Module 5

Basics of Accounting and Finance for

Small Water Systems

Workbook

Financial/Managerial Series
This course includes content developed by the Pennsylvania
Department of Environmental Protection in cooperation with the
following grantees:
RCAP Solutions, Inc.
Penn State Harrisburg Environmental Training Center
 Training Module 5
Basics of Accounting and Finance for Small Water
Systems

Objectives:

The purpose of this training module is to:

Identify Assets, Liabilities, Retained Earnings, Revenue, and

Expenses on a financial statement.

Identify the components of a Balance Sheet, Income Statement

and Statement of Cash Flows.

 Identify the difference between the Cash Basis and Accrual

Basis of Accounting.

 Determine the importance of auditing and internal controls.

Table of Contents

Introduction p. 2
Definitions p. 2
Accounting Systems Considerations p. 5
Financial Statements p. 10
Controls p. 15
Summary p. 16
Resources and References p. 18

1
Introduction

#1

During this training module, we’ll be describing:

Assets, Liabilities, Retained Earnings, revenue, and expenses

that appear on a financial statement;
Components of a Balance Sheet, Income Statement and
Statement of Cash Flows;
Difference between the Cash Basis and Accrual Basis of
Accounting; and
Importance of auditing and internal controls.

This training module will provide a basic introduction to the aspects of

accounting and finance that will be encountered during the operation
of a small water system. This is not intended to be a comprehensive
review. You may wish to speak to your auditor or accountant for
more information.

Definitions

#2

To do this, let’s start with a few basic terms that you need to know.

You need to be familiar with these terms in order to understand the

accounting system and financial reports.

2
 #3

Assets are resources that are expected to increase future cash flows
into the system or reduce the cash flows out.

Examples include Cash, Inventories, Equipment, Plant, and Lines.

Assets are identified on the Balance Sheet, which will be discussed

later.

#4

Liabilities are obligations of the system to outside parties or outside

claims on the system assets.

Examples include Notes Payable (debt) and Accounts Payable

(outstanding bills).

Retained Earnings (RE) is the remaining value after the system’s

Liabilities have been subtracted from the Assets.

These are also identified on the Balance Sheet.

#5

Revenues are increases in Assets resulting from delivery of goods or

services to customers.

An example is water sales.

Expenses are decreases in Assets resulting from delivery of goods or

services to customers

3
An example is electrical use in pumping water.

Income is Revenues less Expenses and all are identified on the

Income Statement, which will be discussed later.

#6

When is a purchase an asset and when is it an expense?

A purchase is an asset when the purchase will provide future

economic benefit to the system and an expense when it relates only
to the current time period.

Examples are a Line Extension (asset) and Testing (expense).

This is an importance distinction since in many cases one asset

(Cash) is exchanged for another (Lines or Plant Expansion).

#7

Let’s complete an exercise to see if you understand the difference

between the terms.

For the following five questions, identify whether the purchase of

each item is an Asset or an Expense:

Answers
1. Electricity __________
2. Pump station __________
3. Meters __________
4. Salaries __________

Now that we’ve reviewed or discussed some of the basics, let’s

discuss some aspects of accounting systems.

4
Accounting Systems Considerations

#8

On the next few slides we will discuss the following points:

• Income Measurement
• Chart of Accounts
• Data Management
• Financial Reporting
• Internal Controls
• Auditing

#9

While there are several ways to measure, there are two main ways to
measure Income that will be covered here.

The first is the Cash Basis.

The Cash Basis of Accounting records Revenue and Expenses when

cash is received or disbursed.

For example, it records an Expense when a bill is paid and cash is

disbursed.

The Cash Basis of Accounting focuses on the system’s ability to

generate cash from its current operations.

Many small water systems use the cash method for reporting to the
board. However, the accrual basis is used during the preparation of
an annual audit.

5
 #10

The second way to determine income is the Accrual Basis.

The Accrual Basis of Accounting records Revenue and Expenses

when these are earned or incurred.

Examples are delivery of water to customers (Revenue) or receipt of

chemicals from a supplier (Expense), even though no Cash has
changed hands.

The Accrual Basis of Accounting focuses on the system’s activities

that increase or decrease all assets and liabilities (such as Accounts
Receivables or Accounts Payables), not just Cash.

#11

A further consideration of the Accrual Basis of Accounting is when to

recognize Revenues and Expenses.

Revenue should be booked when earned, not realized (actual

payment received).

For example, if a customer prepays for water delivery it should be

recorded as revenue over time as water is delivered, not right away
when it is received.

The opposite example also applies to delinquent customers. The

revenue should be booked when the water is delivered to the
customer (when the revenue is earned), not when the customer
eventually pays (when the revenue is realized).

From a practical standpoint, you record Revenue when bills are sent
and record Expenses when bills are received.

6
 #12

Which one should be used?

Accrual Basis is preferred and is now required of many governmental

units.

Accrual Basis provides a more complete system of accounting for the

activities that affect system assets. It provides a picture of the
financial shape of the system that includes outstanding income or
expenses. For example, a board may meet and see that the system
has $10,000 cash in the bank. Under the cash basis of accounting, it
may seem that things are going well. However, the accrual basis will
show that next month, there is a $12,000 bill due. Without that
knowledge you wouldn’t know that the system is in fact in trouble and
action needs to be taken.

Accrual Basis Accounting Tip:

GASB-34 (pronounced “gazby 34”) is the Governmental

Accounting Standards Board Statement No. 34 and it requires
many governmental units to use accrual basis accounting.
Soon nearly all governmental units will have to switch to this
type of accounting.
Additional information on GASB-34 can be found at
http://accounting.rutgers.edu/raw/gasb/repmodel/.

7
 #13

The Chart of Accounts is a listing of all accounts within the

accounting system, such as Water Billing, Tap Fee Fund, Interest
Income, Salaries, etc.

Account numbers need to be assigned to each account.

“Space” should be included between accounts so future accounts can

be added. To allow for this “space,” the account numbers shouldn’t
be consecutive.

You may obtain guidelines from government agencies or your auditor

to help guide you on setting up Chart of Accounts used in this
industry. The PA Dept. of Community and Economic Development
website, www.inventpa.com, has information available on the Chart of
Accounts for municipalities.

#14

Your accounting system will generate a considerable amount of data.

You need a way to manage this data.

This data will likely be best managed through the use of an electronic
ledger. Most existing programs provide preset templates and charts
of accounts and there are many good software programs out there
that are used extensively such as QuickBooks and Peach Tree as
well as many proprietary systems. Some things to consider when
choosing an electronic ledger:

• Does the math for you and generates financial reports

• Provides for easy back ups
• Requires purchase of computer software programs and
hardware
• Requires accounting and computer skills

8
 #15

The other way to manage the data from your accounting system is to
use a paper ledger. Consider the following:

• Low cost
• Requires math and accounting skills

Only very small systems should use this type of ledger system where
the purchase of computer equipment and software would be
prohibitively expensive.

#16

Let’s take a few minutes to review the information so far.

In the following exercise, identify the date when the revenue or

expense (or asset purchase) should be recorded under both the Cash
Basis and the Accrual Basis.

Let’s do the first question together.

1. A customer prepays his upcoming bill on 4-23. The water

system’s next billing cycle ends on 5-01.
a. Cash Basis - _____________
b. Accrual Basis – _____________
2. Your auditor starts the audit of your system on 3-01 and
completes his audit on 3-15. He submits a bill on 4-01 and
is paid on 4-15.
a. Cash Basis – _____________
b. Accrual Basis – _____________
3. You send out water samples for testing on 9-30. The lab
sends you results and a bill on 10-15. The water system
sends the lab a check on 11-01.
a. Cash Basis – _____________

9
 b. Accrual Basis – _____________
4. Your engineer agrees to do an environmental report on 5-02
and completes work on 6-15. He submits his results and a
bill on 6-22. The engineer is paid on 7-01.
a. Cash Basis – _____________
b. Accrual Basis – _____________
5. Water bills are generated and sent to customers on 1-15.
Payments are received on 1-30.
a. Cash Basis – _____________
b. Accrual Basis – _____________

How did everyone do? These were just some basic examples.

There are many instances where it can be much more complicated

and more difficult to determine when to record the Revenue or
Expense. In such cases, it is advisable to consult your auditor or
other expert source for guidance.

Financial Statements

#17

Now that you know some of the basics and are familiar with some
accounting terms, we’re going to discuss financial statements. The
four main types of financial statements are:

• Balance Sheet
• Income Statement
• Statement of Cash Flows
• Statement of Retained Earnings (dealing with stockholders)

The first three will be discussed further in this section. Since you are
not generally dealing with stockholders, you don’t need to worry too
much about the Statement of Retained Earnings.

10
 #18

The Balance Sheet provides the financial position of the company at

a given point in time. It has three main parts:

• Assets
• Liabilities
• Retained Earnings (RE)

The Assets section includes the resources needed to operate the

system such as Cash, Equipment, and Plant. The value of some
long-term assets is reduced every year by the amount of depreciation
and this accumulates each year.

The Liabilities section includes the debt of the system such as Loans
and Accounts Payable.

The RE section includes the net worth of the system after Liabilities
are subtracted from Assets.

#19

Let’s take a look at an example of a Balance Sheet. Refer to

Appendix 1.

It is called a “Balance” Sheet because the Asset side equals the

Liabilities and Retained Earnings side.

#20

The Income Statement provides the financial results of system

operation over a specified time period (generally a year, quarter, or

11
month) and gives the Net Income which is the Revenue less the
Expenses for the period.

It provides information on the resources used in the operation of the

system and is also known as the Profit and Loss (P&L) statement.
The financial success of the system can be gauged by the amount of
Net Income.

#21

Let’s take a look at an example of an Income Statement. Refer to

Appendix 2.

#22

The Statement of Cash Flows provides information on Cash Flows

(CF), where cash came from and where it went, during a specified
time period. It has three main parts:

CF from Operating Activities

CF from Investing Activities
CF from Financing Activities

The CF from Operating Activities includes Cash from transactions

relating to the operation of the system.

The CF from Investing Activities includes Cash from changes in long

term assets and securities.

The CF from Financing Activities includes Cash from borrowing or

repaying loans.

12
 #23

Let’s take a look at an example of a Statement of Cash Flows. Refer

to Appendix 3.

Note that Depreciation is added back in to cash flow since it is

originally deducted from Net Operating Income to determine taxable
income.

#24

So how are these statements related?

Net Income from the Income Statement gets added to the Retained
Earnings on the Balance Sheet.

Beginning cash balance on the Statement of Cash Flows comes from

the last Balance Sheet.

Ending cash balance on the Statement of Cash Flows goes onto the
current Balance Sheet.

This can be difficult to see on the handouts since these statements

relate over time. The Appendices you have are for a specific year.

#25

So how do these statements differ?

The Income Statement provides a record of Revenues and Expenses

over time.

13
The Statement of Cash Flows provides a record of the actual Cash
that has come into or left the system over time.

The Balance Sheet provides a listing of the Assets, Liabilities, and

Retained Earnings at a point in time.

The point is that it is important to review all financial statements and

not just rely on one.

#26

Review the provided financial statements to find the following

information. Determine which Financial Statement has the
information and the amount of the item.

Statement: Amount:
1. Investment income: ________ ________
2. Total operating revenue: ________ ________
3. Loan interest expense: ________ ________
4. Accounts payable: ________ ________
5. Salaries: ________ ________
6. Ending cash balance: ________ ________
7. Land: ________ ________
8. Net income: ________ ________
9. Total current assets: ________ ________
10. Payroll taxes: ________ ________

Now that we’ve covered financial statements, let move on to the

important topic of internal and external controls.

14
Controls

#27

An effective accounting system needs to have internal controls to

ensure the proper use of system funds and prevent fraud.
Internal controls can be written such as in a procedural manual or the
chart of accounts.

They can also be functional such as through the separation of

employee function, i.e. purchasing vs. accounting, and requiring two
signatures on checks. This may not be possible for a small system
and typically is noted on the auditor’s findings, but the system should
research alternatives for checks and balances.

#28

You can also maintain internal control through review and approval
such as the following:

Board approves operating budget

Board approves major expenditures
Board reviews financial statements for inconsistencies
Board treasurer or other official can review bank statements

The board is ultimately responsible for ensuring that internal controls

are in place and effective, not the employees.

#29
Instructor Note: Display Slide #29.

Generally, any water system that has received federal funding is

required to have an audit performed by an independent auditor.

15
The use of an auditor provides an external control.

#30
Instructor Note: Display Slide #30.

The auditor provides an “opinion” on the water system’s financial

statements and accounting system.

This opinion may include “findings” that identify deficiencies in areas

such as internal controls or Generally Accepted Accounting Principles
(GAAP).

If the auditor’s opinion includes findings, these will need to be

addressed by the board.

Summary

#31

Before we summarize, let’s complete a short exercise to see what

you’ve learned.

Fill In-the Blank

1. ________ are resources expected to increase future cash flows

into the system or reduce the cash flows out of the system.

2. Obligations of the system to outside parties or outside claims on

the system assets are considered ________.

3. Retained Earnings is the remaining value after the system’s

liabilities have been subtracted from the ________.

16
4. A(n) ________ in Assets resulting from the delivery of goods or
services to customers is considered an expense.

5. A purchase is an Asset when the purchase will provide ________

economic ________ to the system and an Expense when it
relates only to the current time period.

6. The ________ Basis of Accounting records Revenue and

Expenses when cash is received or disbursed.

7. The ________ Basis of Accounting records Revenue and

Expenses when these are earned or incurred.

8. Four main types of financial statements include a) the Balance

Sheet, b) the Income Statement, c) ______________________
and d) Statement of Retained Earnings.

9. Three main parts of the Balance Sheet are ________, Liabilities,

and Retained Earnings.

10. The ________________ provides the financial results of system

operation over a specified time period.

11. Requiring two signatures on checks is an example of a(n)

________________.

12. Internal controls are important in preventing ________.

#32

The key points of this training module are:

An effective accounting system is crucial to the financial

tracking of system revenues and expenses and to the
prevention of fraud and misuse of system funds.

17
 An understanding of financial reports is necessary for the board
when planning for the system’s future finances.

Many governmental entities and utilities (water systems) track

revenue on a cash basis; however, most will be required to
move to an accrual basis.

The three main financial reports are the Income Statement,

Statement of Cash Flows, and the Balance Sheet.

Auditing and internal controls help to prevent the misuse of

system funds.

Resources and References

#33

The following are references and resources you can use when you
need additional information on the topics presented today.

PA Dept. of Environmental Protection, Technical Assistance and

Outreach, (717) 772-4058, Dennis Lee

RCAP Solutions, Inc, (814) 861-6093

Don Schwartz, PA/NJ Program Manager

The complete list of training modules includes:

Module 1, Water Supply System Basic Operations
Module 2, Responsibilities of Governing Boards
Module 3, The Safe Drinking Water Act
Module 4, Dealing with Consultants, Technical Assistance
Providers, Regulators, and Funding Agencies
Module 5, The Basics of Accounting and Finance for Small
Water Systems
Module 6, Business Planning for Small Water Systems

18
Module 7, Budgeting and Capital Improvements Planning
Overview for Small Water Systems
Module 8, Rate Design Overview for Small Water Systems
Module 9, Bidding, Purchasing, and Leasing
Module 10, Project Management Overview for Small Water
Systems

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Appendix 1

Littletown Water Authority

LITTLETOWN WATER AUTHORITY

BALANCE SHEET 12/31/02

Assets
CURRENT ASSETS
Cash and cash equivalents $ 92,540
Accounts receivable 8,945

Total current assets $ 101,485

PROPERTY, PLANT, AND EQUIPMENT

Land $ 13,535
Plant and equipment 2,456,897
$ 2,470,432
Less accumulated depreciation 45,342
Net property, plant, and equipment 2,425,090

Total assets $ 2,526,575

Liabilities and Retained Earnings

CURRENT LIABILITIES
Current maturities of long-term debt $ 16,982
Accounts payable 6,572
Accrued interest payable 14,769

Total current liabilities $ 38,323

LONG-TERM DEBT, less current maturities 1,365,231

Total liabilities $ 1,403,554

RETAINED EARNINGS

Capital grant, federal, for construction $ 916,568

Capital grant, state, for construction 86,927
$ 1,003,495
Retained earnings, unreserved 119,526

Total retained earnings $ 1,123,021

20
Appendix 2

LITTLETOWN WATER AUTHORITY

INCOME STATEMENT
Year ended 12-31-02

OPERATING REVENUE
Water billing $ 136,572
Tap-in and inspection fees 7,835

Total operating revenue $ 144,407

OPERATING EXPENSES
Salaries $ 13,503
Advertising 78
Professional Services 6,014
Depreciation 22,671
Office Expense 1,041
Plant operation 14,789
Insurance 703
Payroll Taxes 1,276
Repair and maintenance 875
Supplies 1,463
Travel 159
Utilities 6,794
Miscellaneous 569

Total operating expenses 69,935

Net operating income $ 74,472

NON-OPERATING INCOME (EXPENSES)

Interest income $ 2,178
Interest expense (17,983)

Total non-operating income (expense) (15,805)

NET INCOME $ 58,667

21
Appendix 3

LITTLETOWN WATER AUTHORITY

STATEMENT OF CASH FLOWS

Year ended 12-31-02

BEGINNING CASH BALANCE $ 12,786

CASH FLOWS FROM OPERATING ACTIVITIES

Net operating income $ 74,472
Depreciation 22,671
Changes in assets and liabilities:
(Increase) in accounts receivable (2,353)
(Decrease) in accounts payable (1,387)
Increase in accrued expenses 2,156

Net cash provided by operating activities $ 95,559

CASH FLOWS FROM INVESTING ACTIVITIES

Investment income $ 2,178

Net cash provided by investing activities $ 2,178

CASH FLOWS FROM FINANCING ACTIVITIES

Loan interest expense (17,983)

Net cash provided by financing activities $ (17,983)

ENDING CASH BALANCE $ 92,540

22