Government Debt Accounting: Bonds, Notes, Leases, and Refundings

Debt

Government Debt Accounting: Bonds, Notes, Leases, and Refundings

Government debt financing is one of the largest sources of capital for infrastructure, and the accounting for that debt is correspondingly complex. General obligation bonds backed by the taxing authority, revenue bonds secured by enterprise revenues, notes payable, certificates of participation, and lease obligations each have distinct accounting treatments. For finance professionals, auditors, and analysts, understanding the accounting mechanics—how debt premiums and discounts are amortized, how refundings are recorded, and how debt covenants are monitored—is essential to accurate financial reporting and debt management.

This guide covers the accounting for government debt instruments, the treatment of debt premiums and discounts, refunding mechanics, and covenant compliance.

Types of Government Debt

General Obligation (GO) Bonds

General obligation bonds are backed by the full faith and credit of the government—meaning that the government commits to pay principal and interest using its full taxing power if revenues from the pledged revenue source are insufficient.

Characteristics:

  • Secured by general revenues (property taxes, sales taxes)
  • Typically lower coupon rates (lower cost of borrowing) due to security
  • May be subject to voter approval (constitutional requirement in many states)
  • Include legal limit on total outstanding debt (debt ceiling)

Common Uses:

  • School buildings, courthouses, public facilities
  • Water and sewer infrastructure (GO bonds often back these even though they are enterprise functions)
  • Parks and recreation
  • Roads and transportation (shared with revenue bonds)

Revenue Bonds

Revenue bonds are secured by a specific revenue stream (not general tax revenues). The bondholder's security is limited to that revenue source.

Characteristics:

  • Secured by identified revenues (water utility revenues, parking fees, airport revenues)
  • Higher coupon rates (higher cost) due to weaker security
  • No voter approval required (in most jurisdictions)
  • No constitutional debt limit (if backed by enterprise revenues)

Common Uses:

  • Water and wastewater systems
  • Electric utilities
  • Transit systems
  • Airports and ports
  • Parking facilities
  • Solid waste facilities

Certificates of Participation (COPs)

COPs are hybrid instruments: they are secured by lease payments rather than by general tax or enterprise revenues. A government leases an asset (building, equipment) to a third party, and the lease payments secure the COP holders.

Example: A city needs office space but lacks bonding authority or capital. Instead of issuing debt, it arranges a sale-leaseback: it sells a city-owned building to an investor, then leases it back. The investor issues COPs secured by the lease payments. The city's lease payments flow to COP holders.

Bond Anticipation Notes (BANs) and Revenue Anticipation Notes (RANs)

BANs and RANs are short-term borrowing instruments typically used to bridge timing gaps between when capital projects begin and when long-term debt is issued.

Bond Anticipation Notes (BANs):

  • Issued to fund capital projects pending long-term bond issuance
  • Typically mature in 1-3 years
  • Repaid from proceeds of long-term bonds

Revenue Anticipation Notes (RANs):

  • Issued when a government expects to receive specific revenues (grants, tax collections) that will not arrive until later in the fiscal year
  • Typically mature in 12 months
  • Repaid from the anticipated revenue

Tax Anticipation Notes (TANs)

TANs are issued by governments at the beginning of the fiscal year in anticipation of property tax collections that occur later in the year. TANs are very short-term (90 days to 12 months).

Commercial Paper Programs

Some larger governments establish commercial paper programs: short-term borrowing facilities that allow continuous issuance of notes (typically 30-90 day maturity) rolled over as needed. These provide liquidity for ongoing operations and bridge funding.

Accounting for Debt Issuance: Initial Recognition

Journal Entry for Debt Issuance

When a government issues bonds, the accounting entry differs slightly depending on whether the bonds are issued at par, at a premium, or at a discount.

Issuance at Par (Face Value):

Dr. Cash                                 $5,000,000
    Cr. Bonds Payable                                   $5,000,000

A government issues $5 million in 20-year bonds at 4% coupon rate. The coupon rate (4%) equals the market yield (4%), so the bonds sell at par.

Issuance at a Premium:

Dr. Cash                                 $5,250,000
    Cr. Bonds Payable                                   $5,000,000
    Cr. Bond Premium                                      $250,000

A government issues $5 million in bonds, but investor demand is strong; the bonds sell at a yield lower than coupon, so investors pay more than par. The $250,000 premium is recorded as a separate account.

Issuance at a Discount:

Dr. Cash                                 $4,750,000
Dr. Bond Discount                          $250,000
    Cr. Bonds Payable                                   $5,000,000

A government issues $5 million in bonds, but investor demand is weak; the market yield exceeds coupon, so investors pay less than par. The $250,000 discount reduces the cash received.

Amortization of Premium and Discount

The premium or discount is amortized over the life of the debt using the effective interest method (in government accounting, straight-line amortization is also used). This amortization reduces or increases interest expense each period.

Premium Amortization Mechanics: When bonds are issued at a premium, interest expense is lower than the coupon payment. The premium is "given back" to the bondholder over time.

Example: $5,000,000 bond, 4% coupon, 20-year maturity, issued at $5,250,000

Annual coupon payment:                   $200,000
Effective interest (at issue yield):     $190,000
Annual premium amortization:              $10,000

Journal entry (annual):
    Dr. Interest Expense                 $190,000
    Dr. Bond Premium                      $10,000
        Cr. Cash                                      $200,000

Over 20 years, the $250,000 premium is fully amortized, and the Bonds Payable liability is reduced to the maturity value of $5 million.

Discount Amortization Mechanics: When bonds are issued at a discount, interest expense is higher than the coupon payment. The discount represents "yield" the bondholder receives in addition to the coupon.

Example: $5,000,000 bond, 3% coupon, 20-year maturity, issued at $4,750,000

Annual coupon payment:                   $150,000
Effective interest (at issue yield):     $160,000
Annual discount amortization:             $10,000

Journal entry (annual):
    Dr. Interest Expense                 $160,000
        Cr. Cash                                      $150,000
        Cr. Bond Discount                             $10,000

Over 20 years, the $250,000 discount is fully amortized, and the Bonds Payable liability grows to the maturity value of $5 million.

Government-Wide vs. Fund Financial Statements

Government-Wide Statement (Full Accrual)

In government-wide statements, debt is presented at net carrying value:

Statement of Net Position:

Long-Term Liabilities:
  Bonds Payable                    $5,000,000
  Less: Bond Discount                ($10,000)  [current year]
  Net Bonds Payable                $4,990,000

Interest expense is recorded on an accrual basis:

Statement of Activities:

Interest Expense (Non-Operating)   $160,000

Fund Financial Statements (Modified Accrual)

In fund financial statements (for governmental funds), debt is not recorded. Instead, debt issuance appears as a financing source, and debt repayment appears as a financing use:

Statement of Revenues, Expenditures, and Changes in Fund Balance:

Financing Sources:
  Bond Proceeds                    $5,000,000

Financing Uses:
  Debt Service - Principal           $250,000
  Debt Service - Interest             $200,000

Interest is recorded on a cash basis (when paid), not accrual basis.

Difference: The government-wide statements show the liability on the balance sheet and record interest expense on an accrual basis. The fund statements show debt issuance as a financing source (not an increase in fund balance) and debt payments as expenditures.

Refunding and Debt Extinguishment

Current Refunding

A current refunding occurs when a government issues new debt and immediately uses proceeds to retire old debt. This typically occurs when interest rates have fallen and the government can save money by refunding.

Example: A government issued $10 million in bonds in 2006 at 5% coupon. In 2016, interest rates have fallen to 3%. The government can issue new $10 million bonds at 3% and use proceeds to retire the 5% bonds, reducing annual interest expense by $200,000.

Journal Entry:

Dr. Bonds Payable (old)             $10,000,000
    Cr. Cash                                     $10,000,000
    [Retire old bonds]

Dr. Cash                            $10,200,000
    Cr. Bonds Payable (new)                     $10,000,000
    Cr. Bond Premium                               $200,000
    [Issue new bonds at 102]

If the new bonds are issued at a premium (102), the government received $10.2 million in proceeds but owes only $10 million at maturity, so the premium of $200,000 amortizes to reduce interest expense over the life of the new bonds.

Gain or Loss on Refunding: The gain or loss on a current refunding is the difference between the cash paid to retire old bonds and the cash received from new bonds.

If old bonds have a book value of $9.8 million (due to accumulated amortization of discount) and the government pays $10 million in cash to retire them, there is a loss of $200,000 (or, alternatively, the government realizes a gain of $200,000 if it pays less than par to retire the bonds).

Advance Refunding

An advance refunding occurs when a government issues new debt, but the proceeds are not immediately used to retire old debt. Instead, proceeds are invested in U.S. Treasury securities or other permitted investments, and the maturing principal and interest accumulate to pay off the old debt at a future maturity date.

Why Advance Refund? Advance refundings allow governments to refinance debt before the original maturity date, even if immediate retirement is not legally permitted or practical. By placing funds in escrow and investing them, the government locks in interest savings without prematurely calling the old debt.

Accounting: In government-wide statements, the old debt is removed from the balance sheet and replaced with the investment of refunding proceeds.

Before Refunding:
  Bonds Payable                    $10,000,000

After Advance Refunding:
  Investments (Escrow Funds)       $10,200,000
  Bonds Payable - Escrow            $10,000,000

The escrow investment grows through interest earnings; the principal plus interest will equal the amount needed to retire the old bonds at maturity.

Defeasance: Advance refundings are sometimes called "defeasance"—placing debt in a legally irrevocable escrow arrangement such that the government is no longer obligated for debt service. Accounting standards require removing the old debt from the balance sheet if the government is legally released from the obligation.

Deferred Amount on Refunding (GASB 86)

GASB 86, introduced in 2017, changed how governments account for gains and losses on debt refundings.

Previously, gains and losses on refundings were recorded immediately in the Statement of Activities. GASB 86 requires deferring the gain or loss and amortizing it over the life of the new debt (or the life of the old debt, if shorter).

Example: A government refunds $10 million in old debt by issuing $9.8 million in new debt (a $200,000 gain due to favorable refunding).

Under Previous Standards (Before GASB 86):

Gain on Debt Refunding            $200,000

The $200,000 gain was recorded immediately in the Statement of Activities.

Under GASB 86:

Deferred Outflow: Deferred Amount on Refunding   $200,000
[Amortize $200,000 over life of new debt]

The gain is deferred and amortized as a reduction to interest expense over the life of the new debt. This better matches the benefits of the refunding to the periods in which interest savings are realized.

Debt Covenants and Monitoring

Rate Covenant

A rate covenant requires that the issuer maintain rates or revenues sufficient to generate a debt service coverage ratio (DSCR) of at least a specified level—typically 1.25x (meaning revenues must be 1.25 times annual debt service).

Calculation:

Net Operating Revenues        $50,000,000
Debt Service (P&I)            $35,000,000
DSCR                          1.43x
Covenant Requirement          1.25x
Status: IN COMPLIANCE

The covenant is met because the DSCR of 1.43x exceeds the minimum of 1.25x.

Additional Bonds Test

Before issuing additional debt, the issuer must certify that pro-forma (projected or historical) revenues will continue to meet the rate covenant. This prevents over-leveraging.

Calculation:

Historical or Pro-Forma Net Operating Revenues    $50,000,000
Existing Annual Debt Service                      $35,000,000
New Annual Debt Service (proposed issuance)        $5,000,000
Combined Debt Service                             $40,000,000
Pro-Forma DSCR                                    1.25x
Covenant Requirement                              1.25x
Status: MEETS TEST (at minimum threshold)

The additional bonds test is typically met with a margin above the minimum. An DSCR of 1.25x is the floor; if the calculation shows exactly 1.25x, the issuer has no cushion for revenue fluctuations.

Debt Service Fund Accounting

Debt service funds accumulate resources to pay principal and interest on long-term debt. They are reported as a separate fund in the fund financial statements.

Structure:

  • Revenues are dedicated to debt service (e.g., a portion of sales tax)
  • Investments generate interest income
  • Resources are accumulated to cover principal and interest payments

Key Requirement: The debt service reserve requirement (DSRR) typically equals the maximum annual debt service (MADS) owed on outstanding bonds. If a utility's debt ranges from $5 million annually (years 1-5) to $8 million annually (years 6-20), MADS is $8 million. The debt service fund must maintain a $8 million reserve.

Journal Entry—Accumulation Phase:

Dr. Cash (from tax revenues)        $4,000,000
    Cr. Revenues                                      $4,000,000
    [Record property tax dedication to debt service]

Dr. Investments                    $4,000,000
    Cr. Cash                                        $4,000,000
    [Invest excess resources]

Journal Entry—Payment Phase:

Dr. Expenditures - Debt Service - Principal   $5,000,000
Dr. Expenditures - Debt Service - Interest    $3,000,000
    Cr. Cash                                        $8,000,000
    [Pay principal and interest]

Flow of Funds and Reserve Requirements

Enterprise fund debt service is often structured with a "flow of funds" hierarchy: revenues flow through multiple reserves before reaching debt service.

Typical Flow of Funds (Water Utility Example):

Revenues (customer billings)                  $50,000,000
    |
    v
Operations & Maintenance Reserve              ($40,000,000)
[Operating expense reserve; ensures funds for salaries, chemicals, etc.]
    |
    v
Insurance & Contingency Reserve               ($2,000,000)
[Insurance premiums, emergency repairs]
    |
    v
Debt Service Reserve Fund                     +$8,000,000
[Accumulates principal and interest payment]
    |
    v
Repair & Replacement Reserve (if available)   $0 or positive
[Capital improvement fund; funded after debt service is assured]

The flow of funds ensures that operating expenses are paid first, then debt service, then capital improvements. This prioritization protects bondholders.

Common Debt Accounting Issues

Capitalized Interest During Construction

When a government issues debt to finance a capital project under construction, interest incurred during construction can be capitalized (added to the asset) rather than expensed.

Example: A utility issues $10 million in debt to construct a water treatment plant. Construction takes 18 months. During construction, the utility pays $500,000 in interest.

Accounting:

Dr. Construction in Progress        $500,000
    Cr. Interest Expense                           $500,000
[Capitalize interest during construction]

Dr. Water Treatment Plant          $500,000
Dr. Accumulated Depreciation         ($50,000)
    [Interest is reclassified to plant when construction is complete]

The $500,000 is capitalized and becomes part of the asset; it is then depreciated over the life of the plant. This approach matches the cost of borrowing with the long-term benefit of the asset.

Debt Issuance Costs

Under GASB 65, debt issuance costs (underwriter fees, legal fees, printing costs) are expensed when incurred, not capitalized. This is different from private-sector GAAP (ASC 835), where debt issuance costs are capitalized and amortized.

Journal Entry:

Dr. Debt Issuance Expense           $50,000
    Cr. Cash                                       $50,000
[Underwriter and legal fees for bond issuance]

This treatment immediately reduces reported net income, which some argue understates the benefits of long-term financing.

Direct Placement Debt

Some governments issue debt directly to lenders (banks, insurance companies) rather than publicly. Direct placements often carry covenants specific to the lender, and the accounting is otherwise identical to public bonds.

Lease Obligations (GASB 87)

GASB 87, effective for fiscal years ending after June 15, 2021, requires governments to record most lease obligations on the balance sheet. A lease obligation is recorded as a liability, with a corresponding right-of-use asset. This expands the government's reported debt.

Example: A city leases office space for 10 years at $1 million annually. Under GASB 87, the city records:

Dr. Right-of-Use Asset          $8,500,000
    Cr. Lease Liability                          $8,500,000
[Record present value of future lease payments at inception]

The lease liability is reduced as payments are made, and the right-of-use asset is depreciated over the lease term. Lease expense (on an accrual basis) is recorded annually.

Monitoring Debt Health

Debt Service Coverage Ratio (DSCR)

DSCR = Net Operating Revenues / Debt Service

A ratio above 1.5x indicates strong coverage; below 1.25x indicates stress.

Debt Outstanding Per Capita

Dividing total debt outstanding by population provides a per-capita debt metric useful for comparing across governments of different sizes.

Debt as Percentage of Assessed Value (Real Property)

For go bonds backed by property taxes, debt as a percentage of assessed property value indicates leverage. Generally, 5% is considered moderate; above 10% is high.

Trend Analysis

Monitoring whether debt is growing, stable, or declining relative to revenues and assets is important. A government whose debt grows faster than its revenue base is approaching unsustainability.

Key Takeaways

  1. Debt issuance mechanics differ by instrument. GO bonds, revenue bonds, COPs, notes, and leases each have distinct security and accounting treatment.

  2. Premium and discount amortization is non-negotiable. Both must be amortized over the life of the debt using the effective interest method, reducing or increasing interest expense annually.

  3. Government-wide and fund statements present debt differently. Government-wide shows the liability at net book value; fund statements show debt issuance as a financing source.

  4. Refundings are complex. Current refundings retire old debt immediately; advance refundings use escrow. GASB 86 requires deferring refunding gains/losses.

  5. Covenants are binding commitments. Rate covenants and additional bonds tests are not merely aspirational; non-compliance can trigger default and loss of borrowing capacity.

  6. Flow of funds prioritizes creditors. Debt service reserves and hierarchical fund flow ensure that bondholders are paid before capital projects are funded.

  7. Debt ratios provide early warning. Declining DSCR, rising debt per capita, and growing debt-to-revenue ratios signal fiscal stress.

Government debt accounting is rigorous because debt is a binding legal obligation backed by the full faith and credit (for GO bonds) or specific revenues (for revenue bonds). Accurate accounting, transparent covenant monitoring, and realistic debt management are essential to maintaining access to debt markets and protecting taxpayers and ratepayers.

This article was prepared with AI-assisted research by DWU Consulting. It is provided for informational purposes only and does not constitute legal, financial, or investment advice. All data should be independently verified before use in any official capacity.

This article was prepared with AI-assisted research by DWU Consulting. It is provided for informational purposes only and does not constitute legal, financial, or investment advice. All data should be independently verified before use in any official capacity.