available spendable resources rather than on costs of services. They are, therefore, accounted for on a spending measurement focus using a modified accrual basis of accounting. Enterprise funds, on the other hand, are used to account for operations that are financed and operated in a manner similar to private business enterprises -- where the intent of the governing body is that the costs, (expenses, including depreciation) of providing goods or services to the general public on a continuing basis be financed or recovered primarily through user charges. Services accounted for in an enterprise fund are tangible, and it is possible to determine the extent to which they benefit individual service consumers. Governments providing such services must decide whether they want to recover all, some, or none of the costs of providing them through user charges. Enterprise fund accounting is designed to accumulate the total cost (including depreciation) of providing a particular service and to indicate the extent to which user charges imposed upon service consumers are sufficient to cover those costs. Revenues and expenses are accounted for on an accrual .basis so that periodic net income or loss can be determined. The retained earnings account represents the accumulated earnings of the fund minus any losses. Retained earnings as shown on the balance sheet are not necessarily cash nor are they necessarily available for anything. The balance sheet item retained earnings simply shows how much of previous earnings was retained in the fund. Sound financial administration requires the preparation and adoption of a comprehensive annual operating budget for the entire government including each of its enterprise funds. Budgets help to assure that: (1) service objectives are attained; (2) expenditures are properly controlled; and (3) adequate resources will be available to finance current operations, repay long term liabilities, and meet capital outlay requirements. However, accounting principles do not require budgetary comparisons in financial reports for enterprise funds. A second major difference between a general fund and an enterprise fund is in the use of depreciation. Depreciation is a means of allocating the cost of an asset to the periods in which services are received from the asset (its useful life). Since control in a general fund is on a source and use of resources basis, the use of depreciation is not necessary or appropriate. In an enterprise fund where the objective is income determina- tion, it is necessary to include the depreciation cost of assets over their useful lives. The purchase of a pick-up truck in each of these funds can be used to illustrate the difference. Assume that on January 1 each fund buys a $10,000 truck with a useful life of 10 years. The general fund would show an expenditure of $10,000 and that is all. It would be relatively easy to budget the $10,000 and show a budget to actual comparison. The source and use concept of resources is followed completely. In the enterprise fund, the purchase of this same truck would require a cash outlay of $10,000 but would be depreciated over 10 years, thereby generating a one year expense of $1,000. The $1,000 would reduce net income by $1,000. The $10,000 payment would reduce cash but would not be reflected in the results of opera- tions. The transaction has simply traded one asset (cash) for another asset (truck) with no impact on operations until the depreciation is changed. On a cash outlay basis, one would budget $10,000; however, on a net income basis, one would budget $1,000. It is important to note that depreciation expense does not require a cash outlay but is an expense of operations and needs to be used for income determination. For this reason depreciation can be a source of funds if revenues are high enough and depreciation is funded. If revenues are not high enough to fund depreciation, the enterprise will show a loss from opera- tions and the cash will not be generated. In general, the use of depreciation does not automatically guarantee a replacement fund for plant and equipment. No reserves are generated with depreciation. I In budgeting for the water and sewer departments in the enterprise fund at the City of Eagan, we have focused on the less complicated source and use concept consistent with the general fund. This means that we have projected revenues and cash outlays (including purchases of some assets which will be depreciated) and ignored non-cash expenses such as depreciation. Because of the cyclical nature, most large capital items have also been ignored e.g. wells, reservoirs, the water treatment plant. These items generally require some cash flow from current operations at various levels. The net effect of this process is that some sort of balancing account has been required to account for the difference between projected revenues and those cash outlays which have been listed. This account appears only in the budgets and is called "transfer to reserves". I believe that the title is somewhat misleading and we should note that this budgeting process does not necessarily generate large reserves, cash balances, or indicate that service rates are too high. The confusion surrounding this process is increased more by the structure of this fund in which the operations of water, sewer and street lighting are segregated into departments and all non- operating revenues and expenses are combined for reporting purposes. This situation can be illustrated by a review of 1982 and 1983 activity. Sewer Water 1982 Operating Income (Loss) $13,819 $95,682 1982 Non -Operating Revenues Street Lighting ($1,558) Total $107.943 Combined $684,578 The operating income total is 6.18 of sales ($1,783,113) which is not particularily high. The $684,578 of non-operating revenue consists of $403,039 of interest earnings and $256,085 of connection charges. The interest earnings could subsidize current operations, however, the connection charges are dedicated to future construction. Included in the water revenue for the year (including some interest) is the water treatment plant surcharge of $202,984. Removing that surcharge from operations would create a significant loss. The total transfer to reserves was budgeted at $424,970 for 1982. Sewer Water 1983 Operating Income (Loss) $89,565 $164,917 1983 Non -Operating Revenues Street Lighting ($6,036) Total $284,446 Combined $659,743 The operating income total is 12.38 of sales ($2,027,076) which is double the 1982 rate. The $659,743 of non-operating revenue consists of $259,045 of interest earnings and $367,370 of connection charges. Included in the water revenue for the year (again including some interest) is the water treatment plant surcharge of $315,402. Removing that surcharge from operations again creates a significant loss. The total transfer to reserves was budgeted at $580,140 for 1983. This process is further complicated by the rate setting method in which depreciation is not used, but figures for system renewal and replacement are substituted. The 1982 and 1983 rate setting amounts were $57,707 and $65,170 respectively as compared to actual depreciation amounts of $187,770 and $205,136 in the sewer department. In the water department, rate setting amounts were $66,238 and $75,301 for 1982 and 1983 respectively while actual depreciation expenses were $225,456 and $258,720. There are currently two reserves being accounted for within the utility fund. The first is for the debt service on the debt related to the water treatment plant. This is a cash reserve which has been generated with the quarterly surcharge and a portion of the overall rate. We expect to draw against this reserve to make debt service payments to the extent that current revenues are not great enough. The second reserve is for construction of Water Source, Supply and Storage Improvements. This reserve had a deficit of $311,962 at December 31, 1983, and is funded entirely from connection charges. The deficit is caused by the timing problem which requires the constructon prior to the collection of the related connection charges. Since there is a cash deficit related to this construction, payments are made with cash generated from current operations. An additional review of the proposed 1985 budgets for water and sewer indicates that they are generally in line with previous budgets. They also reflect all of the previously discussed complications. The Sewer Department shows, in the City Administrator's recommendation budget, a transfer to reserves of $223,650, capital outlay of $65,140 and shows no depreciation. Estimated sewer service revenue is $1,235,000. I would recommend that estimated revenue be increased to $1,340,000 which increases the proposed transfer to reserves budgeting account to $328,650. Taking out the capital outlay and estimated interest earnings of $100,000 and including depreciation of approximately $210,000, an income from operations of $83,790 would be generated at the proposed level of appropriations. This net income would be approximately equal.to the 1983 level. This proposal would fully fund depreciation and would not use or generate any reserve accounts. 4 The Water Department shows, inthe City Administrator's recommendation budget, a transfer to reserves of $1,207,470, capital outlay of $81,150, no depreciation and a revenue transfer in of $595,580 for debt service requirements on the water treatment plant bonds. Estimated water sales revenue is $1,207,500. I would recommend that estimated revenue be reduced to $975,000 which would decrease the proposed transfer to reserves budgeting account to $874,970. Taking out the capital outlay and estimated interest earnings of $400,000 and including depreciation of approximately $260,000, an amount of $396,120 would remain. Included in that number is the $595,580 transfer in to cover debt service. The transfer in would be reduced to whatever amount could not be covered by current revenues. Also included in the $396,120 is $295,000 of connection charges which are dedicated to the reserve account for Water Source Supply and Storage Improvement construction. Both water and sewer sales are estimated at 1984 rates. Any change to them would generate changes to these estimated results. It appears to me that the following questions need to be addressed as policy items: 1. Should depreciation expenses be fully funded? If they are, a cash balance would result if the cash was not used for other purchases or expenses. If depreciation expenses are not funded, net loss from operations will result. 2. Should rates be set based on depreciation expense, which is the accounting concept, or on renewal and replacement p estimates, which is not depreciation and an engineering lkk- concept? The current renewal and replacement concept causes a partial funding of depreciation. 3. What reliance on interest earnings should be used to� generate overall net income rather than income from„x►''�a�• operations? This answer is directly dependent on number 1 1Av�c and similar results would show. All of these questions can be summarized to the basic question of who should pay for what. The concept of funding depreciation would require current users to pay for the current system on a historical cost basis through the rates. Some of these users are paying for portions of this system through special assessments at the same time. The cash flow generated from funded depreciation would allow for limited repair and replacement at a point in the future without a shock to rates at that point. Some available cash to combine with new assessments would undoubtedly make replacement more acceptable to future users or to current users at a future time. S In spite of its length, I doubt this memo answers the specific questions asked. However, it does hopefully point out the complications related to the budgeting process for the utility fund and raises the questions that should possibly be reviewed at the policy level. �Av _ Finance irector/City Clerk EJV/hd/jj C MEMO TO: CITY ADMINISTRATOR HEDGES FROM: FINANCE DIRECTOR/CITY CLERK VANOVERBEKE DATE: NOVEMBER 19, 1984 SUBJECT: UTILITY FUND PERMANENT TRANSFER At your request, I have reviewed the above transfer based on the concerns expressed at the recent special City Council meeting. As I understand those concerns, they were generally that the amount was currently too high and was increasing too fast. At the time I proposed the level of this revenue source in the general fund budget, I had the same concerns and did some review of the history of this transfer satisfying myself that the proposed level was reasonable. That review is summarized as follows. Prior to the 1981 budget, certain employees were charged to the general fund and to the utility fund at various percentage amounts. I felt at that time, and I believe that you agreed, that it would be more straight forward to account for these employee costs 1008 in the general fund and transfer in the related revenue from the utility fund. It was agreed at that time that the transfer should be at the level of the expenditures and could not be looked at as another revenue source for the general fund. It was also felt that this type of accounting would consolidate administrative, supervisory and clerical costs related to these utility operations thereby increasing the overall clarity of the presentation. The 1981 budget included the following employees being budgeted (historically) to the utility fund at the following percentages: Tom Colbert 608 Bill Branch 1008 Lorna Olson 1008 Vicki Busik 808 Ann Goers 608 Brad Swenson 608 Bette Parks 33 1/38 The proposed salaries and fringes related to these employees at their charged percentages amounted to $123,898 and the transfer was approved at $120,000 --split $80,000 to water and $40,000 to sewer. The 1982 budget increased this transfer by 12 percent to $134,400. The 1983 budget increased these personnel costs by 108 to $147,840, added Joe Connolly at $35,000 when his title was changed from foreman to superintendent, and added $10,000 for the costs of the LOGIS utility billing system which was paid out of the general fund. This 1983 transfer then totaled $192,840. The 1964 budget increased the personal services cost by 58 to $192,000 and increased the LOGIS costs to $12,000 for a grand total of $204,000. The 1985 budget has been proposed with another 58 increase to the UTILITY FUND PERMANENT TRANSFER NOVEMBER 19, 1984 PAGE TWO personal services to $204,000 and LOGIS at $12,000 for a total of $216,000. These transfer amounts have all been split 1/3 and 2/3. The 1985 amounts are $144,000 for water and $72,000 for sewer. Using the same logic as 1981, the 1985 budget would have included the following employees budgeted to the utility fund at the following percentages: Tom Colbert 608 Bill Branch 100% Joe Connolly 1008 Lorna Olson 1008 Ann Goers 608 Jane Helebrant 608 Ed Kirscht 608 Bette Parks 33 1/38 Scott Merkley 608 Rich Hefti 608 These people, not including the new engineering technician, gener- ate personal services costs of $210,500 which would have been appropriated to the utility fund. This amount plus the $12,000 LOGIS costs seem to indicate that the proposed transfer of $216,000 is not out of line. The argument can certainly be made that these personal service costs are not the appropriate basis for this transfer. However, those were the costs being billed directly to the utility fund when the system of transfers was started. There are no other support services such as your time, my time or general accounting services, being paid for by the utility fund. On the other hand, they are not paid for snowplowing activities from the general fund. I have been of the opinion for some time that the transfer should not be looked at as a payment for personal service costs for certain employees but rather as a payment by a utility company made in lieu of taxes. Using this approach the question becomes one of what would a private utility company operating in the City pay in taxes to support the City's operations. The payment of these taxes is a legitimate cost of doing business for a utility. Our utility system certainly places demands for services as any public utility would and I believe a payment in lieu of taxes to help finance these services is appropriate. I don't know how the taxes would be calculated; however, at December 31, 1983, the City had an historical cost of $33,388,169 in this utility system. The City's largest taxpayer, Sperry Corporation, had a market value of $22,351,500. There is no question that the demand for services between these two is not comparable. However, the point I am trying to make is that it UTILITY FUND PERMANENT TRANSFER NOVEMBER 19, 1984 PAGE THREE does not appear to me that a payment in lieu of taxes of $216,000 for our utility system is unreasonable. I believe this got a bit more involved than what you had in mind but please use what you feel is appropriate. I would be happy to provide whatever additional information you may desire or to discuss the matter in more detail. Finan irector/City Clerk EJV/kf SPECIAL CITY COUNCIL MEETING TUESDAY DECEMBER 11, 1984 5:00 P.M. I. ROLL CALL II. ARTHUR YOUNG STUDY III. UTILITY FUND BUDGET IV. OTHER BUSINESS V. ADJOURNMENT MEMO TO: HONORABLE MAYOR S CITY COUNCILMEMBERS FROM: CITY ADMINISTRATOR HEDGES DATE: DECEMBER 7, 1984 SUBJECT: SPECIAL CITY COUNCIL WORKSHOP FOR DECEMBER 11, 1984 ARTHUR YOUNG STUDY A special City Council workshop is scheduled for 5:00 p.m. on Tuesday, December 11, 1984. We are planning a working "light dinner" so the meeting can adjourn at approximately 7:30 p.m. There are two (2) items that are planned for the agenda. The first item is consideration of the Arthur Young study for the non-union positions. Mr. Mark Christianson, representing Arthur Young S Associates, will be present and present results of the position evaluation, discuss the evaluation of an on- going performance appraisal system and provide some general salary information concerning all these positions. During December, 1983, equity adjustments were not given consideration once a decision was made to carry out the study that has now been performed. As a part of that discussion, retroactivity to May 1 in 1984 for positions that were substantially underpaid was a consideration once the salary results were accepted by the City Council. It was the intention of the City Administrator to complete this study during the late summer/early fall. However, due to external factors (mainly the Minnesota race track proposal), development of the RFP was delayed until May of 1984 and consequently, the study has been pushed back accordingly. Mr. Christianson will present salary information relative to each of the grades and bands that have been established through the study for the purpose of comparing internal equity. In addition, salary information for comparable cities and the private sector will be available to make an external comparison, which is desirable for a market comparison. Mr. Christianson and the City Administrator will' -explain how this all relates to comparable worth at the meeting. UTILITY FUND BUDGET At the special workshop meeting held on November 13, the City Administrator and Director of Finance were directed to review the operating income, retained earnings, and the net income before operating transfers to provide justification for the proposed transfer that is being considered in the 1985 public enterprise budget. It is difficult to analyze what this transfer represents without discussing the difference in general fund and public enterprise fund budgeting. Also, some history as to how the "transfers" were treated in previous years is important to review. The Director of Finance has prepared a rather comprehensive memorandum addressing these issues. The memorandum is detailed and may be difficult to interpret because of the some of the accounting language and examples. However, the framework and explanation is in the memorandum. Once you have read and attempted to digest the report that is given by the Director of Finance, it will allow the verbal presentation by the City Administrator and the Director of Finance to be meaningful on Tuesday. After you have read the Director of Finance's memorandum, it might help you to review the following in more simplified terms. Consider in 1983 that the public enterprise fund realised a net income or operating transfer of $900,619. What this figure represents is an operating income of $248,446 of which approximately $157,000 was earmarked for the water treatment plant. Also, $259,045 was received from interest on investments and that money is available for maintenance and working capital for the public enterprise fund. The remaining amount, $367,370, was collected from connection charges and that money is specifically earmarked toward water source supply and storage or, in other words, expansion of the system. With the amount of construction that is occurring with our rapid growth, the connection charges have not been high enough or numerous enough to keep up with the total cost obligated to capital improvements. The breakdown of the transfer that was originally recommended by the City Administrator and which has been revised by the Director -of Finance in his memorandum relates to the comparison I have just illustrated. The City Administrator and Director of Finance have discussed the possibility of changing the budget format for 1985 to include a budgeting procedure that is more parallel with public enterprise fund auditing and financial operations. Frankly, this type of change should occur and would better reflect the specific use of operating funds that are available. This can be further discussed at the meeting on Tuesday. This kind of change would not require any additional meetings or work effort on the part of the City Council; however, it would provide a more accurate accounting of the dollars the "transfer" is being planned for in the public enterprise fund budget. s/Thomas L. Hedges Attachment 1) MEMO TO: CITY ADMINISTRATOR HEDGES FROM: FINANCE DIRECTOR VANOVERBERE DATE: DECEMBER 4, 1984 SUBJECT: UTILITY FUND BUDGET As you recall, at the special City Council meeting held on November 13, 1984, we were asked to review the status of various reserve and transfer accounts within the sewer and water departments individually and in the combined fund. Before attempting to address the particular questions I would like to provide some general background material relating to the budgeting and accounting process. I think a comparison of these processes between the general fund and the enterprise fund would be helpful. A general fund is used to account for most of the current operating expenditures of a government, certain capital outlays and, in certain cases, some debt service amounts. Accounting principles require the preparation of a budget for a general fund, thereby providing legal authorization for spending. Comparisons of approved budgeted amounts with actual results of operations are required to be included in the governmental financial reports of a general fund. The resources of the general fund are ordinarily largely expended and replenished on an annual basis. Consequently, the annual differences between sources and uses of resources which is closed to fund balance can be viewed as available spendable resources. The appropriate level of fund balance is typically determined by cash flow requirements to pay for subsequent operations prior to the receipt of new revenues and by the need to provide a cushion against unforeseen requirements, the latter being referred to as a "rainy day" fund. The accounting focus of the general fund is on sources and uses of available spendable resources rather than on costs of services. They are, therefore, accounted for on a spending measurement focus using a modified accrual basis of accounting. Enterprise funds, on the other hand, are used to account for operations that are financed and operated in a manner similar to private business enterprises -- where the intent of the governing body is that the costs, (expenses, including depreciation) of providing goods or services to the general public on a continuing basis be financed or recovered primarily through user charges. Services accounted for in an enterprise fund are tangible, and it is possible to determine the extent to which they benefit individual service consumers. Governments providing such services must decide whether they want to recover all, some, or none of the costs of providing them through user charges. Enterprise fund accounting is designed to accumulate the total cost (including depreciation) of providing a particular service and to indicate the extent to which user charges imposed upon service consumers are sufficient to cover those costs. Revenues and expenses are accounted for on an accrual .basis so that periodic net income or loss can be determined. The retained earnings account represents the accumulated earnings of the fund minus any losses. Retained earnings as shown on the balance sheet are not necessarily cash nor are they necessarily available for anything. The balance sheet item retained earnings simply shows how much of previous earnings was retained in the fund. Sound financial administration requires the preparation and adoption of a comprehensive annual operating budget for the entire government including each of its enterprise funds. Budgets help to assure that: (1) service objectives are attained; (2) expenditures are properly controlled; and (3) adequate resources will be available to finance current operations, repay long term liabilities, and meet capital outlay requirements. However, accounting principles do not require budgetary comparisons in financial reports for enterprise funds. A second major difference between a general fund and an enterprise fund is in the use of depreciation. Depreciation is a means of allocating the cost of an asset to the periods in which services are received from the asset (its useful life). Since control in a general fund is on a source and use of resources basis, the use of depreciation is not necessary or appropriate. In an enterprise fund where the objective is income determina- tion, it is necessary to include the depreciation cost of assets over their useful lives. The purchase of a pick-up truck in each of these funds can be used to illustrate the difference. Assume that on January 1 each fund buys a $10,000 truck with a useful life of 10 years. The general fund would show an expenditure of $10,000 and that is all. It would be relatively easy to budget the $10,000 and show a budget to actual comparison. The source and use concept of resources is followed completely. In the enterprise fund, the purchase of this same truck would require a cash outlay of $10,000 but would be depreciated over 10 years, thereby generating a one year expense of $1,000. The $1,000 would reduce net income by $1,000. The $10,000 payment would reduce cash but would not be reflected in the results of opera- tions. The transaction has simply traded one asset (cash) for another asset (truck) with no impact on operations until the depreciation is changed. On a cash outlay basis, one would budget $10,000; however, on a net income basis, one would budget $1,000. It is important to note that depreciation expense does not require a cash outlay but is an expense of operations and needs to be used for income determination. For this reason depreciation can be a source of funds if revenues are high enough and depreciation is funded. If revenues are not high enough to fund depreciation, the enterprise will show a loss from opera- tions and the cash will not be generated. In general, the use of depreciation does not automatically guarantee a replacement fund for plant and equipment. No reserves are generated with depreciation. I In budgeting for the water and sewer departments in the enterprise fund at the City of Eagan, we have focused on the less complicated source and use concept consistent with the general fund. This means that we have projected revenues and cash outlays (including purchases of some assets which will be depreciated) and ignored non-cash expenses such as depreciation. Because of the cyclical nature, most large capital items have also been ignored e.g. wells, reservoirs, the water treatment plant. These items generally require some cash flow from current operations at various levels. The net effect of this process is that some sort of balancing account has been required to account for the difference between projected revenues and those cash outlays which have been listed. This account appears only in the budgets and is called "transfer to reserves". I believe that the title is somewhat misleading and we should note that this budgeting process does not necessarily generate large reserves, cash balances, or indicate that service rates are too high. The confusion surrounding this process is increased more by the structure of this fund in which the operations of water, sewer and street lighting are segregated into departments and all non- operating revenues and expenses are combined for reporting purposes. This situation can be illustrated by a review of 1982 and 1983 activity. Sewer Water 1982 Operating Income (Loss) $13,819 $95,682 1982 Non -Operating Revenues Street Lighting ($1,558) Total $107.943 Combined $684,578 The operating income total is 6.18 of sales ($1,783,113) which is not particularily high. The $684,578 of non-operating revenue consists of $403,039 of interest earnings and $256,085 of connection charges. The interest earnings could subsidize current operations, however, the connection charges are dedicated to future construction. Included in the water revenue for the year (including some interest) is the water treatment plant surcharge of $202,984. Removing that surcharge from operations would create a significant loss. The total transfer to reserves was budgeted at $424,970 for 1982. Sewer Water 1983 Operating Income (Loss) $89,565 $164,917 1983 Non -Operating Revenues Street Lighting ($6,036) Total $284,446 Combined $659,743 The operating income total is 12.38 of sales ($2,027,076) which is double the 1982 rate. The $659,743 of non-operating revenue consists of $259,045 of interest earnings and $367,370 of connection charges. Included in the water revenue for the year (again including some interest) is the water treatment plant surcharge of $315,402. Removing that surcharge from operations again creates a significant loss. The total transfer to reserves was budgeted at $580,140 for 1983. This process is further complicated by the rate setting method in which depreciation is not used, but figures for system renewal and replacement are substituted. The 1982 and 1983 rate setting amounts were $57,707 and $65,170 respectively as compared to actual depreciation amounts of $187,770 and $205,136 in the sewer department. In the water department, rate setting amounts were $66,238 and $75,301 for 1982 and 1983 respectively while actual depreciation expenses were $225,456 and $258,720. There are currently two reserves being accounted for within the utility fund. The first is for the debt service on the debt related to the water treatment plant. This is a cash reserve which has been generated with the quarterly surcharge and a portion of the overall rate. We expect to draw against this reserve to make debt service payments to the extent that current revenues are not great enough. The second reserve is for construction of Water Source, Supply and Storage Improvements. This reserve had a deficit of $311,962 at December 31, 1983, and is funded entirely from connection charges. The deficit is caused by the timing problem which requires the constructon prior to the collection of the related connection charges. Since there is a cash deficit related to this construction, payments are made with cash generated from current operations. An additional review of the proposed 1985 budgets for water and sewer indicates that they are generally in line with previous budgets. They also reflect all of the previously discussed complications. The Sewer Department shows, in the City Administrator's recommendation budget, a transfer to reserves of $223,650, capital outlay of $65,140 and shows no depreciation. Estimated sewer service revenue is $1,235,000. I would recommend that estimated revenue be increased to $1,340,000 which increases the proposed transfer to reserves budgeting account to $328,650. Taking out the capital outlay and estimated interest earnings of $100,000 and including depreciation of approximately $210,000, an income from operations of $83,790 would be generated at the proposed level of appropriations. This net income would be approximately equal.to the 1983 level. This proposal would fully fund depreciation and would not use or generate any reserve accounts. 4 The Water Department shows, inthe City Administrator's recommendation budget, a transfer to reserves of $1,207,470, capital outlay of $81,150, no depreciation and a revenue transfer in of $595,580 for debt service requirements on the water treatment plant bonds. Estimated water sales revenue is $1,207,500. I would recommend that estimated revenue be reduced to $975,000 which would decrease the proposed transfer to reserves budgeting account to $874,970. Taking out the capital outlay and estimated interest earnings of $400,000 and including depreciation of approximately $260,000, an amount of $396,120 would remain. Included in that number is the $595,580 transfer in to cover debt service. The transfer in would be reduced to whatever amount could not be covered by current revenues. Also included in the $396,120 is $295,000 of connection charges which are dedicated to the reserve account for Water Source Supply and Storage Improvement construction. Both water and sewer sales are estimated at 1984 rates. Any change to them would generate changes to these estimated results. It appears to me that the following questions need to be addressed as policy items: 1. Should depreciation expenses be fully funded? If they are, a cash balance would result if the cash was not used for other purchases or expenses. If depreciation expenses are not funded, net loss from operations will result. 2. Should rates be set based on depreciation expense, which is the accounting concept, or on renewal and replacement p estimates, which is not depreciation and an engineering lkk- concept? The current renewal and replacement concept causes a partial funding of depreciation. 3. What reliance on interest earnings should be used to� generate overall net income rather than income from„x►''�a�• operations? This answer is directly dependent on number 1 1Av�c and similar results would show. All of these questions can be summarized to the basic question of who should pay for what. The concept of funding depreciation would require current users to pay for the current system on a historical cost basis through the rates. Some of these users are paying for portions of this system through special assessments at the same time. The cash flow generated from funded depreciation would allow for limited repair and replacement at a point in the future without a shock to rates at that point. Some available cash to combine with new assessments would undoubtedly make replacement more acceptable to future users or to current users at a future time. S In spite of its length, I doubt this memo answers the specific questions asked. However, it does hopefully point out the complications related to the budgeting process for the utility fund and raises the questions that should possibly be reviewed at the policy level. �Av _ Finance irector/City Clerk EJV/hd/jj C MEMO TO: CITY ADMINISTRATOR HEDGES FROM: FINANCE DIRECTOR/CITY CLERK VANOVERBEKE DATE: NOVEMBER 19, 1984 SUBJECT: UTILITY FUND PERMANENT TRANSFER At your request, I have reviewed the above transfer based on the concerns expressed at the recent special City Council meeting. As I understand those concerns, they were generally that the amount was currently too high and was increasing too fast. At the time I proposed the level of this revenue source in the general fund budget, I had the same concerns and did some review of the history of this transfer satisfying myself that the proposed level was reasonable. That review is summarized as follows. Prior to the 1981 budget, certain employees were charged to the general fund and to the utility fund at various percentage amounts. I felt at that time, and I believe that you agreed, that it would be more straight forward to account for these employee costs 1008 in the general fund and transfer in the related revenue from the utility fund. It was agreed at that time that the transfer should be at the level of the expenditures and could not be looked at as another revenue source for the general fund. It was also felt that this type of accounting would consolidate administrative, supervisory and clerical costs related to these utility operations thereby increasing the overall clarity of the presentation. The 1981 budget included the following employees being budgeted (historically) to the utility fund at the following percentages: Tom Colbert 608 Bill Branch 1008 Lorna Olson 1008 Vicki Busik 808 Ann Goers 608 Brad Swenson 608 Bette Parks 33 1/38 The proposed salaries and fringes related to these employees at their charged percentages amounted to $123,898 and the transfer was approved at $120,000 --split $80,000 to water and $40,000 to sewer. The 1982 budget increased this transfer by 12 percent to $134,400. The 1983 budget increased these personnel costs by 108 to $147,840, added Joe Connolly at $35,000 when his title was changed from foreman to superintendent, and added $10,000 for the costs of the LOGIS utility billing system which was paid out of the general fund. This 1983 transfer then totaled $192,840. The 1964 budget increased the personal services cost by 58 to $192,000 and increased the LOGIS costs to $12,000 for a grand total of $204,000. The 1985 budget has been proposed with another 58 increase to the UTILITY FUND PERMANENT TRANSFER NOVEMBER 19, 1984 PAGE TWO personal services to $204,000 and LOGIS at $12,000 for a total of $216,000. These transfer amounts have all been split 1/3 and 2/3. The 1985 amounts are $144,000 for water and $72,000 for sewer. Using the same logic as 1981, the 1985 budget would have included the following employees budgeted to the utility fund at the following percentages: Tom Colbert 608 Bill Branch 100% Joe Connolly 1008 Lorna Olson 1008 Ann Goers 608 Jane Helebrant 608 Ed Kirscht 608 Bette Parks 33 1/38 Scott Merkley 608 Rich Hefti 608 These people, not including the new engineering technician, gener- ate personal services costs of $210,500 which would have been appropriated to the utility fund. This amount plus the $12,000 LOGIS costs seem to indicate that the proposed transfer of $216,000 is not out of line. The argument can certainly be made that these personal service costs are not the appropriate basis for this transfer. However, those were the costs being billed directly to the utility fund when the system of transfers was started. There are no other support services such as your time, my time or general accounting services, being paid for by the utility fund. On the other hand, they are not paid for snowplowing activities from the general fund. I have been of the opinion for some time that the transfer should not be looked at as a payment for personal service costs for certain employees but rather as a payment by a utility company made in lieu of taxes. Using this approach the question becomes one of what would a private utility company operating in the City pay in taxes to support the City's operations. The payment of these taxes is a legitimate cost of doing business for a utility. Our utility system certainly places demands for services as any public utility would and I believe a payment in lieu of taxes to help finance these services is appropriate. I don't know how the taxes would be calculated; however, at December 31, 1983, the City had an historical cost of $33,388,169 in this utility system. The City's largest taxpayer, Sperry Corporation, had a market value of $22,351,500. There is no question that the demand for services between these two is not comparable. However, the point I am trying to make is that it UTILITY FUND PERMANENT TRANSFER NOVEMBER 19, 1984 PAGE THREE does not appear to me that a payment in lieu of taxes of $216,000 for our utility system is unreasonable. I believe this got a bit more involved than what you had in mind but please use what you feel is appropriate. I would be happy to provide whatever additional information you may desire or to discuss the matter in more detail. Finan irector/City Clerk EJV/kf