Clarification of the “How we reconcile our budget” section of the City of Toronto 2023 Financial Report

See the City’s 2023 Financial Report here.

Understanding the differences between City and audited budgets is illuminating. I conclude that

• City budgets use an over-simplified accounting method which results in severe distortions, obscures key information, and obstructs accountability
• Audited budgets show the effect that external revenues and expenses have on the value of the organization, as budgets should
• City budgets should use standard accounting methods which would alleviate many of its problems, and require far less drastic transformations to get to the audited budgets
• The inclusion of amortization in the audited budgets, and deferral of highly conditional revenues in the audited statements should be the only main differences to take into account in comparing City and audited budgets

First of all, let’s be clear about what’s being reconciled in the How we reconcile our budget section. The City’s budgets, as presented to Council and authorized, both Operating and Capital budgets together, are being reconciled to the budget presented in the audited financial statement report Consolidated statement of operations and accumulated surplus. The City and audited budgets are quite different.

Second, a reminder of the context. There are two main types of financial statements — the operations of the period which disclose how the value of an organization has changed during the year, and the balance sheet which discloses the current value of the organization at the end of the year, including the most recent changes of value shown in the operations. In this case the operating statement is the aforementioned Consolidated statement of operations and accumulated surplus, and the balance sheet is the Consolidated statement of financial position.

So the reconciliation we’re investigating transforms the City’s internal budgets to an audited operating budget which shows how the operations of the City were intended to impact the value of the City corporation.

To begin the reconciliation the City’s external auditor combines all City budgets into a single aggregate budget. These budgets are displayed as columns in a table shown in the How we reconcile our budget section, as

• Operating (the tax-based operating budget)
• Capital (the capital budget)
• Non-levy (water, waste and parking, paid for by fees)
• Consolidated entities (agency and corporation budgets, notably TCHC, which are part of the City but not included in City internal budgets — they should be!)

The aggregated budgets are then adjusted to produce the operating budget presented in the statement of operations — the adjustments are listed in the Adjustments column of the presented table. (See more detail in Note 22 of the audited financial statements.)

As I said, understanding the differences between City and audited budgets is illuminating.

The accounting method the City applies to its budgets (they call it the “cash basis”) is important. As far as I can tell, this accounting method is a version of fund accounting in which the aggregate City budgets are considered a standalone fund. All budgeted amounts are considered cash. All cash coming into a fund component, from any source whatsoever, whether internal to the City or external, or even from within the fund itself, is treated as revenue. All cash going out of a fund component, to any destination whatsoever, whether internal to the City or external, or even to another component within the fund itself, is treated as expenditures. Inter-divisional Charges and Inter-divisional Recoveries are examples of cash originating from components within the fund itself, and transferred to destination components within the same fund.

So for example the City operating budgets (tax-based and non-levy) include the following in revenue:

• external revenues (eg. senior governments transfers, property taxes, user fees)
• contributions from internal reserves and capital budget accounts
• expense recoveries (internal and external)

Those operating budgets include the following in expenditures:

• external expenses (for goods and services)
• contributions to internal reserves and capital accounts
• revenue discounts (internal and external)
• debt principal payments

In summary, with the fund accounting method, internal cash transfers are conflated with external revenues and expenses. Recoveries are treated as revenues, and discounts are treated as expenses. These treatments are non-standard, and much of the reconciliation is dedicated to correcting them by applying conventional standards (identified in the financial report as PSAS — Public Sector Accounting Standards).

The purported reason for using the fund accounting method is to show all sources of funding in revenues, and all destinations of funding in expenditures. In my view there is a better way to do this (by isolating internal cash transfers in their own section). Also the fund accounting method causes confusion. The more conventional accounting methods show external revenues and expenses separately, in order to disclose and emphasize how these impact the value of the organization over the period. This information is obscured with fund accounting. Internal transfers are just accounting entries, and therefore have no effect on the value of an organization.

The fund accounting approach to City budgets does have one advantage for City staff: it simplifies accounting. Transaction analysis for posting to revenues or expenditures consists of simply determining if there is a plus sign (for expenditures) or a minus sign (for revenues) in front of the transaction amounts. But in my opinion that approach is inappropriately over-simplified.

The result of the fund accounting approach is that both revenues and expenditures are substantially distorted from conventionally calculated amounts. By my research City budget operating revenues compared to purely external revenues are overstated by about 10%, and operating expenditures compared to purely external expenses are overstated by about 25%. In addition, because all kinds of transaction types are conflated in City operating budgets, all transaction types are in aggregate obscured, and therefore difficult to see and understand.

Fortunately there are a couple of simple principles available to resolve these problems.

Principle 1. The most important operating budget amounts are those which impact the value of the organization in the period, namely external revenues and expenses.

Principle 2. Transactions should be posted in such a way as to be most meaningful and accurate for the reader (this applies to recoveries and discounts).

These principles are applied to the aggregate City budgets for purposes of transforming them into a conventional operating budget in the audited statements, and for reconciliation.

For principle 1, the first step is to remove City capital budget items that don’t effect the net total of the balance sheet from the aggregated budgets above. This includes debt proceeds, contributions to capital from reserves, and capital from current from capital revenues; tangible capital assets (TCA) from capital expenditures. Debt proceeds is an exchange of cash for a liability. Capital from current and contributions from reserves are internal transfers. Tangible capital assets are exchanged for cash or liability. None of these change the net value of the organization. Removing those items from the City budgets in effect allocates the remaining capital budget revenues and expenses to the audited operating budget (just under half of the capital budget).

The next step is to remove internal cash transfers (contributions to and from reserves and capital accounts) from both operating revenues and expenditures, and remove debt principal payments from expenditures. The transfers are not new cash, but rather are just accounting entries, so they do not change the value of the organization. Debt principal payments reduce liabilities by an equal amount with no net effect on the organization’s value.

For principle 2, recoveries are changed from revenues to expense offsets (reductions) to accurately reflect net expenses. This includes internal Inter-Divisional Recoveries, and Transfers from Capital, among other things. Analogously discounts are changed from expenses to revenue offsets (reductions) to accurately reflect net revenues. This includes waste collection rebates and some tax discounts among other things.

In a very real sense the reconciliations of these operating items are in fact just corrections of the operating budgets.

In my opinion the listed operating revenue and expense adjustments should not be required. These adjustments should have been corrected in the internal City operating budgets in the first place. As I have modelled and communicated many times over many years, the City operating budget can be “normalized” for accuracy and disambiguation by simply isolating internal cash transfers from revenues and expenses into a new internal cash transfers section, moving debt principal payments from expenditures to internal cash transfers, and applying conventional accounting standards to recoveries and discounts. Expenditures can then be renamed expenses. No information is lost that way, and much meaning is gained.

There are still two more important adjustments required for reconciliation. First, the auditor adds (accrues) amortization to the budget expenses to match the amortization that is reported in the actual figures. Second, the auditor allocates (accrues) some of the revenue (that which has strict conditions attached) to deferred revenues on the balance sheet as liabilities, and in turn allocates much of previous deferred revenues to current revenues as the contractual obligations are satisfied. See Note 10 of the audited financial statements for details. I don’t have a problem with not including these accruals in the City internal budgets, as they are of little interest for current planning purposes.

So ideally, if the City’s operating budgets were normalized, there would basically be only three reconciliations required:

• adding amortization
• accruing deferred revenues
• adding the appropriate portion of the City capital budget to the audited operating budget

We are now in a position to compare the reality I have outlined here, to the explanations offered by the City in the How we reconcile our budget section.

City staff offer explanations in two parts: first, justification for the City of Toronto budgets, and second, justification for the transformed budget in the audited financial statements.

As expected, the main justification for use of the “cash basis” (fund accounting) method in City of Toronto internal budgets is to show all sources and applications of funding. As I’ve already indicated, there is a better way to do this (by isolating internal cash transfers into their own section). Also some entries, such as Inter-Divisional Charges and Recoveries are contrived. Finally applying the cash basis technique to recoveries and discounts obscures their net effect.

Note that there is an error in the text:

we present the budget using a methodology known as “cash basis”, where the cash inflows that will be used to pay for expenses are budgeted.

(emphasis mine) “expenses” near the end should be “expenditures”.

The second justification is that the City budgets are key accountability documents. In my opinion, the fund accounting method substantially weakens accountability by confusing and obscuring the budgets. Also the implied cash flow method, as I’ve written elsewhere, makes the City’s internal operating variance reports tend to zero variances, which makes them misleading, and functionally almost eliminates meaningful accountability. As an aside, City support systems (last I checked) are in any case unable to match detailed actual line items against detailed budget line items, making detailed accountability impossible.

Regarding the transformed audited budget, the main justification presented in the text is to provide “key historical information to the public”. That’s true, as the transformed budgets are compared with actuals. The text then goes on to describe the overall nature of the financial statements in ways that aren’t really directly relevant to the reconciliation. The text seems to present the difference between City budgets and audited budgets as being primarily the result of including accruals in the audited budgets. As I’ve shown above, that’s not true.

Finally, the text asserts that the surpluses/deficits shown in the audited budgets are merely the consequence of the technical differences between the two. The truth is that the audited statements disclose the net effect of operations on the value of the organization, and the audited budgets can be compared to the actuals to determine meaningful budget variances. The same cannot be said of the City’s internal budgets.

The bottom line here is that the City of Toronto budgets should adopt a more conventional accounting method for budgeting. Among many other benefits, this would substantially reduce the volume of reconciliations required between the City budgets and the audited budgets.

For more information about Toronto budgets, see my article The mystification of the City of Toronto budget.

For more information on reconciliation, see Tracing the City of Toronto expenditure budget to the audited expense budget (2023)

If you care about this, please consider taking up the cause yourself (hopefully with a group), and pushing the City to make improvements to its budgets. I’m getting too old for this, and I’ve been doing it for too long. It’s up to you now.

Henrik Bechmann is a retired software developer. From 2015 to 2024 he was a “student” of City of Toronto budgets. Contact at X (formerly Twitter): ‘@henrikbechmann’