Question

Many governments use internal service funds to account for activities that provide services to the government itself. What are the ramifications of such an accounting arrangement? What are the effects on the government’s financial statements?

Answer 1

Governments commonly use internal service funds (ISF) as cost centers. They permit agovernment to accumulate all costs (including depreciation) of providing a specific service toother activities or functions of the government. Use of the ISF in external financial reportingoverstates the expenditure/expense of the combined entity by the amount of billings to thevarious departments. The costs of providing the services are accumulated in the ISF. Whenthe ISF bills the departments, the amounts billed are reported as expenditures/expenses in thevarious funds. Because there are no eliminations in the fund financial statements, the costs of providing service are counted twice. Duplications are removed in the government-widefinancial statements

Governments that wish to include a depreciation charge in a governmental fund can do so byaccounting for an activity in an ISF, billing the governmental fund an amount that reimbursesthe ISF for all costs, including depreciation.The billing rates used by an ISF are supposed to cover costs. Management of the governmenthas the power to set the rates and can set them at any amount they choose. The billings arearbitrary and may make the fund financial statements less than objective.If the general fund is prohibited from operating at a deficit and it accounts for an activity thatcan be transferred to an internal service fund, management could hide any deficit bytransferring that activity to an ISF. That is, management could set an ISF billing ratearbitrarily low and avoid displaying the deficit in the general fund