A Quick Review of the Series So Far:
A budget involves forecasting revenues and expenses for the coming year and helps to ensure appropriate spending levels on the utility’s highest priority concerns. The budget provides a variety of benefits to everyone in the utility (especially those in management, finance, and the ultimate decision-makers) including providing greater knowledge of the water utility’s financial picture and improved control of expenditures.
A budget is created by anticipating the revenues and expenses for the upcoming year. These estimates may be based off of last year’s information, using a zero-based approach, or starting with a blank slate and creating the budget from there. Once a draft budget is made, it should be reviewed thoroughly to ensure it fits the needs and priorities of the governing body and the community it serves. It must also balance revenues and expenses with some funding remaining for deposit into reserve accounts (e.g., emergency reserves, operating capital reserves, debt service reserves). Once the budget is in its final form, it needs to be formally adopted by the governing body.
Expenditures should be logged against the budget categories to enable a comparison of actual expenditures to budgeted expenses. A monthly check is a good time horizon to review actuals against projected expenses, but if that is not possible, quarterly checks should be completed. These checks should allow for mid-course corrections in order to align expenditures in various categories.
The first blog in this series, “Getting Started,” should be reviewed as a first step for guidance about getting started with the budget process. The second blog in the series, “Creating the Budget” should be reviewed to determine how revenues and expenses should be estimated. This blog will cover depreciation, reserve accounts, and balancing the budget.
Depreciation:
Depreciation is a method through which the costs of assets are allocated over time. It requires an estimate of the expected useful life of the asset and allocates a portion of the total cost of the asset that gets ‘used up” each year as the asset deteriorates. For example, if an asset costs $500,000 and is expected to last 40 years, each year, $12,500 would be the annual depreciation expense. This amount, along with all other asset depreciation expenses, should be included in the budget.
A logical question would be: why should we include the depreciation expense within the budget? There are multiple reasons, but the best reasons may be to ensure the financial sustainability of the utility and to achieve fair and equitable rates. If each year users are paying the share of asset life their usage has caused, costs can be equitably attributed. This is particularly important for long-lived assets. Imagine that customers in 2025 pay for a large, multi-million dollar expenditure on a pipe replacement and no depreciation is used. The pipe is assumed to have a lifespan of 75 years. A customer who moves to town in 2035 will benefit from the pipe replacement but will not be paying for it. If they move out in 2045, long before the replacement, they will not have contributed towards future replacement that their usage caused. If instead, depreciation is included in rates, the customer who lived there for 10 years will pay for the portion of pipe depreciation that their usage caused.
Adding depreciation accounts for the fact that a long-lived asset will lose value each year of use helps ensure that at least some money is available to replace the assets at the end of their useful life. Depreciation in the rates also helps reduce spikes in expenses that can cause large increases in rates. The intent is to spread out the impact of the rate increases over time, so they are more manageable.
High dollar, long-lived assets should be depreciated. However, assets that last less than a few years should not be depreciated, unless a short-lived asset has an extremely high cost. However, assets lasting less than 1 year should never be depreciated. The inclusion of deprecation serves as a leveling effect that presents a more realistic picture of revenues and expenses.
Balancing the Budget:
Creating the budget involves determining both revenues and expenses separately. The last step is probably the most important one – the budget must balance, meaning that the revenues have to meet or exceed the expenses. A public utility cannot make a profit, so the revenues have to equal expenditures, including “other projected uses” of the money. The “other projected uses” refers to money that will be placed into reserve accounts for future expenditures. Reserve accounts are discussed in the next section. Reserve accounts are not operating expenses, per se, but are necessary for sustainability of the water system.
As long as the budget includes the items necessary to have a well-operated and managed utility and revenues cover expenses plus whatever funding is needed for the reserve accounts, the outcome looks good. There are three issues that require additional consideration in the current budget.
Expenses Exceed Revenue – Budget Shortfall:
If the expenditures exceed the revenues, there is the potential for a budget shortfall. If this has occurred in previous years, the shortfall needs to be addressed in future years to fill in the gap. The shortfall may have been addressed by taking money out of reserve accounts (if the utility has them) to cover the expenses, in which case, the future budget needs to have that gap amount, or at least a portion of it, if it will be filled in over time, added to the budget to “pay back” the reserve.
If the shortfall was addressed by canceling work or eliminating a portion of necessary expenses, money will need to be added to the budgeted items that were eliminated. In any case, budget shortfalls are to be avoided, as this is the most financially critical situation for a utility. A utility needs to pay its bills to be viable and continue to serve the needs of its customers.
If budget projections indicate that the budget for the upcoming year will continue in the shortfall mode, the water utility has three options: 1) cut expenses, 2) raise rates, or 3) a combination of both. Cutting expenses might appear to be the easiest option, but should not occur if the cuts will result in impacts to the safety of the water supply, reductions in service levels to customers, or inadequate operation and maintenance of assets. If rate increases are the desired approach, previous blog posts address rates and finance issues. They can be found here.
Revenues Exceed Expenses – Budget Surplus:
If the revenues exceed expenses, there is the potential for a budget surplus. If this occurs, the money can be used for several different purposes: 1) increasing amounts to reserve accounts, 2) paying down existing debt, 3) addressing unmet needs within the utility (e.g., maintenance, asset replacement), or 4) considering staff increases. Using budget surpluses to reduce rates is not recommended. There are most likely needs for the money within the utility and lowering and raising rates each year based on surpluses or shortfalls sends confusing signals to customers and makes it difficult for them to budget.
Expenses Left Out of the Budget:
If the system has chosen to eliminate some items from the budget to artificially create a balanced budget, the utility may feel the negative repercussions from that removal throughout the year. The repercussions may cause asset failures, regulatory compliance issues, inability to train or retain staff, difficulties paying utilities or other necessary expenses, or many other negative consequences. It is highly recommended that the budget be crafted such that ALL required and necessary expenditures be included in the budget and the only items that truly can be removed be left out. It is important that the governing body understands the importance of all budget items and the need to raise rates if necessary to keep the utility sustainable.
Reserve Accounts:
Every utility should have reserve accounts to put away money for future needs. The number and how the reserves are funded is specific to each utility. However, a minimum of operating cash reserves and emergency reserves should be set up by each system. If the system has outstanding debt, the funding agency may require a debt service reserve. Other reserve accounts can be set up for other specific purposes to address the needs of the system. Types of reserve accounts and their purposes are shown below.
| Type of Reserve | Purpose |
| Operating Cash Reserve | Provide a way for a utility to pay its bills during times of low revenues |
| Emergency Reserve | Provide funds for unforeseen expenses |
| Repair/Replacement Reserve | Purchase, repair, or rehabilitate assets or equipment with a short-term life expectancy (1 to 10 years) |
| Planned Capital Improvements Reserve | Construct or upgrade facilities due to growth, changes in regulations, improvements to customer service, or other planned needs. The funds can also be used to match grants or loans, pay for pre-construction costs, or keep debt to a minimum. |
| Debt Service Reserve | Ensure funds are available for debt payment requirements (principal and interest) |
Reserve accounts should be maintained separately from other funds and should be tracked using standard accounting principles. The accounts should be reviewed at least quarterly; the intent of accounts should be reviewed annually. The goals of the accounts can be revised if necessary to address other utility needs.
While it is important to have money in the reserve accounts equal to the goals of the utility at a minimum, it is also important to remember that the reserves are there to use if they are needed. For example, if the utility has an emergency need and has reserve accounts, the reserve accounts can be used to pay the expense rather than waiting for outside funds which may take far longer and cause hardships for employees or customers. If funds are used, they can be replenished in future years.
Summary
It is very important that the utility budget is balanced such that revenues meet or exceed expenses. If the budget is not balanced, action must be taken to ensure that it balances in the future. The utility should include depreciation expenses for equity and long-term sustainability. This money can be put in the reserve accounts for future capital improvements. The budget should include amounts to enable the funding of reserve accounts. The accounts should be set up to serve the specific purposes and needs of the utility. If there is additional revenue left over, the utility should place it in the appropriate reserve account.
Stay Tuned for Blog #4 in this series that will present an example budget.