Question

The following information pertains to a city government. a) The city (1) purchased a 3-year, 7 percent U.S. Treasury note (2) used the note to enter into a 90-day short-term loan transaction that incorporated an interest rate of 6 percent and (3) used the proceeds from the short-term loan transaction to purchase another 3-year 7 percent U.S. Treasury note. What are the benefits and risks of the city’s investment practices? b) In 2015 the city constructed a new highway at a cost of $120 million. In the years following 2015, the city did not record a depreciation charge on the highway – not even in its government-wide statements. Can the omission of the depreciation charge be justified under GASB standards? Explain.

Answer 1

(a)

The benefits are:-

1) It results in 1 percent profit for every pair of buy/sell.

2) Once the last pair of arbitrage is done, the princpal amount is still with the arbitrager (Which will otherwise not be the case if it were to be Invested in the 7% Note alone). This Principal could further be invested elsewhere to gain interest. This is an extra income too.

3) Arbitrage in practice lasts for a very short time. This could result in encashing on an opportunity to make short term high ticket profits.

4) It could be Leveraged by borrowing the funds for investment.

Risks:-

1) It could be considered Arbitrage abuse if the information is known within the firm (insider trading)

2) It lasts for a very less time.This arises due to market inefficiencies which may not last long. If not arbitraged by then, there could be a lost opportunity to invest elsewhere.

(b)

1) GASB standards, statement No. 34, permit the government not to charge depreciation on infrastructure assets.

2) Infrastructure consists of roads, bridges, streets, sidewalks, and similar assets that are immovable and of value only to the State.

3) Infrastructure assets are required to be accounted similarly as other capital assets, but there is a difference with regards to depreciation expense treatment on infratructure assets in contrast to other capital assets.

4) Infratructure assets are not required to be depreciated as long as the government manages those assets using an asset management system that has certain characteristics and the government can document that the assets are being preserved approximately at (or above) a condition level established and disclosed by the government ( Modified approach).

So, the omission of depreciation charge in government wide statements under GASB Standards is justified if the city manages those assets using an asset management sytem and if the city opts to report road preservation charge in lieu of depreciation.