Financial management represents one of the most critical aspects of municipal administration, providing the means to obtain and allocate resources and the methods to effectively achieve publicly determined ends.

An important part of financial management is the study and application of capital budgeting, which encompasses (1) the preparation, adoption, and implementation of a budget for major capital projects or acquisitions and (2) the funding of those capital projects and acquisitions through a combination of pay-as-you-go and debt financing.

A municipality should have a process for the planning, budgeting, and financing of capital projects and acquisitions that is separate from its annual operating budget. But why? Six reasons are presented here, ranging from the cost magnitude of capital projects and acquisitions to the ways in which capital projects differ from one year to the next.

Stakes are high

The capital infrastructure, facilities, and equipment built or acquired by municipalities are often large and expensive, requiring considerable amounts of money to be raised and spent to bring the projects and acquisitions to fruition. Special planning, financing, and management procedures are called for to ensure that the projects and acquisitions are needed, well designed, and efficiently implemented—that is to say, that the money invested in them is well spent.

Decisions have implications for years

Capital assets, by definition, are those have useful lives that extend beyond one year. The equipment acquired and used by local governments (vehicles, for example) can have a useful life of many years, and capital infrastructure (buildings, roads) generally lasts for decades. Because the citizens and municipal officials who use these capital assets must live for many years with the results of the decisions to build or acquire them, those decisions need to be based on careful planning. Only then will the resulting projects and acquisitions suit the needs they are supposed to serve.

Long-term implications are more likely to be considered in a separate capital bud­geting process than in an operating budget environment where the focus is primarily on annual operations.

Spending varies from year to year

Because capital assets are long lived, the need to replace them typically recurs infrequently. Moreover, growth and development often occur in spurts, requiring spending on infrastructure to be concentrated in some years and limited in others. Meeting and funding such capital needs would create problems for the operating budget, in which resources generally change incrementally from one year to the next and most new resources are needed for ongoing service delivery.

Trend analysis also is difficult given budget variations that would occur from year to year if the operating budget had to cover major capital projects and acquisi­tions; such situations create planning problems, pose revenue-raising challenges, and can have political repercussions, as constant adjustments must be made to meet changing capital needs. Again, planning and budgeting for capital projects and acquisitions require a long time frame and special financing sources, both of which are difficult to incorporate into the operating budget.

Implementation takes time

Depending on their size, complexity, environmental risk, and other factors, under­taking and completing infrastructure and capital facility projects can take as long as a decade. This includes time to define the project, secure approval, finish the design, acquire and prepare land, schedule the project, and complete construction. Change orders also can increase the complexity of projects and postpone their completion dates. Even the acquisition of sophisticated and expensive equipment can take several years from identification of need through approval, preparation of specifications, order, delivery, installation or preparation for operation, and acceptance.

Laws vary, but operating budgets may provide spending authority that lasts for only one year. Although unspent appropriations for capital projects or acquisitions that are obligated by contracts are encumbered, the law may require encum­bered funds to be reappropriated in the next year's budget, and local governing bodies sometimes have trouble understanding why they must reappropriate encumbrances. This issue can be avoided by budgeting capital projects and acquisitions in such a way that spending authority is provided for the duration of the project or acquisition process.

Debt financing is often used

While some municipalities, especially small ones, follow a strictly or predomi­nantly pay-as-you-go approach to financing capital projects and acquisitions, many finance large capital assets by issuing bonds or other forms of debt. The debt is then repaid, with interest, in installments over future years. For major debt issues, the repayment term can extend for twenty years or more; for interme­diate-size projects or equipment acquisitions, the repayment terms typically range from five to fifteen years. However, repayment terms should not exceed the esti­mated useful life of the asset financed with the debt.

When local officials or citizens (through a vote) approve debt to finance a project, they are in effect requiring citizens in future years to pay for their decision. This commitment of future revenues to debt service obligations also reduces future budget flexibility. Because of these long-term consequences, offi­cials should make sure that debt-financed projects are well planned, designed, and implemented. This is more likely to occur in a multi-year capital budgeting process.

Capital projects differ from year to year

As noted previously, changes that occur in the operating budget from year to year are generally incremental. Therefore, local officials can draw on recent bud­get experiences when reviewing next year's budget requests. However, the capi­tal projects or acquisitions requested in one year are often very different from those requested or approved the year before or over the past several years. This is because many capital assets have long, useful lives and need to be replaced infrequently. To compensate for this lack of relevant experience, local officials should exercise special care in budgeting for major capital projects and acquisitions, which they can do more effectively in a separate capital budgeting process.