CHAPTER 11

INTERNAL SERVICE FUNDS

ANSWERS TO QUESTIONS

Question 11-1

Among the advantages to the unit establishing such an Internal Service Fund are the
following:

1. Centralized purchasing. Centralized purchasing might permit a more qualified

purchasing agent to be employed; lead to the acquisition of better goods for the
same price or goods of equal quality to those now being acquired at a lower
price; result in better control of quantities ordered; increase both the quantity
discounts received and the purchase discounts taken by buying in larger units
and in planned order sizes and by improving purchase discount control; reduce
the number of purchase orders that have to be processed; etc.

2. Central storeroom. A central storeroom might lead to better assessment of

purchasing needs; less obsolete inventory; less total investment in inventory,
through avoiding duplication of inventory items in several departments; better
control over theft and other causes of inventory shrinkage; improved inventory
costing, both within the Internal Service Fund and with regard to amounts
charged to the various departments; fewer out-of-stock delays; etc.

Question 11-2

Many benefits should accrue as a result of costing the activities financed through an
Internal Service Fund, including:

1. The knowledge of what a good or service costs is provided, as well as the ability
to compare the cost of the goods or services provided through the Internal
Service (IS) Fund with that of similar goods or services provided commercially.
In this sense it serves both to enhance general knowledge and as a control over
the IS activity to ensure that it does not price its goods or services above the
market price of similar ones.
2. Related to the first, it should facilitate more intelligent "make or buy" decisions
at all levels.
3. It helps create a "cost conscious" attitude among employees at all levels and
thereby encourages economy and efficiency of governmental management.
4. The ability, over time, to observe cost trends and changes therein permits one to
better manage and evaluate management of the IS activity.
5. It enhances the ability to distribute costs of IS activities equitably among user
departments.
Question 11-3

The level of activity—and hence the expenditure requirements and revenues—of an

Internal Service Fund are determined by the demands of the user departments for its
services. Hence, the Internal Service Fund should not normally be constrained to fixed
budget limitations that might hamper its ability to fulfill its service functions—but should
be budgeted on a flexible basis. Furthermore, the appropriations made for the user
departments serve as an indirect budgetary ceiling on the Internal Service Fund, making
formal budgetary control on a fixed basis less essential for the Internal Service Fund than
for the expendable funds through which the departments served by the Internal Service
Fund activity are financed.

Question 11-4

Internal Service Funds are required to be reported by fund type in the basic financial
statements. This means that only one column for Internal Service Funds is reported on
the proprietary funds statement of net assets, the statement of revenues, expenses, and
changes in net assets, and the statement of cash flows regardless of how many internal
service funds are maintained by the governmental entity. It is a combined column. For
governments that prepare a Comprehensive Annual Financial Report, combining
financial statements are required in the supplemental statements and schedules if the
government has more than one Internal Service Fund.

Question 11-5

The original capital required to establish an Internal Service Fund may be acquired in a
variety of ways:

1. Transfers from the General Fund or other funds of the governmental unit.

2. Advances from the General Fund or other funds. Because an advance is

temporary, presumably Internal Service Fund rates would be established
somewhat higher than cost in order to repay the advance. In this case, reported
user fund expenditures/expenses of future years will be higher than cost (or there
will be transfers) to build up the capital of the Internal Service Fund.
Precautions must be taken to assure that this practice is not abusive and does not
result in unallowable costs being charged to grants, etc.

3. Proceeds of bond issues or other debt instruments may be used to provide either
permanent or temporary capital.
 4. Transfer of existing equipment, inventory, and the like from other funds or from
general capital assets.

5. Grants or advances from other governmental units.

Question 11-6

Direct cost of goods or services provided, with no provision being made for items such as
depreciation or overhead, would be appropriate as the basis for Internal Service Fund
reimbursement when (1) such other costs (other than direct costs) are immaterial, as
where an Internal Service Fund entity is used merely to distribute common costs (such as
telephone or two-way radio facility services) equitably among the various user
departments—and is in essence a "flow through" or "clearance" device; and (2) when
such costs as salary or other overhead are being financed through separate departmental
appropriations and it is the intent that neither these nor depreciation and similar costs be
recovered through Internal Service Fund charges. Those cases falling within the latter
category must be evaluated carefully to assure that the intent and the resultant fee
structure are indeed appropriate. But so long as the intent of the governing board is
indicated, the reimbursement rates and Internal Service Fund accounting must be
consistent with the intent of the governing body.

Question 11-7

The change in the net assets balance of an Internal Service Fund that is intended to break
even may be disposed of as follows:

1. If the intent is that it break even each year, then the change in net assets
(positive or negative) would be disposed of through supplemental billings to, or
issuance of credit memos to, the user departments on an equitable basis.

2. If the intent is for the Internal Service Fund to break even over a span of several
years, the results of a particular year being considered of lesser consequence, the
change in net assets would be closed to Net Assets. The causes of the change in
net assets should be examined to see if they indicate that the rate at which
Internal Service Fund activities are billed to user departments should be
adjusted.

Question 11-8

Accounting for an Internal Service Fund that is controlled by a fixed budget is often
called "double accounting" if a dual budgetary and proprietary accounting system is used
in which (1) a single transaction often necessitates that both budgetary and proprietary
entries be made, while (2) other transactions or events require entries in only one or the
other type of accounts.

Question 11-9

a. If the bonds are still outstanding, at least the cash and near cash items (such as
investments and receivables) typically should be transferred to the Debt Service
Fund which will retire the bonds. If the other assets are sold, the proceeds should be
placed in the Debt Service Fund. If the other assets are to be used by a proprietary
fund, the assets should be transferred to that fund; if the assets are to be used by a
governmental fund, the assets should be recorded in the General Capital Assets and
General Long-Term Liabilities accounts. In both of the latter cases it is preferable
that cash in the amount of their fair value be transferred to the Debt Service Fund.
Question 11-9 (continued)

b. If the bonds are no longer outstanding, the Internal Service Fund assets may be
disposed of as the governing body sees fit. Capital assets should be recorded in
proprietary funds or in the General Capital Assets and General Long-Term Liabilities
accounts, as appropriate.

Question 11-10

One approach to pricing Internal Service Fund goods or services is to estimate the total
costs expected to be incurred and the total quantity of goods or services expected to be
required by user departments or agencies. A predetermined rate is determined based
upon this information.

A second approach is to charge the departments or agencies based on actual costs

determined at the end of each month, quarter, or year. The limitations and problems
associated with this pricing method are discussed in the answer to Question 11-6.

Question 11-11

Centralized risk financing activities are required to be accounted for through the General
Fund or in an Internal Service Fund.

Question 11-12

While there are various reasons that some governments charge more than historical cost
for Internal Fund Services in order to build up the level of net assets, one of the most
understandable is that the replacement cost of assets is often significantly greater than
their historical cost. (Some governments base their Internal Service Fund billings on
replacement cost estimates as a mechanism for financing replacement of existing assets at
the expected higher costs). While it is prudent for management to be concerned about
this issue, there are financial reporting concerns and legality issues that are important to
understand.

From a financial reporting standpoint, the billings to departments in excess of historical

costs should technically be reported as transfers. From a legality standpoint,
overcharging user departments sometimes results in diverting restricted resources to other
purposes. The practice may result in the illegal use of intergovernmental grant or other
restricted resources. Internal Service Fund charges (included in expenditures submitted
for grant reimbursements) are watched closely by federal auditors.

Question 11-13

Governments with more than one Internal Service Fund must present Internal Service
Fund combining financial statements in their Comprehensive Annual Financial Reports.
These combining financial statements are reported in the combining and individual funds
financial statements in the financial section.

Question 11-14

The required financial statements for an Internal Service Fund are:

• Balance sheet (Statement of net assets)
• Statement of revenues, expenses, and changes in net assets
• Statement of cash flows

SOLUTIONS TO EXERCISES

Exercise 11-1

1. c
2. f
3. b
4. f
5. c
6. a
7. b
8. e
9. d (While Internal Service Funds would be allowed to transfer funds to other
funds, this practice would be far less common than the Internal Service Fund
purchasing capital, borrowing from another fund or being the recipient of
transfers from another fund. In general, Internal Service Funds are not a common
source of financial resources for other funds. )
10. a

Exercise 11-2

1. b
2. e
3. f
4. c
5. b
6. c
7. d
8. b
9. d
10. b

Exercise 11-3

1. Salaries Expense............................................................. 10,300

Cash......................................................................... 10,000
Accrued Salaries Payable........................................ 300
To record salary payments and accruals.

2. Equipment....................................................................... 50,000
Cash......................................................................... 5,000
Notes Payable—Long-Term.................................... 45,000
To record purchase of equipment using note.

3. Due from Other Funds.................................................... 10,000

Cash................................................................................ 90,000
Revenues—Billings to Departments.......................
100,000
To record sales and collections.

4. Losses—Claims and Judgments..................................... 25,000

Claims and Judgments Liabilities—Long-Term..... 25,000
To record contingent loss.

5. No entry.

6a. Inventory of Supplies...................................................... 41,000

Vouchers Payable.................................................... 41,000
To record purchase of supplies.

6b. Vouchers Payable........................................................... 41,000

Cash......................................................................... 41,000
To record payment of vouchers.

7. Supplies Expense............................................................ 25,000

Inventory of Supplies.............................................. 25,000
To record use of supplies.

8. Depreciation Expense—Equipment................................ 16,000

 Depreciation Expense—Buildings.................................. 25,000
Accumulated Depreciation—Equipment................. 16,000
Accumulated Depreciation—Buildings................... 25,000
To record depreciation.

9. Interest Expense ($45,000 x .1 x .75)*........................... 3,375

Interest Payable....................................................... 3,375
To record interest on note.
. Exercise 11-3 (continued)

Cash................................................................................ 10,000
Accumulated Depreciation—Equipment........................ 21,000
Equipment................................................................ 28,000
Gain on Sale of Equipment...................................... 3,000
To record sale of equipment.