As an investor in local government debt instruments, you might often hear the term ‘CAFR’ and its importance in maintaining financial transparency for local governments for financial markets and their investors. As the name suggests, a Comprehensive Annual Financial Report (CAFR) is a set of financial reports produced by local governments, states and other entities to comply with the reporting rules set by Government Accounting Standards Board (GASB). GASB also serves as the oversight board to ensure compliance and communicate any new updates or changes to reporting methods. In addition, an independent auditor audits the CAFR using GASB standards prior to their publication. The local and state governments produce many comprehensive documents and reports; however, the CAFR and the entity’s budget book are typically considered two of the most important documents. Where the budget is a forward-looking document that plans for the future fiscal year and shows how the revenues will be allocated, the CAFR shows the actual numbers of financial activities for the previous fiscal year. In this article, we will take a closer look at different sections of the CAFR and how investors can find information pertinent to their investments in a particular local government’s CAFR.
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Guide to Understanding CAFR
As mentioned above, a CAFR is a set of financial statements that presents a wide variety of information needed for readers to understand the true financial picture of a local government’s finances and how they compared to the financial data (both revenue and expenditures) projected in the budget book. There are three main section in a CAFR book: introduction, financial section and statistical section.
The introduction section primarily guides a reader through the report with a table of contents for various sections and often includes a transmittal letter from the entity executive. The transmittal letter is one of the legal requirements for the CAFR that typically includes the local government’s profile, provides an economic update on the local economy, lists any major initiatives undertaken by the local government and states that financial reports are management’s responsibility.
After the introduction, the CAFR’s second and more detailed/comprehensive section is its financial section that includes all financial reports, narratives explaining the financial information and an auditor’s report. An auditor’s report is typically the first item in the financial section that renders the auditor’s opinion on the financial reporting and presentment. This is followed by the financial statements (both government-wide financial statements and fund financial statements); this information includes narratives written by various departments throughout the local government, explaining the data presented in the financial reports.
The third section is the statistical section, and is also crucial as it outlines financial trends, revenue capacity, debt capacity, demographic information and other operating information about the local government.
- It contains trend information to help the reader understand how the local government’s financial performance and fiscal health have changed over time.
- Revenue Capacity schedules contain information to help the reader assess the local government’s most significant revenue sources: property tax, retail sales tax, business and occupation tax, etc.
- Debt Capacity schedules present information to help the reader assess the affordability of the local government’s current levels of outstanding debt, and the state’s ability to issue additional debt in the future.
- Demographic schedules offer demographic and economic indicators to help the reader understand the environment in which the local government’s financial activities take place.
- Operating Information schedules offer operating data to help the reader understand how the information in the local government’s financial report relates to the services it provides and the activities it performs.
“High points” in a CAFR
The CAFR provides a wide variety of information that’s quite comprehensive in nature for its readers. However, for some investors and taxpayers, it might not all be pertinent or easy to follow and, depending on the reader’s interest, some information might be more relevant than other information.
Hence, generally speaking, a reader can go through the financial section of the CAFR and find the ‘high points’ by reading through the Management Discussion and Analysis (MD&A). This section describes the previous year’s results and key factors influencing them; shows the local government’s current financial condition; and provides an overview of likely future prospects.
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Investors in Local Government Debt
For investors who are either prospective buyers of local government debt instruments or currently hold these securities, all information provided in the CAFR can be pertinent depending on your issue and the revenue sources backing your debt (for example, General Obligation debt or Enterprise debt backed by specific revenue streams). In the statistical section of the CAFR, there is pertinent information about the local government’s debt capacity, essentially highlighting how much debt the government can prudently afford.
In addition to the debt capacity, it’s also important to review the legal debt margin, which is the difference between the amount of debt, or debt service, the government is authorized to carry and the amount of debt or debt service the government is actually carrying. It indicates how much room the government has for additional debt before it reaches its legal limit. Furthermore, investors in local government instruments must also pay close attention to various debt ratios like Debt to Tax Collections, which looks at the tax revenue and debt service pledge against these revenues. Overall, debt ratios showcase the overall risk for the local government and its investors.
The Bottom Line
CAFR is one of the most important documents for any local or state government to establish financial transparency and establish credibility with its creditors and oversight agencies. As seen in the case of Manassas Park, VA, the inability to produce a CAFR in a timely manner can lead to rating suspensions or downgrades – which would totally limit a government’s ability to access capital markets to fund any future projects and can have serious negative impacts on outstanding debt. For any local government debt investors, CAFR is certainly a great place to start your research on the financial standing and actual revenue and expenditure numbers.
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Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisors prior to making any investment decisions.