What Is an Internal Service Fund?
An internal service fund is a type of proprietary fund used in governmental accounting to account for the financing of goods or services provided by one department or agency of a government unit to other departments or agencies of the same government unit, or to other governmental units, on a cost-reimbursement basis. These funds fall under the broader category of fund accounting, which is a system of accounting used by non-profit organizations and governments to track financial resources and ensure compliance with legal restrictions and financial reporting requirements. The primary purpose of an internal service fund is to achieve economies of scale and to enhance accountability by charging user departments for the services they consume, thereby encouraging efficient resource utilization.
History and Origin
The concept of segregating governmental financial activities into distinct funds evolved over time to provide clearer accountability for public resources. The formalization and widespread adoption of internal service funds, along with other proprietary funds, received significant emphasis with the issuance of Governmental Accounting Standards Board (GASB) Statement No. 34, "Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments" in 1999. This landmark standard established the current financial reporting model for state and local governments, requiring proprietary funds, including internal service funds, to be prepared using the economic resources measurement focus and the accrual accounting basis, similar to private-sector businesses.,,
- An internal service fund provides goods or services primarily to other departments or agencies within the same government.
- It operates on a cost-reimbursement basis, meaning it charges user departments to recover the full cost of its operations.
- These funds use the accrual accounting method, similar to business-type activities, to measure both current and long-term financial effects.
- Common services managed through an internal service fund include motor pools, central purchasing, information technology, and self-insurance.
- The goal of an internal service fund is to promote efficiency, cost transparency, and accountability within government operations.
Interpreting the Internal Service Fund
An internal service fund is interpreted as a self-supporting entity within the government structure, aiming to recover its full expenses through charges to other departments. The financial performance of an internal service fund is measured by its ability to break even over time, meaning its revenues should ideally equal its costs, including depreciation on its fixed assets. A significant accumulation of surplus or deficit in an internal service fund's net position may indicate that its rates are not appropriately set, potentially leading to overcharging or undercharging user departments.
Hypothetical Example
Consider the City of Harmony, which operates a centralized motor pool for all its departments, including public works, police, and sanitation. Instead of each department owning and maintaining its vehicles, the motor pool is established as an internal service fund.
- Establishment: The City Council approves the creation of an internal service fund for the motor pool.
- Initial Funding: An initial transfer of cash from the general fund provides the necessary working capital to purchase vehicles and equip a repair shop.
- Service Provision & Billing: The motor pool fund acquires and maintains vehicles. When the public works department uses a vehicle, the internal service fund bills them based on mileage, fuel consumption, and maintenance time.
- Cost Recovery: The rates charged are designed to cover all operating costs, including fuel, maintenance, salaries for mechanics, and vehicle replacement costs (effectively, depreciation). If a new vehicle is purchased for $50,000, that cost is allocated over its useful life via depreciation, and the fund's charges aim to recover this as well.
- Financial Reporting: At year-end, the motor pool internal service fund prepares its own financial statements, showing its revenues from user departments and its expenses, aiming for a near break-even result in its statement of activities. This ensures that the true cost of transportation services is accurately reflected in the budgets of the user departments.
Practical Applications
Internal service funds are widely used across various levels of government to manage common services efficiently and transparently. For instance, a municipal government might use an internal service fund for its central purchasing department, charging other departments for the goods procured. Similarly, a state government could operate an internal service fund for its self-insurance programs, where various agencies contribute premiums to cover potential claims. This mechanism ensures that the cost of shared services is appropriately allocated to the departments that benefit from them, rather than being absorbed by the general fund or other specific program budgets. The Government Finance Officers Association (GFOA) provides best practices for budgeting and pricing internal services, emphasizing the importance of recovering the full cost of services to achieve efficiency and accountability. The o4bjective of an internal service fund is to measure the complete cost of providing goods or services to fully recover that cost through fees or charges.
L3imitations and Criticisms
While internal service funds offer benefits in terms of cost allocation and transparency, they are not without limitations. A common challenge is setting appropriate charge rates. If rates are too high, they can lead to excessive accumulation of fund balance and potential overcharging of user departments, which might then seek external vendors, undermining the fund's purpose. Conversely, rates that are too low can result in the internal service fund operating at a deficit, requiring subsidies from the general fund or other sources, thereby obscuring the true cost of services. Maintaining accurate cost accounting for diverse services and ensuring that charges are perceived as fair by customer departments can also be complex. A report by the Utah Legislature highlighted concerns regarding internal service funds' ability to effectively manage rates to "break even" and avoid subsidizing "free-of-charge" activities, emphasizing the need for improved transparency. Addit2ionally, there is always a risk that an internal service fund may become less efficient over time if it does not face external market competition, potentially leading to inflated costs that are simply passed on to internal customers.
Internal Service Fund vs. Enterprise Fund
Both internal service funds and enterprise funds are classified as proprietary funds in governmental accounting, meaning they focus on measuring financial position and operating results on the accrual basis of accounting, similar to private-sector businesses. The key distinction lies in their primary customer base. An internal service fund primarily provides goods and services to other departments or agencies within the same governmental unit. Its purpose is to allocate costs internally. In contrast, an enterprise fund provides goods and services to external users (the general public) for a fee. Examples of enterprise funds include municipal utilities (water, sewer, electric), public transportation systems, or airports, where services are rendered to external parties, and fees are charged to cover costs. While an internal service fund aims for cost recovery from internal customers, an enterprise fund often operates with a profit motive or a clear intent to recover all costs, including capital costs, from external users.
F1AQs
What is the primary purpose of an internal service fund?
The primary purpose of an internal service fund is to provide goods or services to other departments or agencies within the same government on a cost-reimbursement basis, promoting efficiency and cost transparency for shared services.
How does an internal service fund get its money?
An internal service fund typically receives its money by billing other governmental departments or agencies for the services it provides. It may also receive initial start-up capital from the general fund or through interfund loans.
What types of activities are typically accounted for in an internal service fund?
Common activities accounted for in an internal service fund include central motor pools, information technology services, central purchasing and stores, self-insurance programs, and printing services, among others.
Do internal service funds aim to make a profit?
No, internal service funds generally aim to break even over time. Their goal is to recover the full cost of providing services, not to generate a profit like a private business or an enterprise fund.
Why are internal service funds considered proprietary funds?
Internal service funds are considered proprietary funds because they operate similarly to a business, focusing on the economic resources measurement focus and the accrual accounting basis. This allows for a comprehensive measurement of revenues and expenses related to their operations, including depreciation and other long-term financial impacts.