A city maintains an internal audit department and accounts for it in its general fund. In the coming year, the department will purchase $300,000 of computer and other office equipment, all of which will be paid for out of current resources (i.e., not with debt).

City officials have given top priority to reducing general fund expenditures. To that end, the city comptroller has proposed accounting for the internal audit department in an internal service fund rather than in the general fund.

As envisioned by the comptroller, the audit department would bill each of the units (all of which are accounted for in the general fund) for each audit performed. Fees would be established so that they would cover all audit department costs. The fund would be established by a transfer of $300,000 from the general fund to cover the cost of the new equipment. The city estimates that for the coming year the audit department’s operating costs, excluding any costs relating to the new equipment, will be $1,600,000. The equipment is expected to have a useful life of five years.

1. Assume that the city accepts the comptroller’s suggestion. Prepare journal entries in the internal service fund to record:

a. The transfer-in of the $300,000

b. The acquisition of the equipment

c. The operating and other costs

d. The billings to and collection of cash from the general fund

2. Prepare journal entries in the general fund to record:

a. The transfer-out of the $300,000

b. The billings from and payment of cash to the internal service fund

3. Would the establishment of the internal service fund result in a decrease in overall government costs (e.g., cash outflows)? Would it result in a reduction in reported general fund expenditures? Explain.

4. Suppose that in the following year, the city does not plan to acquire additional capital assets. Comment on whether reported general fund expenditures would be greater if the internal service fund were to be established than if it were not.