Fund Balance

There are standards set by municipal management organizations that suggests that municipalities should maintain three to five months of spending in their unreserved fund balance to manage cash flow during the fiscal year. Municipalities may forgo separate contingency funds and maintain significantly higher reserves in their unreserved fund balance for any contingencies. Municipal policies generally apply ending balances to the unreserved fund balance to maintain a fifteen (15) to twenty (20) percent ratio to the overall budget as recommended by municipal management organizations, such as Government Finance Officers Association and the annual audit report.
The principal source of discretionary funds for municipalities is the unreserved fund balance and/or a formally designated rainy day fund. Technically, a governmental fund balance equals the difference between its current total assets and current total liabilities. The fund balance includes reserved and unreserved funds. An unreserved fund balance represents the unencumbered funds at the end of the fiscal year after all spending commitments are made. Unreserved fund balance is that portion of the total fund balance that is not restricted for future payments to satisfy outstanding or future liabilities.
Many municipalities have state statutory limitations on taxes and spending mandates that reduce options for reacting to economic downturns and further limit municipalities’ ability to take advantage of fiscal opportunities. Economic grants and development activities (e.g., land purchase) are common areas of fiscal opportunity for municipalities that may necessitate surplus funds or slack resources. Pursuing such opportunities to obtain future benefits often requires municipalities to invest more resources than are available in their current operating budget.
The flexibility of slack resources can be altered by the organizational and fiscal characteristics of the municipality’s ability to react to different levels of risk. Risk is defined here as an organization’s exposure or vulnerability to detrimental fiscal shocks and changes in the environment. Accordingly, municipalities with tax limitations face more risk because these conditions reduce their ability to compensate for or adapt to shocks and changes. Another structural feature that affects municipalities’ fiscal risk and need for slack resources is their dependence on revenues that are highly elastic and volatile or revenues they do not control. For example, municipalities that rely heavily on grants and shared revenue are more vulnerable to fiscal shock as the result of decisions by other governments and, therefore, require more slack resources. Alternatively, municipalities that depend on stable property taxes may require less slack.
With respect to political and governing preferences, municipalities that are more politically conservative, reformed, and professional accumulate more reserves.[1] Such municipalities are more risk averse and aware of the fiscal risks in their environment. Alternatively they may accumulate reserves to better take advantage of fiscal opportunities such as grants that require matching funds. However, another explanation of these findings from an economic viewpoint might be that municipal professionals are simply better able to convince politicians and voters that high surpluses are necessary.
[1] Rebecca Hendrick, 2006. “Role of Slack in Managing Local Government Fiscal Conditions” Public Budgeting and Finance, 26(1): 14-46.