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NORTH CAROLINA COMPREHENSIVE ANNUAL FINANCIAL REPORT FOR THE FISCAL YEAR ENDED JUNE 30, 2004 MICHAEL F. EASLEY GOVERNOR ROBERT L. POWELL STATE CONTROLLER Prepared by Statewide Accounting Division Office of the State Controller http:// www. ncosc. net/ 2 State of North Carolina This report was prepared by the Statewide Accounting Division of the North Carolina Office of the State Controller. John Barfield, CPA ASSISTANT STATE CONTROLLER jbarfield@ ncosc. net Anne Godwin, CPA Statewide Accounting and Financial Reporting Manager agodwin@ ncosc. net Amber Young Central Compliance Manager ayoung@ ncosc. net Statewide Accounting Division Staff Robert Alford, CPA Martha Hunt, CPA Cindy Salgado, CPA Ann Anderson Cathy Johnson Melody Tart Angela Clark Darlene Langston, CPA Shirley Trollinger John Eliadis Michelle Lassiter Cynthia Vincent Pam Fowler, CPA Clayton Murphy, CPA Helen Vozzo, CPA Luke Harris Terri Noblin, CPA Virginia Warren Special appreciation is given to the chief fiscal officers and the dedicated accounting personnel throughout the State. Their efforts to contribute accurate and timely financial data for their agencies, universities, community colleges, and institutions made this report possible. State of North Carolina 3 MICHAEL F. EASLEY Governor of North Carolina 4 State of North Carolina TABLE OF CONTENTS Comprehensive Annual Financial Report For the Fiscal Year Ended June 30, 2004 INTRODUCTORY SECTION Letter of Transmittal.................................................................................................................... ............................................................................................ 8 Certificate of Achievement for Excellence in Financial Reporting...................................................................................................................... ................... 19 Organization of North Carolina State Government, including principal State officials........................................................................................................... 20 FINANCIAL SECTION Report of Independent Auditor........................................................................................................................ ........................................................................ 24 Management's Discussion and Analysis....................................................................................................................... ........................................................... 28 Basic Financial Statements Government- wide Financial Statements Statement of Net Assets — Exhibit A- 1.............................................................................................................................. .................................................... 52 Statement of Activities — Exhibit A- 2.............................................................................................................................. ..................................................... 54 Fund Financial Statements Balance Sheet— Governmental Funds — Exhibit B- 1.............................................................................................................................. ............................... 58 Reconciliation of the Governmental Funds Balance Sheet to the Statement of Net Assets — Exhibit B- 1a............................................................................ 59 Statement of Revenues, Expenditures, and Changes in Fund Balances— Governmental Funds — Exhibit B- 2...................................................................... 60 Reconciliation of the Statement of Revenues, Expenditures, and Changes in Fund Balances of Governmental Funds to the Statement of Activities — Exhibit B- 2a........................................................................................................................... 61 Statement of Net Assets— Proprietary Funds — Exhibit B- 3.............................................................................................................................. ................... 62 Statement of Revenues, Expenses, and Changes in Fund Net Assets— Proprietary Funds — Exhibit B- 4.............................................................................. 63 Statement of Cash Flows— Proprietary Funds — Exhibit B- 5.............................................................................................................................. .................. 64 Statement of Fiduciary Net Assets— Fiduciary Funds — Exhibit B- 6.............................................................................................................................. ...... 66 Statement of Changes in Fiduciary Net Assets— Fiduciary Funds — Exhibit B- 7............................................................................................................. 67 Notes to the Financial Statements..................................................................................................................... ....................................................................... 70 Required Supplementary Information Schedules of Funding Progress— All Defined Benefit Pension Trust Funds.......................................................................................................................... 150 Schedule of Contributions from the Employers and Other Contributing Entities— All Defined Benefit Pension Trust Funds.............................................. 151 Schedule of Revenues, Expenditures and Changes in Unreserved Fund Balances— Budget and Actual —( Budgetary Basis— Non- GAAP) General Fund........................................................................................................................... ................................ 152 Notes to Required Supplementary Information— Budgetary Reporting...................................................................................................................... ............ 153 Combining Fund Statements and Schedules Nonmajor Governmental Funds Combining Balance Sheet— Nonmajor Governmental Funds — Exhibit C- 1.......................................................................................................................... 160 Combining Statement of Revenues, Expenditures, and Changes in Fund Balances— Nonmajor Governmental Funds — Exhibit C- 2.................................. 161 Combining Balance Sheet— Nonmajor Special Revenue Funds — Exhibit C- 3...................................................................................................................... 164 Combining Statement of Revenues, Expenditures, and Changes in Fund Balances— Nonmajor Special Revenue Funds — Exhibit C- 4.............................. 168 Combining Schedule of Revenues, Expenditures and Changes in Unreserved Fund Balances — Budget and Actual ( Budgetary Basis— Non- GAAP) Nonmajor Special Revenue Funds — Exhibit C- 5................................................................ 172 Combining Balance Sheet— Nonmajor Capital Projects Funds — Exhibit C- 6....................................................................................................................... 178 Combining Statement of Revenues, Expenditures, and Changes in Fund Balances— Nonmajor Capital Projects Funds — Exhibit C- 7............................... 179 Combining Balance Sheet— Nonmajor Permanent Funds — Exhibit C- 8.............................................................................................................................. 182 Combining Statement of Revenues, Expenditures, and Changes in Fund Balances— Nonmajor Permanent Funds — Exhibit C- 9....................................... 183 Proprietary Funds Nonmajor Enterprise Funds Combining Statement of Net Assets— Nonmajor Enterprise Funds — Exhibit D- 1................................................................................................................ 188 Combining Statement of Revenues, Expenses, and Changes in Fund Net Assets— Nonmajor Enterprise Funds — Exhibit D- 2........................................... 189 Combining Statement of Cash Flows— Nonmajor Enterprise Funds — Exhibit D- 3.............................................................................................................. 190 Internal Service Funds Combining Statement of Net Assets— Internal Service Funds — Exhibit E- 1......................................................................................................................... 192 Combining Statement of Revenues, Expenses, and Changes in Fund Net Assets— Internal Service Funds — Exhibit E- 2.................................................... 194 Combining Statement of Cash Flows— Internal Service Funds — Exhibit E- 3....................................................................................................................... 196 Fiduciary Funds Combining Statement of Fiduciary Net Assets— Private Purpose Trust Funds — Exhibit F- 1............................................................................................... 202 Combining Statement of Changes in Fiduciary Net Assets— Private Purpose Trust Funds — Exhibit F- 2....................................................................... 203 Combining Statement of Changes in Assets and Liabilities— Agency Funds — Exhibit F- 3.................................................................................................. 206 State of North Carolina 5 Comprehensive Annual Financial Report For the Fiscal Year Ended June 30, 2004 Nonmajor Component Units - Discretely Presented Combining Statement of Net Assets— Nonmajor Component Units — Exhibit G- 1............................................................................................................... 212 Combining Statement of Activities— Nonmajor Component Units — Exhibit G- 2................................................................................................................ 213 STATISTICAL SECTION Revenues by Source and Expenditures by Function— All Governmental Fund Types ( GAAP Basis) — Table 1................................................................... 216 Schedule of Revenues by Source— General Fund ( GAAP Basis) — Table 2.......................................................................................................................... 218 General Obligation Bonds Debt Ratios — Table 3.............................................................................................................................. .................................... 220 Revenue Bond Coverage — Table 4.............................................................................................................................. .......................................................... 221 Schedule of General Obligation Bonds Payable — Table 5.............................................................................................................................. ...................... 222 Schedule of Special Obligation Debt — Table 6.............................................................................................................................. ....................................... 228 Statewide Assessed Property Values— Real Property, Tangible Personal Property and Public Service Companies — Table 7............................................. 229 Schedule of Bank and Savings and Loan Deposits of Financial Institutions Located in North Carolina — Table 8............................................................... 230 Cash Receipts from Farming by Commodities — Table 9.............................................................................................................................. ........................ 231 Major Private Employers in North Carolina — Table 10............................................................................................................................. ........................... 232 Schedule of Demographic Data — Table 11............................................................................................................................. .............................................. 234 Ten Largest Non- Agricultural Industries by Number of Employees — Table 12.................................................................................................................... 236 Total Number of State Government Permanent Positions Funded in the State Budget by Agency — Table 13...................................................................... 237 Required Supplementary Information— Ten- Year Claims Development Information — Public School Insurance Fund — Table 14................................... 238 Schedule of Miscellaneous Statistics — Table 15............................................................................................................................. ...................................... 240 6 State of North Carolina THIS PAGE INTENTIONALLY LEFT BLANK. INTRODUCTORY SECTION State of North Carolina Office of the State Controller Michael F. Easley, Governor Robert L. Powell, State Controller MAILING ADDRESS 1410 Mail Service Center Raleigh, NC 27699- 1410 Telephone: ( 919) 981- 5454 Fax Number: ( 919) 981- 5567 State Courier: 56- 50- 10 LOCATION 3512 Bush Street Raleigh, NC Website: www. ncosc. net An Equal Opportunity/ Affirmative Action/ Americans With Disabilities Employer The Honorable Michael F. Easley, Governor Members of the North Carolina General Assembly Citizens of North Carolina It is our pleasure to furnish you with the 2004 Comprehensive Annual Financial Report ( CAFR) of the State of North Carolina in compliance with G. S. 143B- 426.39. This report has been prepared by the Office of the State Controller. Responsibility for both the accuracy of the data and the completeness and fairness of the presentation, including all disclo-sures, rests with the State government and this office. To the best of our knowledge and belief, this financial report is complete and reliable in all material respects. We believe all disclosures necessary to enable you to gain an understanding of the State's financial activities have been included. Although the State budgets and manages its financial affairs on the cash basis of accounting, G. S. 143- 20.1 requires the Office of the State Controller to prepare a comprehensive annual financial report ( CAFR) in accordance with generally accepted accounting principles in the United States of America ( GAAP). Except for exhibits and notes clearly labeled otherwise, this CAFR has been prepared in accordance with GAAP. For the convenience of users we have divided this comprehensive annual financial report into three major sections, described as follows: • The introductory section includes this transmittal letter and the State's organization chart, including a listing of principal State officials. • The financial section includes management discussion and analysis, the basic financial statements ( government- wide financial statements, fund financial statements, and notes), other required supplementary information, the combining and individual fund financial statements, and schedules. • The statistical section includes selected financial, non- financial and demographic information, much of which is presented on a ten- year basis, as well as required supplementary information. Management of the government is responsible for establishing and maintaining an internal control structure designed to ensure that the assets of the State are protected from loss, theft or misuse and to ensure that adequate accounting data are compiled to allow for the preparation of financial statements in conformity with generally accepted accounting principles. The internal control structure is designed to provide reasonable, but not absolute, assurance that these objectives are met. The concept of reasonable assurance recognizes that: ( 1) the cost of a control should not exceed the benefits likely to be derived, and ( 2) the valuation of costs and benefits requires estimates and judgments by management. GASB Statement No. 34, Basic Financial Statements – and Management’s Discussion and Analysis – for State and Local Governments, requires that management provide a narrative introduction, overview and analysis to accompany the Basic Financial Statements in the form of management discussion and analysis ( MD& A). This letter of transmittal is intended to complement MD& A and should be read in conjunction with it. The MD& A can be found immediately following the Independent Auditor’s Report. State of North Carolina 9 Profile of the Government The State of North Carolina entity as reported in the CAFR includes all fund types of the departments, agencies, boards, commissions and authorities governed and legally controlled by the State's executive, legislative and judicial branches. In addition, the reporting entity includes legally separate component units for which the State is financially accountable. The component units are discretely presented in the government- wide financial statements. The State's discretely presented major component units are the University of North Carolina System; the State's community colleges; Golden LEAF, North Carolina Housing Finance Agency, and North Carolina State Education Assistance Authority. The criteria for inclusion in the reporting entity and its presentation are defined by the Governmental Accounting Standards Board ( GASB) in its GASB Codification Section 2100. These criteria are described in Note 1 of the accompanying financial statements. The State and its component units provide a broad range of services to its citizens, including public education; higher education; health and human services; economic development; environment and natural resources; public safety, corrections, and regulation; transportation; agriculture; and general government services. The costs of these services are reflected in detail and in summary in this report. In addition to internal controls discussed previously, the State maintains budgetary controls. The objective of these budgetary controls is to ensure compliance with legal provisions embodied in the annual appropriated budget approved by the General Assembly. Activities of the General Fund and most departmental special revenue funds are included in the annual appropriated budget. The State Highway Fund and the Highway Trust Fund, the State's major special revenue funds, are primarily budgeted on a multi- year basis. Capital projects are funded and planned in accordance with the time it will take to complete the project. The level of budgetary control ( that is, the level at which expenditures cannot legally exceed the appropriated amount) is exercised at both the departmental and university level by way of quarterly allotments, with allotment control exercised by the State Controller, and on the program line-item levels requiring certain approvals by the Director of the Budget. Legislative authorization of departmental expenditures appears in the State Appropriation Bill. This " Certified Budget" is the legal expenditure authority; however, the Office of State Budget and Management ( OSBM) may approve executive changes to the legal budget as allowed by law. This results in the " Final Budget" presented in the required supplementary information. State Reporting Entity and Its Services Budgetary Control 10 State of North Carolina Economic Condition and Outlook After experiencing robust growth during the first half of the 2004 calendar year, the nation’s economy is now working through what is commonly referred to as a “ soft patch”. This weakness is due to a combination of record energy prices ( in actual dollars) and periodic warnings of potential terrorist activity. An additional issue has to do with the fact that the stimulus from three federal tax packages enacted in recent years is starting to run out. 2001- 02 2002- 03 2003- 04 2004- 05 Actual Actual Actual Projected U. S. INDICATORS Real Economic Growth* 0.8% 2.3% 4.4% 3.5% Nonfarm Employment - 1.0% - 0.6% 0.2% 1.7% Personal Income 2.0% 2.1% 4.7% 4.9% Industrial Production - 3.5% 0.5% 2.4% 4.4% Corporate Profits ( Pre- Tax) - 8.6% 17.3% 15.2% 12.1% Short- Term Interest Rates ( Actual Rate) 2.3% 1.4% 1.0% 2.0% Mortgage Rates ( Actual Rate) 6.9% 6.0% 5.7% 6.1% Inflation ( CPI) 1.8% 2.2% 2.2% 2.5% * Adjusted for inflation. It will be interesting to see how the current weakness affects the speed with which the Federal Reserve ratchets up interest rates. As recently as last winter many observers felt that the tenuous nature of the recovery would eliminate any rate hikes during 2004. Fed officials even confirmed this operating strategy in unusually candid public remarks. However, strong growth during the first few months of the year led to a re- examination of the position last spring. After raising the benchmark federal funds rate from .75% to 1% on June 30 and to 1.25% in August, the Federal Reserve is now signaling additional rate hikes will take place at a “ measured” pace. The message to be gleaned from the Fed’s language is that future actions will depend on how the economic data falls out. The recent weakness may cause monetary officials to hold off on the anticipated September increase, especially in light of their pronouncements about the impact of high energy prices. In any case, the die has been cast and rates will rise over the next couple of years. During the 1994 tightening, short term borrowing rates rose from 3% to 6% in a 13- month period. Economy. com, the forecasting firm used by Fiscal Research, expects the rates to rise to 2.0% by the first quarter of 2005 and to top out at 5.0% during the first quarter of 2007. The forecasting firm used by the Office of State Budget and Management, Global Insight Inc., is also expecting a 2.0% rate by the end of this year, rising to 3.5% by 2006. National Economic Outlook State of North Carolina 11 A continuing problem for the economy is the subpar recovery in jobs. This is due to a combination of the movement of jobs overseas and the reticence of employers to ramp up staffing levels in an atmosphere of uncertainty. North Carolina is on the front line of this shift, due in part to NAFTA. This impact had begun well before the 2001 recession, as shown by the job growth data below: N. C. Employment Growth In Selected Major Sectors Year Manufacturing Finance Services 1994 0.5% 1.2% 7.6% 1995 0.5% 1.9% 4.5% 1996 - 1.7% 8.2% 4.5% 1997 - 1.0% 7.4% 5.7% 1998 - 0.5% 5.3% 6.0% 1999 - 2.5% - 0.4% 6.0% 2000 - 2.4% 0.7% 3.3% 2001 - 7.1% 4.6% 1.4% 2002 - 8.6% .7% 1.1% 2003 - 6.1% 1.5% .7% A second issue has to do with the impact of higher energy prices on consumer spending. From late winter 1999 to early summer 1999, gas prices in North Carolina rose from around 80 cents per gallon to $ 1.00, and to $ 1.25 by early 2000. Once motorists realized that the increase might be more than a temporary spike, they cut back on purchases of other items ( except for vehicles). One way to measure this impact is to look at gross state and local sales tax collections. After rising 8.6% for the second quarter of 1999, the rate of increase fell to 6.3% for the third quarter, 5.4% for the fourth quarter, and to 4.5% by the first quarter of 2000. This problem was compounded by the fact that heavy promotional activity by auto dealers propped up car sales. The net result of these factors meant that the additional dollars going to vehicle purchases and energy costs “ crowded out” spending on other items. So far the impact of higher energy prices in 2004 on the overall economy and retail sales has been muted. For one thing, the recovery in equity prices has enhanced the “ paper wealth” of many investors. In addition, the substitution of natural gas and other energy sources for fuel oil has minimized the impact of higher fuel prices on manufacturing production costs and family budgets. A third factor is the cash received by homeowners who have refinanced their mortgages. A concern is that financing for retail activity may be coming from additional credit card usage and such levels cannot be sustained indefinitely. A measure of this issue is the fact that unlike the 1992- 94 recovery, sales tax collections are growing much faster than withholding tax receipts. Due to this concern and the phase out of the impact of the 2001- 03 federal tax cuts, the underlying national economic assumptions used in the budget reflect the expectation that growth will slow during the 2004- 05 fiscal years. One of the primary characteristics of the 2001 recession was the impact on the manufacturing sector. This is important to North Carolina because 15% of our nonagricultural employment is in manufacturing versus 11% for the U. S. A more important measure is the share of Gross State Product represented by manufacturing: 21% in North Carolina versus 16% for the nation. State Prospects 12 State of North Carolina The loss of manufacturing jobs did not begin with the 2001 recession. Data compiled by the Employment Security Commission indicate that manufacturing experienced a fairly rapid recovery from the 1990- 91 recession, with employment growth of 2.6% in 1993. In fact, the “ boom and bust” nature of manufacturing is one reason why the state’s economy grew 33% faster than the national experience following the 1981- 82 recession and 45% quicker following the Gulf War downturn. Expressed another way, North Carolina was the fifth fastest growing state during the 1992- 93 period in terms of personal income, due in part to the recovery in manufacturing. After a leveling off period, manufacturing employment began a steady decline in mid- 1995 due to the mild national economic slowdown and the kicking in of NAFTA. The rate of decline began to accelerate in February 2001 and peaked at an 8.6% rate in 2002. Particularly hard hit were the textile and apparel sectors, with North Carolina jobs in these sectors dropping over 15% on a year- over- year basis by the spring of 2001. While the rate of decline has slowed due to the start of the economic recovery, the erosion continues. The only saving grace is that the loss of traditional jobs has been so great that these sectors exert a much smaller impact on the overall economy than in the past. For the 2004- 05 fiscal year, we are budgeting on the basis of a continued subpar economic recovery in North Carolina, both in terms of the absolute level and the normal growth premium relative to the U. S. This experience would be very different from the explosive growth in the state’s economy during the last two recoveries. 2001- 02 2002- 03 2003- 04 2004- 05 Actual Actual Actual Projected NORTH CAROLINA INDICATORS Personal Income 2.2% 2.3% 5.2% 5.5% Nonfarm Employment - 2.1% - 1.1% 0.1% 2.1% Unemployment Rate ( Actual Rate) 6.5% 6.5% 6.0% 5.4% Average Hourly Earnings ( Manufacturing) 2.6% 2.6% 4.4% 3.2% Retail Sales 2.5% 1.1% 6.7% 3.9% Housing Activity 7.3% 6.1% 17.0% - 14.3% Auto Sales - 5.5% - 1.4% 8.5% - 10.9% — Economic analysis prepared by David Crotts Fiscal Research Division North Carolina General Assembly October 29, 2004 Issues and Observations During fiscal year 2004, the Governor, the General Assembly, and the departments and agencies of State government worked to address key issues facing State government and the citizens of North Carolina. More discussion of the financial issues of North Carolina can be found in the Management’s Discussion and Analysis ( MD& A) section of this document. Rising healthcare costs continue to be a concern throughout the State and the nation. Healthcare costs impact State budget programs through increasing expenses not only in Medicaid, but also in other State and federal healthcare programs. In recent years, adjustments have been made to deductibles, co- payments, and benefits coverage under the State Health Plan in an attempt to slow the growth of State budget healthcare costs. Other Post- Employment Benefits State of North Carolina 13 In light of the current and future concerns related to rising healthcare costs, the Governmental Accounting Standards Board ( GASB) has been working on the issuance of accounting and reporting standards for other post- employment benefits since the mid- 90’ s. In April 2004, GASB issued Statement No. 43, Financial Reporting for Postemployment Benefit Plans Other Than Pension Plans ( effective for fiscal year 2006- 07), and in June 2004, GASB issued Statement No. 45, Accounting and Financial Reporting by Employers for Postemployment Benefits Other Than Pensions ( effective for fiscal year 2007- 08). These new standards will require governmental employers to start accounting for the cost of certain post employment benefits while employees are still working. Public sector employers already accrue the cost of pensions as employees are working. These new standards will have a significant impact for most state and local governments. In addition to pensions, many state and local governmental employers provide other postemployment benefits ( OPEB) as part of the total compensation offered to attract and retain the services of qualified employees. The cost of these future benefits is a part of the cost of providing public services today. OPEB includes postemployment healthcare, as well as other forms of postemployment benefits, such as life insurance and disability. Currently, the State and most other governmental employers finance OPEB plans on a pay- as- you- go basis. The financial statements generally do not report financial effects of OPEB until the promised benefits are paid, often many years after the related employee services are received. These new GASB standards will improve the relevance and usefulness of financial reporting by ( a) requiring systematic, accrual- basis measurement and recognition of OPEB cost ( expense) over a period that approximates employees’ years of service, and ( b) providing information about actuarial accrued liabilities associated with OPEB and whether and to what extent progress is being made in funding the plan. In addition, the proposed accounting change would provide information useful in assessing potential demands on the employer’s future cash flows. In preparation for the implementation of these new standards, the General Assembly through the 2004 Appropriations Act established the Retiree Health Benefit Trust Fund to hold accumulated contributions from employers and any earnings on those contributions shall be used to provide health benefits to retired and disabled employees and their applicable beneficiaries. Employer contributions to the Fund are irrevocable. The assets of the Fund are dedicated to providing health benefits to retired and disabled employees and their applicable beneficiaries and are not subject to the claims of creditors of the employers making contributions. Three actuarial studies related to retiree healthcare have been completed as the State has worked to get its hands around the issue and how to deal with it. Each of the three studies, beginning in 1996, have reflected a substantial liability related to the State’s commitment to provide healthcare to teacher and state employee retirees. The unfunded actuarial liability has grown based on two formal studies from $ 5.4 billion in 1996, to $ 8.1 billion in 1999. More recently, based on an informal estimate, the unfunded accrued liability may be in excess of $ 10 billion in 2004. This informal study does not reflect any changes that may arise in 2006 due to the “ Medicare Prescription Drug, Improvements, and Modernization Act of 2003”. Beginning in fiscal year 2006- 07, the actuarial data will be disclosed in the notes to the State CAFR and will also be presented as Required Supplementary Information ( RSI). The unfunded actuarial liability will not be recorded as an accounting liability but will be disclosed in the notes to the financial statements, and as required supplementary information. Beginning with the 2008 CAFR, the difference between the State’s contractual requirement and the amount the State contributes or pays for retiree medical benefits will be recorded as an accounting liability on the State’s government- wide financial statements. 14 State of North Carolina The State’s largest OPEB plan, the Retiree Health Care Plan, is currently being funded on a pay- as- you- go basis, resulting in a significant unfunded actuarial liability. The principal results of the Plan’s most recent actuarial valuation are as follows: Because the GASB’s proposed guidance on OPEB will significantly impact the State’s CAFR, we have the following recommendations: • The State needs to obtain an actuarial valuation for the retiree health plan at least biennially. Annual valuations would be preferable for a state of our size, due to the potential impact on teachers and state employees. • On a prospective basis, the State should consider the long- term impact of the current benefits structure as well as potential changes to that structure. The 2004 General Assembly dedicated considerable time and effort into the evaluation of current information technology management, organization, and operations at the statewide and agency levels for North Carolina State government. The result of that evaluation was legislation enacted in Senate Bill 991 that overhauled information technology authority by transferring it from a central management committee to the Chief Information Officer for the State. Senate Bill 991 provides for the abolishment of the Information Resources Management Committee, the heretofore approval and oversight group for IT projects, and consolidated all functions under the Chief Information Officer. These functions include: • Responsibility for the review, approval and management of all IT projects above an established threshold; • The authority to proceed with an enterprise approach for procurement of IT products and services and the authority to implement such solutions; • The responsibility for review and approval of all agency IT plans and the development of a biennial State Information Technology Plan for submission to the General Assembly; • An assessment of the IT inventory throughout State government and an assessment of the IT deficiencies along with a five year plan for unmet needs; • The creation of an Information Technology Fund that may be used to meet statewide enterprise needs as approved by the General Assembly; and • The authority to establish IT standards statewide. In short, the General Assembly adopted the proposal of the Governor to bring the management, oversight and operations of information technology under the direct control of the Governor. Included in Senate Bill 991 is the continuation of the State Business Infrastructure Program ( SBIP) that has been in progress since 2002. This project was authorized by the 2002 General Assembly to evaluate the State’s core business functions and report back to the General Assembly with an assessment and plan to address deficiencies. This activity occurred in two phases that included an inventory and assessment, followed by a blueprint for addressing priority deficiencies. The final report was presented to the 2004 General Assembly and funding was authorized under Senate Bill 991 to proceed with the development of business requirements for the most “ at risk” component of the study, Human Resources and Payroll ( HR/ Payroll). Under the guidance of the Office of the State Controller, and in collaboration with the State Personnel Officer, Chief Information Officer, and Deputy State Budget Officer, the business development phase for HR/ Payroll is currently underway. This process is scheduled to be completed by late Spring, at which time an RFP will be developed and the General Assembly will be asked to consider funding for the implementation phase of this component of the SBIP. Information Technology State of North Carolina 15 If funding is approved, the HR/ Payroll implementation will begin by late 2005 with an expected implementation period of between 18 to 24 months. Concurrent with this is the next phase of the SBIP, the development of a statewide data warehouse for consolidation of information for use by state managers. The SBIP Program Steering Committee will be considering a plan for moving forward with this component of the SBIP within the next thirty to sixty days. Depending on the development plan, the data warehouse project is expected to begin in early 2005. Financial Information The MD& A provides an overview of the State’s financial activities addressing both governmental and business- type activities reported in the government- wide financial statements. In addition, MD& A focuses on the State’s major funds: the General Fund, the Highway Fund and the Highway Trust Fund. The State contributes to the Teachers' and State Employees' Retirement System, the Consolidated Judicial Retirement System, the Legislative Retirement System, the Firemen's and Rescue Squad Workers' Pension Fund, the Supplemental Retirement Income Plan of North Carolina, and the North Carolina National Guard Pension Fund. The Local Governmental Employees' Retirement System is administered by the State but the State is not a participant. The retirement systems experienced a total return from investments of 12.01% for the one-year period, a return of 4.85% for the three- year period and a return of 4.18% for the five- year period, ended June 30, 2004. These returns represent strong investment results, and reflect the conservative asset allocation and attention to investment quality that have guided the plan’s investment policy. The combined North Carolina Retirement Systems lead the nation in fiscal health because of wise management, consistent state contributions and a conservative investment strategy. The Teachers' and State Employees' Retirement System ( TSERS), the largest of the pension trust funds, continued to be fully funded, based on the December 31, 2003 actuarial valuation. Specifically, the TSERS was funded at 108.1%, with the actuarial value of assets of $ 45.118 billion exceeding the actuarial accrued liability of $ 41.734 billion by $ 3.384 billion at December 31, 2003. Employer contributions to the TSERS increased by $ 55.8 million above the prior fiscal year. Investment balances increased by $ 3.546 billion, or 8.21% above the prior fiscal year, with a net investment income of $ 5.132 billion. The TSERS experienced a $ 149.3 million increase in benefit payments to retirees, an increase of 7.4% from fiscal year 2003. The State's general obligation bonds are rated Aa1 by Moody's, AAA by Standard & Poors, and AAA by Fitch. These favorable ratings have enabled the State to sell its bonds at interest rates considerably below the Bond Buyer's Index, thereby providing substantial savings to North Carolina taxpayers. It is the policy of the State that all agencies, institutions, departments, bureaus, boards, commissions and officers of the State shall devise techniques and procedures for the receipt, deposit and disbursement of monies coming into their control and custody which are designed to maximize interest- bearing investment of cash, and to minimize idle and nonproductive cash balances. The State Controller, with the advice and assistance of the State Treasurer, the State Budget Officer, and the State Auditor, develops, implements, and amends the Statewide Cash Management Policy. All cash deposited with the State Treasurer by State entities is managed in pooled investment accounts to maximize interest earnings. During fiscal year 2004, Pension Benefits Debt Administration Cash Management 16 State of North Carolina uncommitted State funds were invested in short- term and medium- term U. S. Government notes and bonds, as well as other deposits, which had a composite average yield of 3.22%. The State maintains self- insurance programs for employee health; general liability; medical malpractice; workers’ compensation; and automobile, fire and other property losses. The State limits its risk for general liability; medical malpractice; and automobile fire and other property losses by purchasing private insurance for losses in excess of deductibles. See Note 14 of the Notes to the Financial Statements for a full description of the State's risk management program. Other Information In compliance with State statute, an annual financial audit of the State reporting entity is completed each year by the North Carolina Office of the State Auditor. The Auditor's examination was conducted in accordance with auditing standards generally accepted in the United States of America and the standards applicable to financial audits contained in Government Auditing Standards, issued by the Comptroller General of the United States, and his opinion has been included in this report. In addition, the State coordinates the Single Audit effort of all federal funds through the State Auditor. The Government Finance Officers Association of the United States and Canada ( GFOA) awarded a Certificate of Achievement for Excellence in Financial Reporting to the State of North Carolina for its comprehensive annual financial report ( CAFR) for the fiscal year ended June 30, 2003. The Certificate of Achievement is a prestigious national award recognizing conformance with the highest standards for preparation of state and local government financial reports. In order to be awarded a Certificate of Achievement, a government unit must publish an easily readable and efficiently organized comprehensive annual financial report, whose contents conform to program standards. The CAFR must satisfy both generally accepted accounting principles and applicable legal requirements. A Certificate of Achievement is valid for a period of one year only. We believe our current report continues to conform to the Certificate of Achievement program requirements, and we are submitting it to GFOA. In conclusion, we believe this report provides useful data to all parties using it in evaluating the financial activity of the State of North Carolina. We in the Office of the State Controller express our appreciation to the financial officers throughout State government and to the Office of the State Auditor for their dedicated efforts in assisting us in the preparation of this report. Any questions concerning the information contained in this Comprehensive Annual Financial Report should be directed to the Office of the State Controller at ( 919) 981- 5454. Respectfully submitted, Robert L. Powell State Controller December 8, 2004 Risk Management Independent Audit Certificate of Achievement Acknowledgments State of North Carolina 17 THIS PAGE INTENTIONALLY LEFT BLANK. CERTIFICATE OF ACHIEVEMENT 20 State of North Carolina ORGANIZATION OF NORTH CAROLINA STATE GOVERNMENT INCLUDING PRINCIPAL STATE OFFICIALS EXECUTIVE BRANCH Council of State Governor Michael F. Easley Lieutenant Governor Beverly E. Perdue Secretary of State Elaine F. Marshall State Auditor Ralph Campbell, Jr. State Treasurer Richard H. Moore Superintendent of Public Instruction Dr. Michael E. Ward Attorney General Roy A. Cooper, III Commissioner of Agriculture Britt Cobb, Jr. Commissioner of Labor Cherie K. Berry Commissioner of Insurance James E. Long Cabinet Secretaries — Appointed by the Governor Administration Gywnn T. Swinson Correction Theodis Beck Crime Control and Public Safety Bryan E. Beatty Cultural Resources Lisbeth C. Evans Commerce James T. Fain Environment & Natural Resources William G. Ross, Jr. Health and Human Services Carmen Hooker Odom Revenue E. Norris Tolson Transportation W. Lyndo Tippett Appointed by Governor, confirmed by Legislature Office of the State Controller Robert L. Powell State Controller State Board of Education Howard N. Lee Chairman H. Martin Lancaster President Molly C. Broad President Appointed by University Board of Governors Appointed by State Board of Community Colleges Juvenile Justice and Delinquency Prevention George L. Sweat State of North Carolina 21 LEGISLATIVE BRANCH JUDICIAL BRANCH Component Units State of North Carolina Web Page http:// www. ncgov. com North Carolina Supreme Court Chief Justice I. Beverly Lake, Jr. Associate Justices Edward Thomas Brady Robert H. Edmunds, Jr. Paul Newby Mark D. Martin Sarah Parker George L. Wainwright, Jr. Administrative Office of the Courts Judge Ralph A. Walker Director University of North Carolina System Community Colleges State Education Assistance Authority General Assembly Senate House of Representatives Co- Speakers James B. Black Richard T. Morgan Democratic Leader Joe Hackney Republican Leader Joe Kiser President Lieutenant Governor President Pro Tempore Marc Basnight Deputy Pres. Pro Tempore Charlie Smith Dannelly Majority Leader Tony Rand Minority Leader James Forrester The Golden LEAF, Inc. NC Housing Finance Agency Other Component Units 22 State of North Carolina THIS PAGE INTENTIONALLY LEFT BLANK. FINANCIAL SECTION 24 State of North Carolina State of North Carolina 25 26 State of North Carolina THIS PAGE INTENTIONALLY LEFT BLANK. MANAGEMENT’S DISCUSSION AND ANALYSIS 28 State of North Carolina Financial Highlights MANAGEMENT'S DISCUSSION AND ANALYSIS ( MD& A) The following is a discussion and analysis of the State of North Carolina’s ( the State’s) financial performance, providing an overview of the activities for the fiscal year ended June 30, 2004. Please read it in conjunction with the transmittal letter at the front of this report and with the State's financial statements, which follow this section. Government- wide Financial Statements: ⎯ The State’s total net assets increased slightly as a result of this year’s operations. While net assets of governmental activities increased by $ 613.2 million, or nearly 2.7 percent, net assets of business- type activities decreased by $ 204.5 million, or about 21.3 percent ( decline related to the Unemployment Compensation Fund). At year- end, net assets of governmental activities and business- type activities totaled $ 22.98 billion and $ 754.1 million, respectively. ⎯ Component units reported net assets of $ 10.66 billion, an increase of $ 1.08 billion or 11.3 percent from the previous year. The majority of the increase ($ 762 million) is due to the net increase in capital assets for the University of North Carolina System and community colleges ( component units). The capital asset additions were financed in part by State debt proceeds. ⎯ GASB Statement No. 39 became effective during the fiscal year ( see Notes 20 and 21 to the financial statements). The beginning net assets of the University of North Carolina System and community colleges were increased by $ 713 million to include nongovernmental component unit foundations. Fund Financial Statements: ⎯ As of the close of the fiscal year, the General Fund reported a total fund balance of negative $ 196.3 million, with reserves of $ 197.4 million, and an unreserved fund balance of negative $ 393.7 million. The total fund balance of the General Fund decreased from the prior year balance of negative $ 167.1 million. ⎯ The Highway Fund and the Highway Trust Fund reported total fund balances of $ 227.8 million and $ 266.1 million, respectively. ⎯ The State’s two major enterprise funds, the Unemployment Compensation Fund and the EPA Revolving Loan Fund, reported net assets of $ 20.1 million and $ 640.5 million, respectively. The net assets of the Unemployment Compensation Fund decreased by 93 percent from the prior fiscal year- end. Capital Assets: ⎯ The State’s investment in capital assets ( net of accumulated depreciation) was $ 25.61 billion, which represents an increase of 7.7 percent from the previous fiscal year. ⎯ The largest component of capital assets, the State highway system, includes roadway surfaces, bridges, signage, railings, markings, traffic signals, and other structures related to the State’s motor vehicle transportation system. The system includes 78,615 miles of roadway, constituting the second largest highway system in the nation. The system also includes 17,250 bridges spanning 380 miles. At year- end, the State reflected $ 13.28 billion ( net of accumulated depreciation) of highway system infrastructure. ⎯ Major capital asset activity included additions to the State highway system ($ 1.2 billion), right- of-way acquisitions ($ 510 million) and the acquisition/ construction of correctional facilities ($ 239 million). Long- term Debt: ⎯ The State had long- term debt outstanding of $ 5.54 billion, an increase of 34.9 percent from the previous fiscal year- end. The long- term debt balance includes $ 519.6 million of special obligation ( non- voted) debt issued for governmental activities. ⎯ The State maintained its AAA bond rating with Standard and Poor’s and Fitch. In August 2002, Moody’s downgraded the State’s credit rating for general obligation debt from “ AAA” to “ Aa1”, representing the first time since 1960 that North Carolina had less than a “ AAA” rating. In September 2004, Moody’s revised the State’s outlook to positive from stable. State of North Carolina 29 OVERVIEW OF THE FINANCIAL STATEMENTS This discussion and analysis is an introduction to the State’s basic financial statements, which comprise three components: 1) government- wide financial statements, 2) fund financial statements, and 3) notes to the financial statements. This report also contains additional required supplementary information ( General Fund budgetary schedule, pension funding progress and contributions) and other supplementary information ( combining financial statements) in addition to the basic financial statements. These components are described below. Government- wide Financial Statements The Statement of Net Assets and the Statement of Activities are two financial statements that report information about the State, as a whole, and about its activities that should help answer this question: Is the State, as a whole, better off or worse off as a result of this year’s activities? These statements include all non- fiduciary assets and liabilities using the accrual basis of accounting. The current year’s revenues and expenses are taken into account regardless of when cash is received or paid. The Statement of Net Assets ( page 52) presents all of the State’s assets and liabilities, with the difference between the two reported as “ net assets”. Over time, increases and decreases in net assets measure whether the State’s financial position is improving or deteriorating. The Statement of Activities ( pages 54 and 55) presents information showing how the State’s net assets changed during the most recent fiscal year. All changes in net assets are reported as soon as the underlying events giving rise to the change occur, regardless of the timing of related cash flows. Therefore, revenues and expenses are reported in these statements for some items that will only result in cash flows in future fiscal periods ( e. g. uncollected taxes and earned but unused vacation leave). Both statements report three activities: Governmental Activities – Most of the State’s basic services are reported under this category. Taxes and intergovernmental revenues generally fund these services. Business- type Activities – The State charges fees to customers to help it cover all or most of the cost of certain services it provides. The State’s Unemployment Compensation Fund and the EPA Revolving Loan Fund are the predominant business- type activities. Discretely Presented Component Units – Component units are legally separate organizations for which the elected officials of the primary government are financially accountable. A description of the component units and an address for obtaining their separately issued financial statements can be found beginning on page 70. All component units are combined and displayed in a separate discrete column in the government- wide financial statements to emphasize their legal separateness from the State. In addition, financial statements for major component units are presented in the notes to the financial statements ( pages 137 and 138). Fund Financial Statements The fund financial statements begin on page 58 and provide detailed information about the major individual funds. A fund is a fiscal and accounting entity with a self- balancing set of accounts that the State uses to keep track of specific sources of funding and spending for a particular purpose. In addition to the major funds, page 160 begins the individual fund data for the non- major funds. The State's funds are divided into three categories, governmental, proprietary, and fiduciary, and they use different accounting approaches. Governmental funds -- Most of the State's basic services are reported in the governmental funds, which focus on how money flows into and out of those funds and the balances left at year- end that are available for future spending. The governmental fund financial statements provide a detailed short- term view of the State's general government operations and the basic services it provides. Governmental fund information helps determine whether there are more or fewer financial resources that can be spent in the near future to finance the State's programs. These funds are reported using modified accrual accounting, which measures cash and all other financial assets that 30 State of North Carolina can readily be converted to cash. Governmental funds include the general, special revenue, capital project, and permanent funds. Because the focus of governmental funds is narrower than that of the government- wide financial statements, it is useful to compare the information presented for governmental funds with similar information presented for governmental activities in the government- wide financial statements. By doing so, readers may better understand the long- term impact of the government’s near- term financing decisions. Both the governmental fund balance sheet and the governmental fund statement of revenues, expenditures, and changes in fund balances provide a reconciliation to facilitate this comparison between governmental funds and governmental activities. Proprietary funds -- When the State charges customers for the services it provides, whether to outside customers or to other agencies within the State, these services are generally reported in proprietary funds. Proprietary funds ( enterprise and internal service) utilize accrual accounting; the same method used by private sector businesses. Enterprise funds are used to report activities for which fees are charged to external users for goods and services. The Unemployment Compensation Fund and the EPA Revolving Loan Fund are our most significant enterprise funds. Internal service funds are used to report activities that provide goods and services to the State’s other programs and activities on a cost- reimbursement basis. - such as the State's State Property Fire Insurance Fund, the Motor Fleet Management Fund, Computing Services Fund, and Telecommunications Services Fund. Internal service funds are reported as governmental activities on the government- wide statements. Fiduciary funds -- The State acts as a trustee or fiduciary, for its employee pension plans. It is also responsible for other assets that, because of a trust arrangement, can be used only for the trust beneficiaries. The State's fiduciary activities are reported in separate Statements of Fiduciary Net Assets and Changes in Fiduciary Net Assets. These funds, which include pension and other employee benefits, private- purpose, investment trust, and agency funds, are reported using accrual accounting. The government- wide financial statements exclude fiduciary fund activities and balances because these assets are restricted in purpose and cannot be used to support the State’s own programs. Notes to the Financial Statements The notes provide additional information that is essential to a full understanding of the data provided in the government- wide and fund financial statements. The notes to the financial statements can be found beginning on page 68 of this report. Additional Required Supplementary Information Following the basic financial statements and note disclosures is additional Required Supplementary Information that further explains and supports the information in the financial statements. The Required Supplementary Information includes General Fund budgetary comparison schedules reconciling the statutory and generally accepted accounting principles ( GAAP) fund balances at fiscal year- end, and pension plan trend information related to funding progress and contributions. Supplementary Information Supplementary information includes the introductory section, and the combining financial statements for non- major governmental, proprietary, and fiduciary funds and for non- major discretely presented component units. These funds are added together, by fund type, and presented in single columns in the basic financial statements, but are not reported individually, as with major funds, on the governmental fund financial statements. State of North Carolina 31 FINANCIAL ANALYSIS OF THE STATE AS A WHOLE The State’s combined net assets increased $ 408.7 million or 1.8 percent over the course of this fiscal year’s operations. The net assets of the governmental activities increased $ 613.2 million or 2.7 percent and business- type activities had a decrease of $ 204.5 million or 21.3 percent. The following table was derived from the government- wide Statement of Net Assets: Net Assets June 30, 2004 and 2003 ( dollars in thousands) 2004 2003 2004 2003 2004 2003 Current and other non-current assets.......................................... $ 1 0,668,632 $ 9 ,882,858 $ 1,217,551 $ 1,161,973 $ 1 1,886,183 $ 1 1,044,831 Capital assets, net....................................... 25,556,896 23,719,972 49,507 46,272 25,606,403 23,766,244 Total assets................................................ 36,225,528 33,602,830 1,267,058 1,208,245 37,492,586 34,811,075 Long- term liabilities...................................... 5,970,092 4,376,222 10,242 10,270 5,980,334 4,386,492 Other liabilities............................................. 7,274,030 6,858,429 502,697 239,375 7,776,727 7,097,804 Total liabilities........................................... 13,244,122 11,234,651 512,939 249,645 13,757,061 11,484,296 Net assets: Invested in capital assets, net of related debt.................................... 24,706,355 23,449,373 40,277 38,450 24,746,632 23,487,823 Restricted.................................................... 1,454,729 1,068,233 665,547 863,426 2,120,276 1,931,659 Unrestricted................................................. ( 3,179,678) ( 2,149,427) 48,295 56,724 ( 3,131,383) ( 2,092,703) Total net assets......................................... $ 2 2,981,406 $ 2 2,368,179 $ 754,119 $ 958,600 $ 2 3,735,525 $ 2 3,326,779 Governmental Business- type Total Primary Activities Activities Government The largest component of the State’s net assets ($ 24.75 billion) reflects its investment in capital assets ( land, buildings, machinery and equipment, State highway system, and other capital assets), less related debt still outstanding that was used to acquire or construct those assets. Restricted net assets are the next largest component ($ 2.12 billion). Net assets are restricted when constraints placed on their use are either externally imposed or are imposed by law through constitutional provisions or enabling legislation. The remaining portion, unrestricted net assets, consists of net assets that do not meet the definition of “ restricted “ or “ invested in capital assets, net of related debt.” The government- wide statement of net assets for governmental activities reflects a negative $ 3.18 billion unrestricted net asset balance. The State of North Carolina, like many other state and local governments, issues general obligation debt and distributes the proceeds to local governments and component units. The proceeds are used to construct new buildings and renovate and modernize existing buildings on the State’s community college and university campuses, assist county governments in meeting their public school building capital needs, and to provide grants and loans to local governments for clean water and natural gas projects. Of the $ 5.54 billion of total long- term debt outstanding at June 30, 2004, $ 4.57 billion is attributable to debt issued as State aid to component units ( universities and community colleges) and local governments. The balance sheets of component unit and local government recipients reflect ownership of the related constructed capital assets without the burden of recording the debt obligation. The policy of selling general obligation bonds and funneling the cash proceeds to non- primary government ( non- State) entities has been in place for decades. However, by issuing such debt, the State is left to reflect significant liabilities on its statement of net assets ( reflected in the unrestricted net asset component) without the benefit of recording the capital assets constructed or acquired with the proceeds from the debt issuances. Additionally, as of June 30, 2004, the State’s governmental activities have significant unfunded liabilities for compensated absences in the amount of $ 327 million and a $ 7.5 million cost settlement payable to the federal government ( see Note 7 to the financial statements). These unfunded liabilities also contribute to the negative unrestricted net asset balance for governmental activities. 32 State of North Carolina Governmental Activities The following financial information was derived from the government- wide Statement of Activities and reflects how the State’s net assets changed during the fiscal year: Changes in Net Assets For the Fiscal Years Ended June 30, 2004 and 2003 ( dollars in thousands) Governmental Business- type Total Primary Activities Activities Government 2004 2003 2004 2003 2004 2003 Revenues: Program revenues: Charges for services............................................. $ 1 ,505,090 $ 1 ,339,016 $ 926,891 $ 688,786 $ 2 ,431,981 $ 2 ,027,802 Operating grants and contributions........................ 10,108,124 9,042,843 305,053 504,550 10,413,177 9,547,393 Capital grants and contributions............................ 884,345 527,498 892 1,241 885,237 528,739 General revenues: Taxes Individual income tax......................................... 7,407,455 7,122,099 — — 7,407,455 7,122,099 Corporate income tax........................................ 760,180 921,611 — — 760,180 921,611 Sales and use tax.............................................. 4,293,040 4,029,403 — — 4,293,040 4,029,403 Gasoline tax...................................................... 1,276,627 1,154,986 — — 1,276,627 1,154,986 Franchise tax..................................................... 560,708 584,584 — — 560,708 584,584 Highway use tax................................................ 578,346 552,759 — — 578,346 552,759 Insurance tax..................................................... 432,975 417,126 — — 432,975 417,126 Beverage tax..................................................... 213,271 198,848 — — 213,271 198,848 Inheritance tax................................................... 128,352 112,150 — — 128,352 112,150 Other taxes........................................................ 313,985 289,261 — — 313,985 289,261 Tobacco settlement............................................... 147,224 173,256 — — 147,224 173,256 Federal grants not restricted to specific programs.............................................. 136,859 136,859 — — 136,859 136,859 Unrestricted investment earnings.......................... 77,225 103,987 — — 77,225 103,987 Miscellaneous....................................................... 62,601 41,137 3 — 62,604 41,137 Total revenues..................................................... 28,886,407 26,747,423 1,232,839 1,194,577 30,119,246 27,942,000 Expenses: General government.............................................. 807,248 773,807 — — 807,248 773,807 Primary and secondary education......................... 7,223,766 6,865,921 — — 7,223,766 6,865,921 Higher education................................................... 3,140,794 2,814,375 3,140,794 2,814,375 Health and human services................................... 11,729,904 10,611,537 — — 11,729,904 10,611,537 Economic development......................................... 536,055 489,111 — — 536,055 489,111 Environment and natural resources....................... 599,575 538,032 — — 599,575 538,032 Public safety, corrections and regulation............... 2,093,404 2,029,233 — — 2,093,404 2,029,233 Transportation....................................................... 1,870,578 1,640,007 — — 1,870,578 1,640,007 Agriculture............................................................. 82,394 73,974 — — 82,394 73,974 Interest on long- term debt..................................... 191,228 151,258 — — 191,228 151,258 Unemployment compensation............................... — — 1,389,266 1,603,796 1,389,266 1,603,796 EPA Revolving Loan............................................. — — 5,342 4,266 5,342 4,266 Other business- type activities................................ — — 43,014 30,750 43,014 30,750 Total expenses.................................................... 28,274,946 25,987,255 1,437,622 1,638,812 29,712,568 27,626,067 Increase ( decrease) in net assets before contributions and transfers................................ 611,461 760,168 ( 204,783) ( 444,235) 406,678 315,933 Contributions to permanent funds......................... 2,068 1,806 — — 2,068 1,806 Transfers............................................................... ( 302) 4,918 302 ( 4,918) — — Increase ( decrease) in net assets....................... 613,227 766,892 ( 204,481) ( 449,153) 408,746 317,739 Net assets - beginning - restated........................... 22,368,179 21,601,287 958,600 1,407,753 23,326,779 23,009,040 Net assets - ending............................................... $ 2 2,981,406 $ 2 2,368,179 $ 754,119 $ 958,600 $ 2 3,735,525 $ 2 3,326,779 As a result of this year’s operations, the net assets of governmental activities increased by $ 613.2 million or 2.7 percent. The net asset increase is primarily related to the overall growth in tax revenues ( e. g., individual income, sales and use, and gasoline taxes) and spending reversions realized during the current fiscal year. The major exception to the growth in taxes was corporate taxes, which declined 17.5 percent from the previous fiscal year- end. Key factors in the decline in corporate taxes were reduced collections, an overall increase in the estimated refund rate, and the legislative suspension in the prior year of required distributions to special revenue funds. Although corporate profits were up, corporate tax collections were down because of tax code changes that allowed businesses to write- off expenses more quickly and the utilization of tax breaks and other incentives designed to attract new jobs to the State. Also, in the prior year, a portion of corporate income taxes, required to be distributed to special revenue funds, were retained by the General Fund to manage a budget shortfall. State of North Carolina 33 Total expenses of governmental activities grew by 8.8 percent during the current period ( compared to total revenues growth of 8.0 percent). The majority of the spending growth was the result of funding increases in the State’s two largest functional areas, education and health and human services. The increase in education spending is related to enrollment increases at the State’s universities and community colleges and funding increases for the State’s public schools. The growth in health and human services is the result of increased spending for Medicaid, which is the State’s largest public assistance program. The growth in Medicaid is explained by an increase in individuals eligible for Medicaid services, a large increase in payments for dental services due to a lawsuit settlement that raised dental rates, and a significant increase in prescription drug payments and Disproportionate Share Hospital payments. There were also significant increases in the Electronic Benefits program due to higher client participation as a result of the recent economic downturn. The following chart depicts revenue sources of governmental activities as percentages of total revenues for the fiscal year: Revenues - Governmental Activities Fiscal Year Ended June 30, 2004 Charges for services 5% Capital grants and contributions 3% Individual income and corporate income taxes 28% Gasoline and highway use taxes 6% Other taxes 6% Miscellaneous 1% Sales and use tax 15% Operating grants and contributions 36% The following chart depicts the total expenses and total program revenues of the State’s governmental functions. This format identifies the extent to which each governmental function is self-financing through fees and intergovernmental aid or draws from the general revenues of the State. 34 State of North Carolina Business- type Activities Expenses - Governmental Activities Fiscal Year Ended June 30, 2004 — $ 1,000 $ 2,000 $ 3,000 $ 4,000 $ 5,000 $ 6,000 $ 7,000 $ 8,000 $ 9,000 $ 10,000 $ 11,000 $ 12,000 $ 13,000 General government Primary and secondary education Higher education Health and human services Economic development Environment and natural resources Public safety, corrections, and regulation Transportation Agriculture Interest on long-term debt Expenses Program Revenues ( excluding Capital Grants) Millions The following chart reflects the dollar change in the functional expenses of governmental activities between fiscal years 2003 and 2004: Dollar Change in Governmental Activities Functional Expenses Between Fiscal Years 2003 and 2004 $ 40 $ 8 $ 231 $ 64 $ 62 $ 47 $ 1,118 $ 326 $ 358 $ 33 $— $ 200 $ 400 $ 600 $ 800 $ 1,000 $ 1,200 Interest on long- term debt Agriculture Transportation Public safety, corrections and regulation Environment and natural resources Economic development Health and human services Higher education Primary and secondary education General government ( dollars in millions) Business- type activities reflect a decrease in net assets of $ 204.5 million or 21.3 percent. The key reason for the decline was the Unemployment Compensation Fund’s significant operating loss, which was financed by the proceeds of short- debt. At year- end, the net assets of the Unemployment Compensation Fund were $ 20.1 million, a decrease of $ 257.4 million or 92.7 percent from the prior fiscal year- end. The Unemployment Compensation Fund and the EPA Revolving Loan Fund are the predominant activities, comprising 87.6 percent of the total net assets of business- type activities. A more detailed discussion of the State’s enterprise funds is provided in the following section. State of North Carolina 35 Governmental Funds FINANCIAL ANALYSIS OF THE STATE’S FUNDS The State uses fund accounting to ensure and demonstrate compliance with finance- related legal requirements The focus of the State’s governmental funds is to provide information on near- term inflows, outflows, and balances of spendable resources. As of the end of the fiscal year, the State’s governmental funds reported combined ending fund balances of $ 3.0 billion, a 14.7 percent increase from the prior fiscal year- end ( as restated). The majority of the increase was related to debt proceeds recognized in other governmental funds for the N. C. Infrastructure Finance Corporation ( Corporation), a blended component unit of the State. The Corporation issued debt for the repair and renovation of State facilities and for the acquisition and construction of correctional facilities. The major governmental funds are discussed individually below. General Fund The General Fund is the chief operating fund of the State. The fund balance of the General Fund decreased from a negative $ 167.139 million at June 30, 2003 ( as restated) to a negative $ 196.287 million at June 30, 2004. A key factor in the decline was the Department of Revenue’s revision of the refund rate for corporate taxes, which resulted in a $ 45.8 million reduction in corporate tax revenues for the 2004 fiscal year ( Note: GAAP requires tax revenues to be reported net of estimated refunds). In addition, the total fund deficit continues to be influenced by the excess of accrued expenditures over accrued revenues for the State’s Medicaid program. A more detailed analysis of the General Fund is provided in the budgetary highlights section ( see next section). 2003- 2004 General Fund Budgetary Highlights The General Fund budget for fiscal year 2003- 04 was signed into law on June 30, 2003. The enacted budget was founded upon an overall nominal ( real growth plus inflation) economic growth rate of 3.5 percent for 2003- 04. The appropriated budget included provisions that were designed to increase General Fund revenues. The most significant revenue adjustment was the continuation of two temporary tax increases that were scheduled to expire in 2003. In 2001, the General Assembly temporarily raised the State sales tax rate by a half- cent to 4.5 percent and the highest individual income tax rate from 7.75 percent to 8.25 percent. The budget continues the State sales tax rate at 4.5 percent and the 8.25 percent income tax bracket. In addition, several streamlining and conformity provisions, as well as departmental fees, were authorized that increase General Fund availability. Finally the Department of Revenue was given broader authority and resources to collect unpaid tax liabilities. The following table summarizes the 2004 revenue enhancements ( amounts expressed in millions). Revenue Enhancements – 2004 Fiscal Year Maintain State sales tax at 4.5%................................................... $ 341.8 Maintain top income tax bracket.................................................... 37.5 Streamline tax revisions................................................................ 78.5 Department of Revenue - Project Tax Collect................................ 90.2 Tobacco settlement funds ............................................................ 66.8 Fee increases and trust fund transfers.......................................... 87.0 Tax reductions for federal conformity............................................. ( 70.0) Federal fiscal relief........................................................................ 136.9 Federal disaster relief funds.......................................................... 108.8 Total 2004 enhancements.................................................... $ 877.5 The majority of funding increases for 2004 were in the education and human service areas. The budget provided full funding for enrollment increases in the University of North Carolina System ($ 46.6 million), the community college system ($ 32 million), and private colleges and universities ($ 2.8 36 State of North Carolina million). In addition, the budget includes funds to hire additional public school teachers to reduce class size in the second grade ($ 25.3 million) and to expand the Governor’s More- at- Four Program ($ 8.4 million), which helps prepare at risk four- year- old children for success in school. It also provides funds for the annual step increase for public school teachers ($ 48.1 million) and for ABC bonuses earned in the 2002- 03 school year ($ 96 million). The budget provides additional funding for the Health Insurance Program for Children ($ 12.2 million), which allows all eligible children to receive health care insurance ( see Note 14C to the financial statements). In addition, expansion funds are provided for the Mental Health Trust Fund ($ 12.5 million) to facilitate the progress toward mental health reform. The budget provided over $ 200 million in 2003- 04 to support employee benefit programs. Specifically, it authorized a $ 550 one- time compensation bonus for State employees not included on the teacher salary schedule. In addition, the State Health Plan received sufficient funds to cover increased employee- related health care costs without reduction in benefits. The budget also began repayment of the funds withheld from the Retirement System in 2000- 01 due to the budget shortfall ( Note: the total obligation to the Retirement System was $ 129.9 million plus accrued interest). Legislation was enacted in 2001 to formalize the General Assembly’s intent to repay the debt, subject to the availability of funds, over a five- year period beginning July 1, 2003. The budget authorized the payment of $ 10 million to partially repay the debt to the Retirement System. At year- end, the General Assembly authorized an additional payment of $ 20 million to the Retirement System. General Fund Budget Variances The original General Fund budget, including State appropriations and appropriations supported by departmental receipts, serves as a starting point or plan for the Governor to execute the General Fund budget pursuant to the powers granted by the Executive Budget Act. At the state level in North Carolina, it is not unusual for the budget to change during the fiscal year in relation to budget adjustments made to accommodate departmental receipts. The General Fund budget supported by State appropriation, is a subset of the General Fund financial schedule presented in the CAFR as required supplementary information. The current CAFR schedule reflects all spending required to support the State’s General Fund activities and the funding to support those activities, including State tax and non-tax revenues, federal revenues, student tuition, and other fees, licenses, and fines. Under current State budget management practice, particularly related to departmental federal receipts, primary emphasis is placed on comparisons of the final authorized budget and actual spending. At the State level, budgetary cuts related to State appropriations are implemented by decreasing allowable actual expenditures, as opposed to decreasing the State appropriation through a formal legislative process. The Governor and State agencies maintain legal authority to spend the dollars originally appropriated to them, however, in recent years the actual spending has been limited by the collection of tax and nontax revenue. In extremely rare cases, the General Assembly has held special sessions to formally amend the State appropriation budget. The portion of the original budget comprising departmental receipts is not intended to be the sole controlling point to manage the State’s General Fund budget. The final budget includes amendments for departmental receipts collected during the fiscal year as allowed by law. General Fund departmental receipts are typically authorized for expenditure within the activity that generated the receipt. Historically, final estimated receipts have varied significantly from the original estimate at the beginning of the fiscal year. State agencies by law must spend departmental receipts prior to spending tax and nontax supported appropriations. If departmental receipts are higher than expected, appropriated dollars may go unspent and be re- appropriated in a subsequent fiscal year. State of North Carolina 37 Variances – Original and Final Budget The budget variance between original and final budget for federal funds revenue is attributable to the awarding of new federal funds during the fiscal year and funds being drawn down to reimburse unanticipated expenditures. The budget variance for intra- governmental transactions revenue is attributable primarily to the following: $ 81.5 million of statewide encumbrance carry forward amounts from fiscal year 2002- 2003, $ 126.4 million of Medicaid Disproportionate Share, $ 8.3 million of Department of Health and Human Services ( DHHS)- cost report settlement, $ 272.9 million of DHHS- intra- governmental transfers within a DHHS general fund budget code, $ 351.2 million of DHHS funds transferred from various budget codes within DHHS, and $ 14.8 million of Mental Health Trust Fund intra- governmental transfers. The budget variance for contributions, gifts and grants revenue is attributable primarily to the decision by the Division of Medical Assistance to change an accounting process to go on cost allocation, leading to the unexpected budgeting of $ 129.1 million for the State match. For expenditures, the variances between the original budget and final budget are related to the corresponding revenue budget variances. As revenue budget accounts are increased, a corresponding increase occurs in the expenditure budget accounts. In addition to those increases, agency expenditure budgets were also increased by the allocation of statewide reserves such as the legislative salary increase, health insurance, and retirement reserves. There was also an additional appropriation of $ 88.1 million authorized for fiscal year 2003- 2004 as a result of special sessions of the General Assembly. Variances - Final Budget and Actual Results The budget variance between final budget and actual revenues for corporate income taxes occurred because the growth in corporate profits exceeded the forecast. Investment Income was below the final budget because market interest rates were below the forecast. Departmental federal funds actually received by agencies were $ 741.9 million less than the final budget. Of this variance, $ 357.2 million was attributable to the Department of Public Instruction. Actual federal draw downs are reflective of the actual expenditures of these federal funds. In addition, $ 190.8 million of the Federal funds variance is attributable to the Department of Health and Human Services not incurring qualifying costs as budgeted. For expenditures, the variances between final budget and actual expenditures for primary and secondary education and public safety, corrections, and regulation occurred because actual revenues were less than the budgeted revenues; therefore, expenditures that depended on the receipt of these funds could not be made. The State ended fiscal year 2003- 04 with an over- collection of tax revenues of $ 242.4 million. The major tax categories that exceeded the budgeted forecast were individual income ( 1.1%), corporate income ( 9.2%), and sales and use ( 4.1%). In addition, unexpended appropriations or reversions of $ 159 million were realized. The State fiscal year 2003- 04 closed out with a $ 289.4 million unreserved fund balance after transferring $ 116.7 million to the Rainy Day Fund and $ 76.8 million to the Repair and Renovation Reserve. 38 State of North Carolina Highway Fund The Highway Fund dates back to 1921, which is when the N. C. General Assembly first imposed the gasoline tax. It accounts for most of the activities of the North Carolina Department of Transportation, including the maintenance and construction of the State’s primary, secondary, and urban road systems, the State Highway Patrol, the Division of Motor Vehicles, and transit and rail. The primary revenue sources of the Highway Fund are federal funds, three- fourths of gasoline taxes, vehicle registration fees, and driver’s license fees. The fund balance of the State Highway Fund decreased from $ 299.9 million at June 30, 2003 to $ 227.8 million at June 30, 2004, a decrease of 24 percent. The decline was the result of total expenditures exceeding total revenues for the current period. Over the past three years, the North Carolina Department of Transportation has used excess cash to advance construction projects and to accelerate contract resurfacing. Unbudgeted emergency relief expenditures for Hurricane Isabel and several ice storms also impacted cash flow. However, the excess of expenditures over revenues of $ 185.3 million in 2004 was smaller than the previous fiscal year because total revenues grew at a faster rate than total expenditures. Total revenues increased by $ 252.2 million or 11.7 percent primarily because of increases in gasoline taxes and federal funds. A 4 percent increase in taxable gallons sold combined with a 3 percent boost in the average fuel tax per gallon raised fuel tax revenues by $ 89.2 million. Federal billings rose $ 180.7 million due to increased Federal Highway Administration construction. Total expenditures increased by $ 207.7 million or 8.7 percent due to increased maintenance and construction expenditures. In addition, operating transfers to other funds increased by $ 24.4 million. During the fiscal year, the Highway Fund also received an advance of $ 15.4 million from a municipality for roadway and pedestrian improvements. In September 2004, the State Board of Transportation approved a new long- range plan that prioritizes transportation investment for the next 25 years. The Statewide Transportation Plan provides a blueprint for greater investment in maintenance, preservation, and modernization of the State’s existing highway system as well as other transportation options such as rail and public transportation. The share of transportation dollars spent on new highway projects will drop from 45 percent to 26 percent. The highway needs of the State’s growing population will be accommodated in part by maintaining and upgrading existing roads and by increasing anti- congestion measures such as synchronized traffic signals. The centerpiece of the plan is the Recommended Investment Scenario, which outlines priorities from the estimated $ 55 billion, in today’s dollars, expected to be available over the next 25 years for transportation investment. Based on this scenario, the Department of Transportation ( NCDOT) will be able to meet an additional 10 percent of its maintenance and preservation needs and nearly 25 percent more modernization infrastructure needs. Additionally, the scenario proposes increasing NCDOT’s investment in other transportation modes. The plan also identifies $ 84 billion in total transportation needs and states that NCDOT will only be able to meet two- thirds of the State’s 25- year transportation needs at its current funding levels, regardless of how NCDOT’s resources are allocated. Full implementation of the Recommended Investment Scenario will be gradual. Highway Trust Fund Legislation creating the Highway Trust Fund was passed by the General Assembly in 1989. It was established to provide a dedicated funding mechanism to meet highway construction needs in North Carolina. The Highway Trust Fund also provides extra money for the State’s municipalities to adequately maintain their streets and pays the debt service on the State’s general obligation bonds issued for highway purposes. The principal revenue sources of the Highway Trust Fund are highway use taxes, one- fourth of gasoline taxes, and various title and registration fees. From the proceeds of the highway use tax, $ 252.4 million was transferred to the general fund for the 2003- 04 fiscal year and thereafter, the transfer amount is scheduled to be $ 240 million per year subject to adjustment for inflation. The General Fund intends to repay by June 30, 2009 the $ 125 million ( plus interest) advanced from the Highway Trust Fund during the 2002- 03 fiscal year ( see Note 9 to the financial statements). State of North Carolina 39 Enterprise Funds The fund balance of the Highway Trust Fund increased from $ 208.2 million at June 30, 2003 to $ 266.1 million at June 30, 2004, an increase of 27.8 percent. The increase was attributable, in part, to $ 400 million of highway bonds issued on November 2003. The proceeds of these bonds were used to reimburse highway expenditures of prior years. These bonds constitute a portion of the $ 950 million highway bond authorization approved by the voters in November 1996 ( Note: $ 250 million of such bonds were issued in 1997). At year- end, the remaining highway bond authorization was $ 300 million. Total revenues increased by $ 54.0 million or 5.7 percent, primarily because of increases in the gasoline tax and the highway use tax. Gasoline taxes rose $ 29.5 million due primarily to a 4 percent increase in taxable gallons sold combined with a 3 percent rise in the average fuel tax per gallon. Highway use taxes on vehicle registrations grew $ 25.6 million or 4.6 percent. Total expenditures increased by $ 220.9 million or 36.3%. The increase is due to a significant rise in contract lettings for the Transportation Improvement Program and N. C. Moving Ahead projects to address transportation infrastructure needs. The 2003 General Assembly passed the Governor’s “ Moving Ahead” transportation initiative to allow, over two years, the use of $ 630 million of Highway Trust Fund cash balances for highway preservation, modernization, and maintenance. Additionally, it allows $ 70 million for public transit, rail, ferry, bicycle, and pedestrian projects. The State’s enterprise funds or business- type activities provide the same type of information found in the government- wide financial statements, but in more detail. The major enterprise funds are discussed individually below. Unemployment Compensation Fund The net assets of the Unemployment Compensation Fund decreased by $ 257.4 million during the current fiscal year, which is a 92.7 percent decrease from the prior fiscal year- end. The decrease is explained primarily by the fund’s significant operating loss ( excess of operating expenses over operating income), which was financed by the proceeds of short- term debt. The operating loss was $ 509.6 million this year versus $ 956.1 million in 2003. At June 30, 2004, the short- term debt balance was $ 251.8 million compared to zero for the previous year- end. To ensure timely payment of unemployment benefits, the State received repayable advances from its Federal Unemployment Account and issued tax anticipation notes ( see Note 6 to the financial statements). The State estimated that it will save millions of dollars in interest payments by selling tax anticipation notes instead of borrowing exclusively from the federal government. Unemployment benefit expenses decreased 13.4 percent in fiscal year 2004 to $ 1.39 billion. These expenses were lower because the State’s unemployment rate fell during the second half of the fiscal year. North Carolina’s seasonally adjusted unemployment rate was 5.5 percent in June 2004, making four consecutive months that the rate was below the national average. While manufacturing jobs declined since January 2004, all other sectors of the economy gained jobs during the second half of the fiscal year. Job gains were especially large in professional and business services and in educational and health services. In fiscal years 2003 and 2002, the State also received funding for extended unemployment benefits. In March 2002, the U. S. Congress signed into law the Temporary Extended Unemployment Compensation Act of 2002. This program, which is financed entirely by federal funds, provided extended benefits to claimants who had exhausted their regular State unemployment benefits. This program ended during the 2004 fiscal year because of the decrease in the State’s average unemployment rate. The 2003 Session of the General Assembly enacted legislation to help preserve the integrity of the unemployment insurance tax system. Session Law 2003- 67 ( Senate Bill 326) clarifies that an employer cannot avoid an undesirable unemployment insurance rate by shifting employees to a newly created company with a more desirable tax rate. This practice is known as State unemployment tax avoidance or “ SUTA dumping” ( i. e., since the bulk of the old company’s employees are moved to a new company and the higher tax rate of the older company is “ dumped”). 40 State of North Carolina Starting January 1, 2005, a 20 percent surcharge will be in effect for unemployment insurance contributions, as required by State statute. The surcharge will be in effect because of the fund’s low reserves. The proceeds of the surcharge will be credited to the Employment Security Commission Reserve Fund and will improve the solvency of the Unemployment Compensation Fund. EPA Revolving Loan Fund The net assets of the EPA Revolving Loan Fund increased by $ 58.9 million during the current fiscal year, which was a 10.1 percent increase from the prior fiscal year- end. Operating income was $ 9.99 million ( excess of operating revenues over operating expenses). Net nonoperating revenues were $ 42.9 million, consisting primarily of federal capitalization grants and investment earnings. In addition, $ 7.4 million of clean water bond proceeds were transferred in from special revenue funds. State of North Carolina 41 Capital Assets Capital Asset and Debt Administration As of June 30, 2004, the State’s investment in capital assets was $ 25.61 billion, which represents an increase of 7.7 percent from the previous fiscal year- end ( see table below). Capital Assets as of June 30 ( net of depreciation, dollars in thousands) 2004 2003 2004 2003 2004 2003 Land................................................... $ 8 ,300,655 $ 7 ,713,505 $ 2,563 $ 2,563 $ 8 ,303,218 $ 7 ,716,068 Buildings............................................ 1 ,578,963 1 ,369,455 13,231 13,975 1 ,592,194 1 ,383,430 Machinery and equipment.................. 5 62,864 5 51,155 1,314 1,047 5 64,178 5 52,202 Infrastructure: State highway system..................... 1 3,284,267 1 2,444,212 — — 1 3,284,267 1 2,444,212 Other infrastructure......................... 7 6,859 8 0,489 7,866 8,669 8 4,725 8 9,158 Intangible assets................................ 1 06,506 1 08,927 — — 1 06,506 1 08,927 Art, literature, and other artifacts........ 1 ,126 7 — — 1 ,126 7 Construction in progress.................... 1 ,645,656 1 ,452,222 24,533 20,018 1 ,670,189 1 ,472,240 Total........................................... $ 2 5,556,896 $ 2 3,719,972 $ 49,507 $ 46,272 $ 2 5,606,403 $ 2 3,766,244 Total percent change between fiscal years 2003 and 2004 7.7 % 7.0 % 7.7 % Governmental Activities Business- type Activities Total Major capital asset activity includes additions to the State highway system ($ 1.2 billion), right- of- way acquisitions ($ 510 million), and the acquisition/ construction of correctional facilities ($ 239 million). The largest component of capital assets is the State highway system and related right- of- ways. The State has approximately a 78,615- mile highway system, making it the second largest State- maintained highway system in the nation. The system continues to increase as roads are widened and new roads and bridges are constructed. The 2002- 2003 Session of the General Assembly authorized the issuance of up to $ 300 million of special indebtedness to finance the repair and renovation of State facilities and related infrastructure that are supported by the State’s General Fund. Of the $ 300 million, approximately $ 157 million will be allocated to the University of North Carolina System ( component unit). Each of the sixteen constituent institutions of the UNC System will receive a portion of the proceeds for repairs and renovations. The remaining $ 143 million of the proceeds will be used to make repairs and renovations to various State facilities located throughout North Carolina. The State issued $ 125 million in certificates of participation during the 2004 fiscal year to finance repair and renovation projects. At year- end, the remaining authorization was $ 175 million. In addition, the most recent session of the General Assembly ( 2003- 2004) directed the transfer on June 30, 2004, of $ 76.8 million from the unrestricted credit balance of the General Fund in fiscal year 2004 to the Repairs and Renovations Reserve Account, to be applied to the repair and renovation of State and university facilities. In July 2003, the N. C Infrastructure Finance Corporation ( Corporation), a blended component unit of the State, acquired three close security correctional facilities by issuing $ 218.4 million in lease-purchase revenue bonds. Also, during the fiscal year, the Corporation issued $ 158.96 million in certificates of participation to construct and equip two close security correctional facilities and to begin designing a third facility. The Department of Correction is undertaking construction initiatives to address a cell shortfall and to allow for the implementation of sentencing reform. The State’s correctional facility population has more than doubled since 1980. The rapid growth in inmates is attributable to increases in the State’s population, increases in length of stay in correctional facilities, and changes in criminal laws. 42 State of North Carolina As further detailed in Note 19( F) to the financial statements, the State has commitments of $ 1.9 billion for the construction of highway infrastructure, which are expected to be financed by gasoline tax collections and federal funds. Other commitments for the construction and improvement of State government facilities totaled $ 522.9 million, which are expected to be financed primarily by debt proceeds ( certificates of participation), State appropriations, and federal funds. More detailed information about the State’s capital assets is presented in Note 5 to the financial statements. State of North Carolina 43 Long- term Debt At year- end, the State had total long- term debt outstanding of $ 5.54 billion, an increase of 34.9 percent from the previous fiscal year- end ( see table below). Outstanding Debt as of June 30 ( dollars in thousands) 2004 2003 2004 2003 2004 2003 General obligation bonds...................... $ 4,982,860 $ 4,066,990 $ — $ — $ 4,982,860 $ 4,066,990 Revenue bonds.................................... 218,405 — 9 ,325 9 ,570 227,730 9,570 Certificates of participation................... 301,165 17,500 — — 301,165 17,500 Notes payable...................................... 25,008 9,629 — — 25,008 9,629 Total.............................................. $ 5,527,438 $ 4,094,119 $ 9 ,325 $ 9 ,570 $ 5,536,763 $ 4,103,689 Total percent change between fiscal years 2003 and 2004 35.0 % ( 2.6)% 34.9 % Governmental Activities Business- type Activities Total The State’s general obligation bonds are secured by a pledge of the faith, credit, and taxing power of the State. The revenue bonds issued by the State are secured solely by specified revenue sources. The certificates of participation ( COPs) and lease- purchase revenue bonds issued by the N. C. Infrastructure Finance Corporation, a blended component unit of the State, are secured by lease and installment payments made by the State, and in the event of default, by a security interest in the leased facilities pursuant to a leasehold deed of trust ( as applicable). The COPs issued for repair and renovation projects ( see below) are not secured by a lien upon or security interest in the projects or any other property of the State. All payments of the State for the COPs and the lease- purchase revenue bonds are subject to appropriation by the General Assembly. During the 2004 fiscal year, the State issued $ 1.159 billion in general obligations bonds ( excluding refunding issues), $ 218.41 million in lease- purchase revenue bonds, and $ 283.96 million in certificates of participation ( COPs). The new general obligation debt consisted of $ 708 million in public improvement bonds ( consolidation of clean water bonds and higher education bonds), $ 400 million in highway bonds, $ 36 million in natural gas bonds, and $ 15 million in clean water bonds. The proceeds of the lease- purchase revenue bonds were used to acquire three close security correctional facilities in Alexander, Anson, and Scotland counties. The proceeds of the COPs will be used to construct and equip two close security correctional facilities in Greene and Bertie counties and to finance the cost of design and certain additional costs of a third close security correctional facility in Columbus County. The State also issued COPs for the repair and renovation of State facilities and related infrastructure that are supported by the General Fund. The State refinanced $ 336.9 million of its existing debt in 2004 to improve cash flow and to take advantage of lower interest rates. By refinancing the debt, the State will reduce its future debt service payments by approximately $ 13.5 million over the next ten years. Higher Education Authorization The 1999- 2000 Session of the General Assembly authorized the issuance of up to $ 3.1 billion of higher education improvement bonds, which were subsequently approved by the voters of the State. The $ 3.1 billion bond authorization represents the largest debt authorization in the State’s history. The proceeds of these general obligation bonds will be used solely to construct new buildings and to renovate and modernize existing buildings on the State's 58 community college and 16 University of North Carolina campuses. These improvements are needed to meet enrollment demand and to ensure that the State’s college and university buildings meet modern code requirements and are equipped to prepare graduates for twenty- first century jobs. The bond legislation passed by the General Assembly specifies the amount of bond funding that will flow to each community college and university campus. At year- end, the authorized but unissued higher education bonds were $ 1.37 billion. 44 State of North Carolina Recent Legislation and Studies The most recent session of the General Assembly ( 2003- 04 Session) authorized the issuance of up to $ 468 million of special indebtedness to finance vital State facilities for health care and biotechnology. No more than $ 310 million of the special indebtedness may be issued during the 2004- 05 fiscal year. The State is authorized to use special indebtedness to provide: − $ 338 million for constructing five new projects in the University of North Carolina ( UNC) System. These projects consist of a cancer center at UNC- Chapel Hill ($ 180 million), a cardiovascular institute at East Carolina University ($ 60 million), a bioinformatics Center at UNC- Charlotte ($ 35 million), a pharmacy program facility at Elizabeth City State University ($ 28 million), and a health center at UNC- Asheville ($ 35 million). − $ 50 million for land acquisition and planning for five other projects in the UNC System; − $ 35 million for constructing up to five youth development centers; − $ 45 million for capital projects within the State Parks System, including repairs and renovations of park facilities and land acquisition. High priority uses of the debt proceeds include acquiring land near military bases to prevent encroachment. The fiscal impact of the $ 468 million of special indebtedness on the General Fund is expected to be zero because of the annual transfer of revenue from other sources to the General Fund in an amount to cover the estimated debt service. The debt service for the UNC System facilities and the youth development centers will be reimbursed from the Health and Wellness Trust Fund and the Tobacco Trust Fund ( special revenue funds). The debt service for the parks projects is fully funded by the streams of revenue available to the Parks and Recreation Trust Fund, the Natural Heritage Trust Fund, and the Clean Water Management Trust Fund ( special revenue funds). The maximum annual debt service is estimated to be $ 47.4 million in fiscal year 2010- 11. The total interest on the $ 468 million of debt is estimated to be $ 310 million. Special indebtedness is non- voted debt that is generally secured only by an interest in State property being acquired or improved ( e. g., certificates of participation and lease- purchase revenue bonds). With this type of debt, there is no pledge of the State’s faith, credit or taxing power to secure the debt, which is why voter approval is not required. If the State defaulted on its repayments, no deficiency judgment could be rendered against the State, but the State property that serves as security could be disposed of to generate funds to satisfy the debt. Failure to repay the debt would have negative consequences for the State’s credit rating. Article 9 of Chapter 142 of the General Statutes prohibits the issuance of special indebtedness except for projects specifically authorized by the General Assembly. The use of alternative financing methods provides financing flexibility to the State and permits the State to take advantage of changing financial and economic environments. During the 2003- 04 Session, the General Assembly created a Debt Affordability Advisory Committee ( Committee) to annually advise the Governor and the General Assembly on the estimated debt capacity of the State for the upcoming ten fiscal years. The Committee is responsible for preparing an annual debt affordability study and establishing guidelines for evaluating the State’s debt burden. The Committee is required to report its findings and recommendations to the Governor, the General Assembly, and the Fiscal Research Division of the General Assembly by February 1 of each year. In April 2004, the State Treasurer presented to the House and Senate Finance Committees of the General Assembly, the second Debt Affordability Study for North Carolina. It provides a methodology for measuring, monitoring, and managing the State’s debt capacity. The study evaluated the State’s current and projected debt burden using indicators such as tax- supported debt to personal income, debt per capita, debt service to tax revenue, and rapidity of principal repayment ratios. In addition, the report includes several recommendations based on the results of the study. According to the report, all of the State’s debt ratios are below median levels for all fifty states, as compiled by Moody’s Investors Service, and for a peer group of seven states rated triple AAA by all three credit rating agencies. Thus, the study concludes that the State’s debt is considered low and is manageable at the current level. However, due to the projected issuance of $ 2.2 billion of tax- supported debt over the next three years State of North Carolina 45 ( 62 percent for higher education purposes), all of the State’s debt ratios are expected to increase over this period. The State Treasurer noted in the report that credit rating agencies consider a debt affordability study as a positive factor when evaluating issuers and assigning credit ratings. Credit Ratings Credit ratings are the rating agencies’ assessment of a governmental entity’s ability and willingness to repay debt on a timely basis. Credit ratings are an important factor in the public credit markets and can influence interest rates a borrower must pay. The State’s general obligation bonds are rated “ AAA” by Fitch Ratings, “ Aa1” with a positive outlook by Moody’s Investors Service ( Moody’s) and “ AAA” with a stable outlook by Standard & Poor’s Ratings Services. All three agencies base their prime ratings on the State’s strong, diverse economic base, its sound financial management, and low debt levels. In September 2004, Moody’s revised the State’s outlook to positive from stable and noted the following: “ This rating reflects the State’s slowly stabilizing economy, its improving tax revenues, its conservative debt policy, and its effective financial management. While general fund balances remain negative, flexible cash reserves outside the general fund are ample, and pension funding is exceptionally strong. Moody’s expects that the state will continue to take actions to restore structural balance and rebuild reserves.” In August 2002, Moody’s downgraded the State’s credit rating for general obligation debt from “ AAA” to “ Aa1”, representing the first time since 1960 that North Carolina had less than a “ AAA” rating. While Moody’s praised the strength of executive powers available to insure a balanced budget, it advised that the primary reasons for the downgrade were the State’s continued budget pressure, reliance on non- recurring revenues, and weakened balance sheet. Also, Moody’s commented that the task of restoring structural budget balance and rebuilding reserves faces political and economic obstacles. The certificates of participation and lease- purchase revenue bonds issued by the North Carolina Infrastructure Finance Corporation are rated “ AA+” by Standard & Poor’s, “ AA” by Fitch, and “ Aa2” by Moody’s. Limitations on Debt The Constitution of North Carolina ( Article 5, Section 3) imposes limitations upon the increase of certain State debt. It restricts the General Assembly from contracting debts secured by a pledge of the faith and credit of the State, unless approved by a majority of the qualified voters of the State, except for the following purposes: 1. To fund or refund a valid existing debt; 2. To supply an unforeseen deficiency in the revenue; 3. To borrow in anticipation of the collection of taxes due and payable within the current fiscal year to an amount not exceeding 50 percent of such taxes; 4. To suppress riots or insurrections; or to repel invasions; 5. To meet emergencies immediately threatening the public health or safety, as conclusively determined in writing by the Governor; and 6. For any other lawful purpose, to the extent of two- thirds of the amount by which the State’s outstanding indebtedness shall have been reduced during the next preceding biennium. More detailed information about the State’s long- term liabilities is presented in Note 7 to the financial statements. 46 State of North Carolina Budget and Economic Update The General Fund budget for 2004- 05 was signed into law on July 20, 2004. The enacted budget was founded upon an overall nominal ( real growth plus inflation) economic growth rate of 5.5 percent for 2004- 05. The budget continues the State sales and use tax rate at 4.5 percent and the 8.25 percent income tax bracket for fiscal year 2004- 05 ( Note: the half- cent sales tax increase and the high income tax bracket are scheduled to sunset at the end of the year), diverts a portion of the national tobacco settlement payments ($ 60 million), and uses monies left over at the end of the 2003- 04 fiscal year ($ 289.4 million). It also earmarked an additional $ 116.7 million for the Rainy Day Fund and $ 76.8 million for the Repair and Renovation Reserve, indicating the State’s intention to continue to replenish its reserves. The 2004 hurricane season produced six tropical systems that directly impacted North Carolina. Federal, State, and local emergency management officials estimate that these storms caused over $ 200 million in damages that are eligible for governmental assistance. Assistance is for a variety of services including emergency protective measures, repair and replacement of homes, debris removal, stream clearance, and bridge repair and replacement. In order to match federal funds available to North Carolina for federal disaster recovery services, the Governor ordered State agencies to revert 0.75 percent of their 2004- 05 budgets to provide an estimated $ 120 million for storm relief. Special exemptions are allowed for constitutionally mandated programs as well as emergency situations related to law enforcement, health care, and public safety. North Carolina’s seasonally adjusted unemployment rate as of September 2004 was 4.8 percent, more than a half a percentage point lower than the national unemployment rate of 5.4 percent. September was the seventh consecutive month that the State’s unemployment rate was below the national average. For comparison, the State and national unemployment rates as of September 2003 were 6.4 percent and 6.1 percent, respectively. 2004- 05 Revenue Update ( Cash Basis) For the first three months of the 2004- 05 fiscal year, General Fund revenues, ( tax and non- tax revenues) came in $ 74.3 million higher than the $ 3.5 billion forecast for the period. A continuation of the current trend would lead to revenue growth of 7.6 percent for the full year versus the 5.5 percent economic growth rate built into the budget. However, an analysis of the collection detail reveals that the improvement is not broad- based. Of the extra collections, $ 65.1 million came from one source, corporate income taxes. While other taxes are also increasing, the net surplus from other revenues is only $ 8.8 million. Additionally, $ 30 million of the extra corporate collections is the result of a one- time settlement in August 2004 of a long- standing corporate tax dispute not directly related to the economy. Also, $ 31.8 million of the corporate surplus came from a 33 percent rise in September 2004 payments. This rise is in contrast to the 10.2 percent decline in June and the 2.7 percent drop in April ( April, June, and September are major corporate collection months). Because of the volatility of the corporate income tax, it will be difficult for the State to maintain this growth as higher interest rates and increased energy costs impact the economy Other taxes are increasing but at different rates. The withholding of individual income tax receipts are $ 18.2 million behind schedule for the first quarter ( 4.6 percent growth versus budgeted rate of 5.7 percent). The primary factor is sluggish job growth. State and local sales tax collections rose by 8.2 percent for the July to September 2004 quarter versus the 6.1 percent projection for the period. However, the rate of growth slowed to 6.7 percent for September from almost 10 percent in August. The impact of recent hurricanes has taken a severe toll on certain areas of the State. The effect on State and local revenues is hard to measure. In a typical disaster event, the front- end loss in withholding and sales tax revenue is eventually offset by gains during the recovery period due to reconstruction efforts and the makeup of lost production. The improving revenue picture, though not as broad- based or as strong during prior recoveries, is dampened by the State’s $ 1.1 billion structural budget gap for the 2005- 06 fiscal year. The gap is due to a combination of tax increases that will expire ($ 525 million), one- time transfers used to balance the 2003- 04 and the 2004- 05 budgets, and one- time budget cuts. The budget gap numbers for North Carolina are typical of other states following the severe 2001- 03 recession. State of North Carolina 47 Conditions Expected to Impact Future Operations The North Carolina Retirement System has identified major issues that will have a significant impact on the State’s fiscal condition. Demographic Factors: The Baby Boomers The process of retirement for the demographic cohort known as the “ Baby Boomers” will have tremendous economic, social, and political impact in North Carolina. Two critical areas in which the “ Boomer” retirement will be significantly consequential are: A) public sector workforce, and B) the cost to the State of providing retirement benefits. Workforce Impact: • The Baby Boomers are an eighteen- year cohort, currently between forty ( 40) and fifty- eight ( 58) years of age. • In North Carolina this cohort constitutes approximately 59 percent of the State’s public workforce. Impact: the State’s public sector workforce will have to be replenished as this cohort moves into retirement. • Further, replacement personnel will be drawn from a shrinking pool of workers made up of considerably smaller generations than the boomer predecessors. Impact: the State will be faced with an increasingly competitive labor market. • Implications: North Carolina will have to address these impacts by one or more of the following: expand its efforts to retain aging boomers in the public sector and thus slow the rate of retirement, or become more competitive in the labor market in order to recruit workers to State employment or reduce the number of public sector positions. Providing Retirement Benefits: • The first year of the eighteen ( 18) year boomer cohort has just reached the average age of retirement in the State system for 2003, which is aged 58 ½ . Impact: the first of the Boomer cohort is on the cusp of retirement, marking the beginning of boomer retirement from the North Carolina public sector. • The total number of retirees in the North Carolina Teachers’ and State Employees’ Retirement System will increase 135% through 2022 ( the total increase for both the State and the Local government systems is 141%). Impact: the cost to the State of providing retirement benefits will increase. ( Note: Increasing costs are not driven by the cost of providing an actual pension as employees and employers fund the pension over the employee’s service career. The increase in cost will come from administrative expenses and the cost of providing Cost of Living Adjustments ( COLAs) for a significantly larger retiree pool.) • While a set rate for Cost of Living Adjustments ( COLA) is not specified in statute, the State has historically provided retirees with an annual COLA that matches the Consumer Price Index ( CPI). Impact: if the State continues to provide a COLA to retirees, expenditures from the General Fund will have to increase to cover the cost of providing such COLAs for an increasing pool of retirees. • Implications: to be competitive in tomorrow’s labor market, North Carolina will have to continue to provide attractive benefits such as the State’s retirement plan; this will occur during a time when system administration and COLAs costs will increase significantly as the number of retirees exponentially expands. Retiree Health Care The Governmental Accounting Standards Board ( GASB) reporting guidelines that will require disclosure of the State’s liabilities for retiree health care costs ( i. e., GASB Statements No. 43 and 45) is one of the State’s largest looming fiscal items. The Retirement System facilitates the benefit by making the deduction for the State Health Plan from retirees’ pension checks. The Retirement System is also the front line organization for retirees who want to voice their concerns about changes, or potential changes, to benefits. Ultimately, the provision of health care for the State’s public sector retirees is the responsibility of the State Health Plan. The unfunded actuarial liability for retiree health care is substantial because of the State’s policy of funding these benefits on a pay- as- you- go basis. 48 State of North Carolina In preparation for the new GASB standards on other postemployment benfits, the North Carolina General Assembly enacted legislation in 2004 establishing a Retiree Health Benefit Fund. The State’s contributions to this fund are irrevocable, and the assets of the fund are not subject to the claims of the State’s creditors. More detailed information about the State’s obligations for Retiree Health Care is presented in the Letter of Transmittal. In addition, the announcement of a new computer manufacturing facility by Dell, Inc. is expected to impact future operations. Dell Manufacturing Facility In November 2004, Governor Michael F. Easley announced that Dell, Inc. ( Dell) will build a computer manufacturing facility in North Carolina. Dell, a leading manufacturer and distributor of computers and related products, plans to build and equip a state- of- the- art, 400,000- square- foot manufacturing and distribution facility in the Piedmont Triad region. Dell currently has two U. S. factories in Nashville, Tennessee and Austin, Texas. The North Carolina General Assembly convened a one- day special session on November 4, 2004 an approved an economic incentive for computer manufacturing companies that in the case of Dell, will provide up to $ 225 million in tax credits over the next fifteen years. For each year in which Dell meets the required performance targets, the State will provide a grant equal to 75 percent of the State personal income withholding taxes derived from the creation of new jobs. Requests for Information This financial report is designed to provide our citizens, taxpayers, customers, and investors and creditors with a general overview of the State’s finances and to demonstrate the State’s accountability for the money it receives. If you have questions about this report or need additional financial information, contact the North Carolina Office of the State Controller, Accounting and Financial Reporting Section, 1410 Mail Service Center, Raleigh, N. C. 27699- 1410. In addition, this financial report is available on the Office of the State Controller’s Internet home page at http:// www. ncosc. net/ financial/ financial. html. BASIC FINANCIAL STATEMENTS 50 State of North Carolina THIS PAGE INTENTIONALLY LEFT BLANK. GOVERNMENT- WIDE FINANCIAL STATEMENTS 52 State of North Carolina STATEMENT OF NET ASSETS June 30, 2004 Exhibit A- 1 ( Dollars in Thousands) Primary Government Governmental Business- type Component Activities Activities Total Units ASSETS Cash and cash equivalents ( Note 3)................................ $ 4,105,858 $ 249,802 $ 4,355,660 $ 2,700,361 Investments ( Note 3)........................................................ 499,164 38,409 537,573 2,050,256 Securities lending collateral ( Note 3)................................ 3,426,369 193,909 3,620,278 — Receivables, net ( Note 4).................................................. 2,051,983 297,705 2,349,688 735,038 Due from component units ( Note 17)................................ 18,202 — 18,202 55,833 Due from primary government ( Note 17).......................... — — — 276,402 Internal balances............................................................... ( 58) 58 — — Inventories......................................................................... 150,730 485 151,215 69,786 Prepaid items.................................................................... 12,337 1,845 14,182 13,854 Advances to component units ( Note 17)........................... 24,242 — 24,242 — Notes receivable, net ( Note 4).......................................... 282,678 435,220 717,898 2,890,667 Endowment investments ( Note 3)..................................... 55,211 — 55,211 1,715,044 Investment in joint venture................................................ — — — 8,319 Deferred charges.............................................................. — 118 118 20,661 Securities held in trust....................................................... 41,638 — 41,638 — Pension assets ( Note 11).................................................. 278 — 278 — Capital assets- nondepreciable ( Note 5)............................ 9,947,437 27,096 9,974,533 1,608,640 Capital assets- depreciable, net ( Note 5)........................... 15,609,459 22,411 15,631,870 5,068,825 Total Assets ..................................................................... 36,225,528 1,267,058 37,492,586 17,213,686 LIABILITIES Accounts payable and accrued liabilities.......................... 1,239,924 24,067 1,263,991 549,345 Medical claims payable..................................................... 762,427 — 762,427 7,308 Unemployment benefits payable....................................... — 20,048 20,048 — Tax refunds payable.......................................................... 1,056,880 — 1,056,880 — Obligations under securities lending................................. 3,426,369 193,909 3,620,278 — Interest payable................................................................. 57,931 35 57,966 24,201 Short- term debt ( Note 6)................................................... — 251,759 251,759 2
Object Description
Description
Title | Comprehensive annual financial report for the year ended June 30,... |
Other Title | North Carolina comprehensive annual financial report |
Date | 2004 |
Description | 2004 |
Digital Characteristics-A | 5 KB; 241 p. |
Digital Format | application/pdf |
Pres Local File Path-M | \Preservation_content\StatePubs\pubs_borndigital\images_master\ |
Full Text | NORTH CAROLINA COMPREHENSIVE ANNUAL FINANCIAL REPORT FOR THE FISCAL YEAR ENDED JUNE 30, 2004 MICHAEL F. EASLEY GOVERNOR ROBERT L. POWELL STATE CONTROLLER Prepared by Statewide Accounting Division Office of the State Controller http:// www. ncosc. net/ 2 State of North Carolina This report was prepared by the Statewide Accounting Division of the North Carolina Office of the State Controller. John Barfield, CPA ASSISTANT STATE CONTROLLER jbarfield@ ncosc. net Anne Godwin, CPA Statewide Accounting and Financial Reporting Manager agodwin@ ncosc. net Amber Young Central Compliance Manager ayoung@ ncosc. net Statewide Accounting Division Staff Robert Alford, CPA Martha Hunt, CPA Cindy Salgado, CPA Ann Anderson Cathy Johnson Melody Tart Angela Clark Darlene Langston, CPA Shirley Trollinger John Eliadis Michelle Lassiter Cynthia Vincent Pam Fowler, CPA Clayton Murphy, CPA Helen Vozzo, CPA Luke Harris Terri Noblin, CPA Virginia Warren Special appreciation is given to the chief fiscal officers and the dedicated accounting personnel throughout the State. Their efforts to contribute accurate and timely financial data for their agencies, universities, community colleges, and institutions made this report possible. State of North Carolina 3 MICHAEL F. EASLEY Governor of North Carolina 4 State of North Carolina TABLE OF CONTENTS Comprehensive Annual Financial Report For the Fiscal Year Ended June 30, 2004 INTRODUCTORY SECTION Letter of Transmittal.................................................................................................................... ............................................................................................ 8 Certificate of Achievement for Excellence in Financial Reporting...................................................................................................................... ................... 19 Organization of North Carolina State Government, including principal State officials........................................................................................................... 20 FINANCIAL SECTION Report of Independent Auditor........................................................................................................................ ........................................................................ 24 Management's Discussion and Analysis....................................................................................................................... ........................................................... 28 Basic Financial Statements Government- wide Financial Statements Statement of Net Assets — Exhibit A- 1.............................................................................................................................. .................................................... 52 Statement of Activities — Exhibit A- 2.............................................................................................................................. ..................................................... 54 Fund Financial Statements Balance Sheet— Governmental Funds — Exhibit B- 1.............................................................................................................................. ............................... 58 Reconciliation of the Governmental Funds Balance Sheet to the Statement of Net Assets — Exhibit B- 1a............................................................................ 59 Statement of Revenues, Expenditures, and Changes in Fund Balances— Governmental Funds — Exhibit B- 2...................................................................... 60 Reconciliation of the Statement of Revenues, Expenditures, and Changes in Fund Balances of Governmental Funds to the Statement of Activities — Exhibit B- 2a........................................................................................................................... 61 Statement of Net Assets— Proprietary Funds — Exhibit B- 3.............................................................................................................................. ................... 62 Statement of Revenues, Expenses, and Changes in Fund Net Assets— Proprietary Funds — Exhibit B- 4.............................................................................. 63 Statement of Cash Flows— Proprietary Funds — Exhibit B- 5.............................................................................................................................. .................. 64 Statement of Fiduciary Net Assets— Fiduciary Funds — Exhibit B- 6.............................................................................................................................. ...... 66 Statement of Changes in Fiduciary Net Assets— Fiduciary Funds — Exhibit B- 7............................................................................................................. 67 Notes to the Financial Statements..................................................................................................................... ....................................................................... 70 Required Supplementary Information Schedules of Funding Progress— All Defined Benefit Pension Trust Funds.......................................................................................................................... 150 Schedule of Contributions from the Employers and Other Contributing Entities— All Defined Benefit Pension Trust Funds.............................................. 151 Schedule of Revenues, Expenditures and Changes in Unreserved Fund Balances— Budget and Actual —( Budgetary Basis— Non- GAAP) General Fund........................................................................................................................... ................................ 152 Notes to Required Supplementary Information— Budgetary Reporting...................................................................................................................... ............ 153 Combining Fund Statements and Schedules Nonmajor Governmental Funds Combining Balance Sheet— Nonmajor Governmental Funds — Exhibit C- 1.......................................................................................................................... 160 Combining Statement of Revenues, Expenditures, and Changes in Fund Balances— Nonmajor Governmental Funds — Exhibit C- 2.................................. 161 Combining Balance Sheet— Nonmajor Special Revenue Funds — Exhibit C- 3...................................................................................................................... 164 Combining Statement of Revenues, Expenditures, and Changes in Fund Balances— Nonmajor Special Revenue Funds — Exhibit C- 4.............................. 168 Combining Schedule of Revenues, Expenditures and Changes in Unreserved Fund Balances — Budget and Actual ( Budgetary Basis— Non- GAAP) Nonmajor Special Revenue Funds — Exhibit C- 5................................................................ 172 Combining Balance Sheet— Nonmajor Capital Projects Funds — Exhibit C- 6....................................................................................................................... 178 Combining Statement of Revenues, Expenditures, and Changes in Fund Balances— Nonmajor Capital Projects Funds — Exhibit C- 7............................... 179 Combining Balance Sheet— Nonmajor Permanent Funds — Exhibit C- 8.............................................................................................................................. 182 Combining Statement of Revenues, Expenditures, and Changes in Fund Balances— Nonmajor Permanent Funds — Exhibit C- 9....................................... 183 Proprietary Funds Nonmajor Enterprise Funds Combining Statement of Net Assets— Nonmajor Enterprise Funds — Exhibit D- 1................................................................................................................ 188 Combining Statement of Revenues, Expenses, and Changes in Fund Net Assets— Nonmajor Enterprise Funds — Exhibit D- 2........................................... 189 Combining Statement of Cash Flows— Nonmajor Enterprise Funds — Exhibit D- 3.............................................................................................................. 190 Internal Service Funds Combining Statement of Net Assets— Internal Service Funds — Exhibit E- 1......................................................................................................................... 192 Combining Statement of Revenues, Expenses, and Changes in Fund Net Assets— Internal Service Funds — Exhibit E- 2.................................................... 194 Combining Statement of Cash Flows— Internal Service Funds — Exhibit E- 3....................................................................................................................... 196 Fiduciary Funds Combining Statement of Fiduciary Net Assets— Private Purpose Trust Funds — Exhibit F- 1............................................................................................... 202 Combining Statement of Changes in Fiduciary Net Assets— Private Purpose Trust Funds — Exhibit F- 2....................................................................... 203 Combining Statement of Changes in Assets and Liabilities— Agency Funds — Exhibit F- 3.................................................................................................. 206 State of North Carolina 5 Comprehensive Annual Financial Report For the Fiscal Year Ended June 30, 2004 Nonmajor Component Units - Discretely Presented Combining Statement of Net Assets— Nonmajor Component Units — Exhibit G- 1............................................................................................................... 212 Combining Statement of Activities— Nonmajor Component Units — Exhibit G- 2................................................................................................................ 213 STATISTICAL SECTION Revenues by Source and Expenditures by Function— All Governmental Fund Types ( GAAP Basis) — Table 1................................................................... 216 Schedule of Revenues by Source— General Fund ( GAAP Basis) — Table 2.......................................................................................................................... 218 General Obligation Bonds Debt Ratios — Table 3.............................................................................................................................. .................................... 220 Revenue Bond Coverage — Table 4.............................................................................................................................. .......................................................... 221 Schedule of General Obligation Bonds Payable — Table 5.............................................................................................................................. ...................... 222 Schedule of Special Obligation Debt — Table 6.............................................................................................................................. ....................................... 228 Statewide Assessed Property Values— Real Property, Tangible Personal Property and Public Service Companies — Table 7............................................. 229 Schedule of Bank and Savings and Loan Deposits of Financial Institutions Located in North Carolina — Table 8............................................................... 230 Cash Receipts from Farming by Commodities — Table 9.............................................................................................................................. ........................ 231 Major Private Employers in North Carolina — Table 10............................................................................................................................. ........................... 232 Schedule of Demographic Data — Table 11............................................................................................................................. .............................................. 234 Ten Largest Non- Agricultural Industries by Number of Employees — Table 12.................................................................................................................... 236 Total Number of State Government Permanent Positions Funded in the State Budget by Agency — Table 13...................................................................... 237 Required Supplementary Information— Ten- Year Claims Development Information — Public School Insurance Fund — Table 14................................... 238 Schedule of Miscellaneous Statistics — Table 15............................................................................................................................. ...................................... 240 6 State of North Carolina THIS PAGE INTENTIONALLY LEFT BLANK. INTRODUCTORY SECTION State of North Carolina Office of the State Controller Michael F. Easley, Governor Robert L. Powell, State Controller MAILING ADDRESS 1410 Mail Service Center Raleigh, NC 27699- 1410 Telephone: ( 919) 981- 5454 Fax Number: ( 919) 981- 5567 State Courier: 56- 50- 10 LOCATION 3512 Bush Street Raleigh, NC Website: www. ncosc. net An Equal Opportunity/ Affirmative Action/ Americans With Disabilities Employer The Honorable Michael F. Easley, Governor Members of the North Carolina General Assembly Citizens of North Carolina It is our pleasure to furnish you with the 2004 Comprehensive Annual Financial Report ( CAFR) of the State of North Carolina in compliance with G. S. 143B- 426.39. This report has been prepared by the Office of the State Controller. Responsibility for both the accuracy of the data and the completeness and fairness of the presentation, including all disclo-sures, rests with the State government and this office. To the best of our knowledge and belief, this financial report is complete and reliable in all material respects. We believe all disclosures necessary to enable you to gain an understanding of the State's financial activities have been included. Although the State budgets and manages its financial affairs on the cash basis of accounting, G. S. 143- 20.1 requires the Office of the State Controller to prepare a comprehensive annual financial report ( CAFR) in accordance with generally accepted accounting principles in the United States of America ( GAAP). Except for exhibits and notes clearly labeled otherwise, this CAFR has been prepared in accordance with GAAP. For the convenience of users we have divided this comprehensive annual financial report into three major sections, described as follows: • The introductory section includes this transmittal letter and the State's organization chart, including a listing of principal State officials. • The financial section includes management discussion and analysis, the basic financial statements ( government- wide financial statements, fund financial statements, and notes), other required supplementary information, the combining and individual fund financial statements, and schedules. • The statistical section includes selected financial, non- financial and demographic information, much of which is presented on a ten- year basis, as well as required supplementary information. Management of the government is responsible for establishing and maintaining an internal control structure designed to ensure that the assets of the State are protected from loss, theft or misuse and to ensure that adequate accounting data are compiled to allow for the preparation of financial statements in conformity with generally accepted accounting principles. The internal control structure is designed to provide reasonable, but not absolute, assurance that these objectives are met. The concept of reasonable assurance recognizes that: ( 1) the cost of a control should not exceed the benefits likely to be derived, and ( 2) the valuation of costs and benefits requires estimates and judgments by management. GASB Statement No. 34, Basic Financial Statements – and Management’s Discussion and Analysis – for State and Local Governments, requires that management provide a narrative introduction, overview and analysis to accompany the Basic Financial Statements in the form of management discussion and analysis ( MD& A). This letter of transmittal is intended to complement MD& A and should be read in conjunction with it. The MD& A can be found immediately following the Independent Auditor’s Report. State of North Carolina 9 Profile of the Government The State of North Carolina entity as reported in the CAFR includes all fund types of the departments, agencies, boards, commissions and authorities governed and legally controlled by the State's executive, legislative and judicial branches. In addition, the reporting entity includes legally separate component units for which the State is financially accountable. The component units are discretely presented in the government- wide financial statements. The State's discretely presented major component units are the University of North Carolina System; the State's community colleges; Golden LEAF, North Carolina Housing Finance Agency, and North Carolina State Education Assistance Authority. The criteria for inclusion in the reporting entity and its presentation are defined by the Governmental Accounting Standards Board ( GASB) in its GASB Codification Section 2100. These criteria are described in Note 1 of the accompanying financial statements. The State and its component units provide a broad range of services to its citizens, including public education; higher education; health and human services; economic development; environment and natural resources; public safety, corrections, and regulation; transportation; agriculture; and general government services. The costs of these services are reflected in detail and in summary in this report. In addition to internal controls discussed previously, the State maintains budgetary controls. The objective of these budgetary controls is to ensure compliance with legal provisions embodied in the annual appropriated budget approved by the General Assembly. Activities of the General Fund and most departmental special revenue funds are included in the annual appropriated budget. The State Highway Fund and the Highway Trust Fund, the State's major special revenue funds, are primarily budgeted on a multi- year basis. Capital projects are funded and planned in accordance with the time it will take to complete the project. The level of budgetary control ( that is, the level at which expenditures cannot legally exceed the appropriated amount) is exercised at both the departmental and university level by way of quarterly allotments, with allotment control exercised by the State Controller, and on the program line-item levels requiring certain approvals by the Director of the Budget. Legislative authorization of departmental expenditures appears in the State Appropriation Bill. This " Certified Budget" is the legal expenditure authority; however, the Office of State Budget and Management ( OSBM) may approve executive changes to the legal budget as allowed by law. This results in the " Final Budget" presented in the required supplementary information. State Reporting Entity and Its Services Budgetary Control 10 State of North Carolina Economic Condition and Outlook After experiencing robust growth during the first half of the 2004 calendar year, the nation’s economy is now working through what is commonly referred to as a “ soft patch”. This weakness is due to a combination of record energy prices ( in actual dollars) and periodic warnings of potential terrorist activity. An additional issue has to do with the fact that the stimulus from three federal tax packages enacted in recent years is starting to run out. 2001- 02 2002- 03 2003- 04 2004- 05 Actual Actual Actual Projected U. S. INDICATORS Real Economic Growth* 0.8% 2.3% 4.4% 3.5% Nonfarm Employment - 1.0% - 0.6% 0.2% 1.7% Personal Income 2.0% 2.1% 4.7% 4.9% Industrial Production - 3.5% 0.5% 2.4% 4.4% Corporate Profits ( Pre- Tax) - 8.6% 17.3% 15.2% 12.1% Short- Term Interest Rates ( Actual Rate) 2.3% 1.4% 1.0% 2.0% Mortgage Rates ( Actual Rate) 6.9% 6.0% 5.7% 6.1% Inflation ( CPI) 1.8% 2.2% 2.2% 2.5% * Adjusted for inflation. It will be interesting to see how the current weakness affects the speed with which the Federal Reserve ratchets up interest rates. As recently as last winter many observers felt that the tenuous nature of the recovery would eliminate any rate hikes during 2004. Fed officials even confirmed this operating strategy in unusually candid public remarks. However, strong growth during the first few months of the year led to a re- examination of the position last spring. After raising the benchmark federal funds rate from .75% to 1% on June 30 and to 1.25% in August, the Federal Reserve is now signaling additional rate hikes will take place at a “ measured” pace. The message to be gleaned from the Fed’s language is that future actions will depend on how the economic data falls out. The recent weakness may cause monetary officials to hold off on the anticipated September increase, especially in light of their pronouncements about the impact of high energy prices. In any case, the die has been cast and rates will rise over the next couple of years. During the 1994 tightening, short term borrowing rates rose from 3% to 6% in a 13- month period. Economy. com, the forecasting firm used by Fiscal Research, expects the rates to rise to 2.0% by the first quarter of 2005 and to top out at 5.0% during the first quarter of 2007. The forecasting firm used by the Office of State Budget and Management, Global Insight Inc., is also expecting a 2.0% rate by the end of this year, rising to 3.5% by 2006. National Economic Outlook State of North Carolina 11 A continuing problem for the economy is the subpar recovery in jobs. This is due to a combination of the movement of jobs overseas and the reticence of employers to ramp up staffing levels in an atmosphere of uncertainty. North Carolina is on the front line of this shift, due in part to NAFTA. This impact had begun well before the 2001 recession, as shown by the job growth data below: N. C. Employment Growth In Selected Major Sectors Year Manufacturing Finance Services 1994 0.5% 1.2% 7.6% 1995 0.5% 1.9% 4.5% 1996 - 1.7% 8.2% 4.5% 1997 - 1.0% 7.4% 5.7% 1998 - 0.5% 5.3% 6.0% 1999 - 2.5% - 0.4% 6.0% 2000 - 2.4% 0.7% 3.3% 2001 - 7.1% 4.6% 1.4% 2002 - 8.6% .7% 1.1% 2003 - 6.1% 1.5% .7% A second issue has to do with the impact of higher energy prices on consumer spending. From late winter 1999 to early summer 1999, gas prices in North Carolina rose from around 80 cents per gallon to $ 1.00, and to $ 1.25 by early 2000. Once motorists realized that the increase might be more than a temporary spike, they cut back on purchases of other items ( except for vehicles). One way to measure this impact is to look at gross state and local sales tax collections. After rising 8.6% for the second quarter of 1999, the rate of increase fell to 6.3% for the third quarter, 5.4% for the fourth quarter, and to 4.5% by the first quarter of 2000. This problem was compounded by the fact that heavy promotional activity by auto dealers propped up car sales. The net result of these factors meant that the additional dollars going to vehicle purchases and energy costs “ crowded out” spending on other items. So far the impact of higher energy prices in 2004 on the overall economy and retail sales has been muted. For one thing, the recovery in equity prices has enhanced the “ paper wealth” of many investors. In addition, the substitution of natural gas and other energy sources for fuel oil has minimized the impact of higher fuel prices on manufacturing production costs and family budgets. A third factor is the cash received by homeowners who have refinanced their mortgages. A concern is that financing for retail activity may be coming from additional credit card usage and such levels cannot be sustained indefinitely. A measure of this issue is the fact that unlike the 1992- 94 recovery, sales tax collections are growing much faster than withholding tax receipts. Due to this concern and the phase out of the impact of the 2001- 03 federal tax cuts, the underlying national economic assumptions used in the budget reflect the expectation that growth will slow during the 2004- 05 fiscal years. One of the primary characteristics of the 2001 recession was the impact on the manufacturing sector. This is important to North Carolina because 15% of our nonagricultural employment is in manufacturing versus 11% for the U. S. A more important measure is the share of Gross State Product represented by manufacturing: 21% in North Carolina versus 16% for the nation. State Prospects 12 State of North Carolina The loss of manufacturing jobs did not begin with the 2001 recession. Data compiled by the Employment Security Commission indicate that manufacturing experienced a fairly rapid recovery from the 1990- 91 recession, with employment growth of 2.6% in 1993. In fact, the “ boom and bust” nature of manufacturing is one reason why the state’s economy grew 33% faster than the national experience following the 1981- 82 recession and 45% quicker following the Gulf War downturn. Expressed another way, North Carolina was the fifth fastest growing state during the 1992- 93 period in terms of personal income, due in part to the recovery in manufacturing. After a leveling off period, manufacturing employment began a steady decline in mid- 1995 due to the mild national economic slowdown and the kicking in of NAFTA. The rate of decline began to accelerate in February 2001 and peaked at an 8.6% rate in 2002. Particularly hard hit were the textile and apparel sectors, with North Carolina jobs in these sectors dropping over 15% on a year- over- year basis by the spring of 2001. While the rate of decline has slowed due to the start of the economic recovery, the erosion continues. The only saving grace is that the loss of traditional jobs has been so great that these sectors exert a much smaller impact on the overall economy than in the past. For the 2004- 05 fiscal year, we are budgeting on the basis of a continued subpar economic recovery in North Carolina, both in terms of the absolute level and the normal growth premium relative to the U. S. This experience would be very different from the explosive growth in the state’s economy during the last two recoveries. 2001- 02 2002- 03 2003- 04 2004- 05 Actual Actual Actual Projected NORTH CAROLINA INDICATORS Personal Income 2.2% 2.3% 5.2% 5.5% Nonfarm Employment - 2.1% - 1.1% 0.1% 2.1% Unemployment Rate ( Actual Rate) 6.5% 6.5% 6.0% 5.4% Average Hourly Earnings ( Manufacturing) 2.6% 2.6% 4.4% 3.2% Retail Sales 2.5% 1.1% 6.7% 3.9% Housing Activity 7.3% 6.1% 17.0% - 14.3% Auto Sales - 5.5% - 1.4% 8.5% - 10.9% — Economic analysis prepared by David Crotts Fiscal Research Division North Carolina General Assembly October 29, 2004 Issues and Observations During fiscal year 2004, the Governor, the General Assembly, and the departments and agencies of State government worked to address key issues facing State government and the citizens of North Carolina. More discussion of the financial issues of North Carolina can be found in the Management’s Discussion and Analysis ( MD& A) section of this document. Rising healthcare costs continue to be a concern throughout the State and the nation. Healthcare costs impact State budget programs through increasing expenses not only in Medicaid, but also in other State and federal healthcare programs. In recent years, adjustments have been made to deductibles, co- payments, and benefits coverage under the State Health Plan in an attempt to slow the growth of State budget healthcare costs. Other Post- Employment Benefits State of North Carolina 13 In light of the current and future concerns related to rising healthcare costs, the Governmental Accounting Standards Board ( GASB) has been working on the issuance of accounting and reporting standards for other post- employment benefits since the mid- 90’ s. In April 2004, GASB issued Statement No. 43, Financial Reporting for Postemployment Benefit Plans Other Than Pension Plans ( effective for fiscal year 2006- 07), and in June 2004, GASB issued Statement No. 45, Accounting and Financial Reporting by Employers for Postemployment Benefits Other Than Pensions ( effective for fiscal year 2007- 08). These new standards will require governmental employers to start accounting for the cost of certain post employment benefits while employees are still working. Public sector employers already accrue the cost of pensions as employees are working. These new standards will have a significant impact for most state and local governments. In addition to pensions, many state and local governmental employers provide other postemployment benefits ( OPEB) as part of the total compensation offered to attract and retain the services of qualified employees. The cost of these future benefits is a part of the cost of providing public services today. OPEB includes postemployment healthcare, as well as other forms of postemployment benefits, such as life insurance and disability. Currently, the State and most other governmental employers finance OPEB plans on a pay- as- you- go basis. The financial statements generally do not report financial effects of OPEB until the promised benefits are paid, often many years after the related employee services are received. These new GASB standards will improve the relevance and usefulness of financial reporting by ( a) requiring systematic, accrual- basis measurement and recognition of OPEB cost ( expense) over a period that approximates employees’ years of service, and ( b) providing information about actuarial accrued liabilities associated with OPEB and whether and to what extent progress is being made in funding the plan. In addition, the proposed accounting change would provide information useful in assessing potential demands on the employer’s future cash flows. In preparation for the implementation of these new standards, the General Assembly through the 2004 Appropriations Act established the Retiree Health Benefit Trust Fund to hold accumulated contributions from employers and any earnings on those contributions shall be used to provide health benefits to retired and disabled employees and their applicable beneficiaries. Employer contributions to the Fund are irrevocable. The assets of the Fund are dedicated to providing health benefits to retired and disabled employees and their applicable beneficiaries and are not subject to the claims of creditors of the employers making contributions. Three actuarial studies related to retiree healthcare have been completed as the State has worked to get its hands around the issue and how to deal with it. Each of the three studies, beginning in 1996, have reflected a substantial liability related to the State’s commitment to provide healthcare to teacher and state employee retirees. The unfunded actuarial liability has grown based on two formal studies from $ 5.4 billion in 1996, to $ 8.1 billion in 1999. More recently, based on an informal estimate, the unfunded accrued liability may be in excess of $ 10 billion in 2004. This informal study does not reflect any changes that may arise in 2006 due to the “ Medicare Prescription Drug, Improvements, and Modernization Act of 2003”. Beginning in fiscal year 2006- 07, the actuarial data will be disclosed in the notes to the State CAFR and will also be presented as Required Supplementary Information ( RSI). The unfunded actuarial liability will not be recorded as an accounting liability but will be disclosed in the notes to the financial statements, and as required supplementary information. Beginning with the 2008 CAFR, the difference between the State’s contractual requirement and the amount the State contributes or pays for retiree medical benefits will be recorded as an accounting liability on the State’s government- wide financial statements. 14 State of North Carolina The State’s largest OPEB plan, the Retiree Health Care Plan, is currently being funded on a pay- as- you- go basis, resulting in a significant unfunded actuarial liability. The principal results of the Plan’s most recent actuarial valuation are as follows: Because the GASB’s proposed guidance on OPEB will significantly impact the State’s CAFR, we have the following recommendations: • The State needs to obtain an actuarial valuation for the retiree health plan at least biennially. Annual valuations would be preferable for a state of our size, due to the potential impact on teachers and state employees. • On a prospective basis, the State should consider the long- term impact of the current benefits structure as well as potential changes to that structure. The 2004 General Assembly dedicated considerable time and effort into the evaluation of current information technology management, organization, and operations at the statewide and agency levels for North Carolina State government. The result of that evaluation was legislation enacted in Senate Bill 991 that overhauled information technology authority by transferring it from a central management committee to the Chief Information Officer for the State. Senate Bill 991 provides for the abolishment of the Information Resources Management Committee, the heretofore approval and oversight group for IT projects, and consolidated all functions under the Chief Information Officer. These functions include: • Responsibility for the review, approval and management of all IT projects above an established threshold; • The authority to proceed with an enterprise approach for procurement of IT products and services and the authority to implement such solutions; • The responsibility for review and approval of all agency IT plans and the development of a biennial State Information Technology Plan for submission to the General Assembly; • An assessment of the IT inventory throughout State government and an assessment of the IT deficiencies along with a five year plan for unmet needs; • The creation of an Information Technology Fund that may be used to meet statewide enterprise needs as approved by the General Assembly; and • The authority to establish IT standards statewide. In short, the General Assembly adopted the proposal of the Governor to bring the management, oversight and operations of information technology under the direct control of the Governor. Included in Senate Bill 991 is the continuation of the State Business Infrastructure Program ( SBIP) that has been in progress since 2002. This project was authorized by the 2002 General Assembly to evaluate the State’s core business functions and report back to the General Assembly with an assessment and plan to address deficiencies. This activity occurred in two phases that included an inventory and assessment, followed by a blueprint for addressing priority deficiencies. The final report was presented to the 2004 General Assembly and funding was authorized under Senate Bill 991 to proceed with the development of business requirements for the most “ at risk” component of the study, Human Resources and Payroll ( HR/ Payroll). Under the guidance of the Office of the State Controller, and in collaboration with the State Personnel Officer, Chief Information Officer, and Deputy State Budget Officer, the business development phase for HR/ Payroll is currently underway. This process is scheduled to be completed by late Spring, at which time an RFP will be developed and the General Assembly will be asked to consider funding for the implementation phase of this component of the SBIP. Information Technology State of North Carolina 15 If funding is approved, the HR/ Payroll implementation will begin by late 2005 with an expected implementation period of between 18 to 24 months. Concurrent with this is the next phase of the SBIP, the development of a statewide data warehouse for consolidation of information for use by state managers. The SBIP Program Steering Committee will be considering a plan for moving forward with this component of the SBIP within the next thirty to sixty days. Depending on the development plan, the data warehouse project is expected to begin in early 2005. Financial Information The MD& A provides an overview of the State’s financial activities addressing both governmental and business- type activities reported in the government- wide financial statements. In addition, MD& A focuses on the State’s major funds: the General Fund, the Highway Fund and the Highway Trust Fund. The State contributes to the Teachers' and State Employees' Retirement System, the Consolidated Judicial Retirement System, the Legislative Retirement System, the Firemen's and Rescue Squad Workers' Pension Fund, the Supplemental Retirement Income Plan of North Carolina, and the North Carolina National Guard Pension Fund. The Local Governmental Employees' Retirement System is administered by the State but the State is not a participant. The retirement systems experienced a total return from investments of 12.01% for the one-year period, a return of 4.85% for the three- year period and a return of 4.18% for the five- year period, ended June 30, 2004. These returns represent strong investment results, and reflect the conservative asset allocation and attention to investment quality that have guided the plan’s investment policy. The combined North Carolina Retirement Systems lead the nation in fiscal health because of wise management, consistent state contributions and a conservative investment strategy. The Teachers' and State Employees' Retirement System ( TSERS), the largest of the pension trust funds, continued to be fully funded, based on the December 31, 2003 actuarial valuation. Specifically, the TSERS was funded at 108.1%, with the actuarial value of assets of $ 45.118 billion exceeding the actuarial accrued liability of $ 41.734 billion by $ 3.384 billion at December 31, 2003. Employer contributions to the TSERS increased by $ 55.8 million above the prior fiscal year. Investment balances increased by $ 3.546 billion, or 8.21% above the prior fiscal year, with a net investment income of $ 5.132 billion. The TSERS experienced a $ 149.3 million increase in benefit payments to retirees, an increase of 7.4% from fiscal year 2003. The State's general obligation bonds are rated Aa1 by Moody's, AAA by Standard & Poors, and AAA by Fitch. These favorable ratings have enabled the State to sell its bonds at interest rates considerably below the Bond Buyer's Index, thereby providing substantial savings to North Carolina taxpayers. It is the policy of the State that all agencies, institutions, departments, bureaus, boards, commissions and officers of the State shall devise techniques and procedures for the receipt, deposit and disbursement of monies coming into their control and custody which are designed to maximize interest- bearing investment of cash, and to minimize idle and nonproductive cash balances. The State Controller, with the advice and assistance of the State Treasurer, the State Budget Officer, and the State Auditor, develops, implements, and amends the Statewide Cash Management Policy. All cash deposited with the State Treasurer by State entities is managed in pooled investment accounts to maximize interest earnings. During fiscal year 2004, Pension Benefits Debt Administration Cash Management 16 State of North Carolina uncommitted State funds were invested in short- term and medium- term U. S. Government notes and bonds, as well as other deposits, which had a composite average yield of 3.22%. The State maintains self- insurance programs for employee health; general liability; medical malpractice; workers’ compensation; and automobile, fire and other property losses. The State limits its risk for general liability; medical malpractice; and automobile fire and other property losses by purchasing private insurance for losses in excess of deductibles. See Note 14 of the Notes to the Financial Statements for a full description of the State's risk management program. Other Information In compliance with State statute, an annual financial audit of the State reporting entity is completed each year by the North Carolina Office of the State Auditor. The Auditor's examination was conducted in accordance with auditing standards generally accepted in the United States of America and the standards applicable to financial audits contained in Government Auditing Standards, issued by the Comptroller General of the United States, and his opinion has been included in this report. In addition, the State coordinates the Single Audit effort of all federal funds through the State Auditor. The Government Finance Officers Association of the United States and Canada ( GFOA) awarded a Certificate of Achievement for Excellence in Financial Reporting to the State of North Carolina for its comprehensive annual financial report ( CAFR) for the fiscal year ended June 30, 2003. The Certificate of Achievement is a prestigious national award recognizing conformance with the highest standards for preparation of state and local government financial reports. In order to be awarded a Certificate of Achievement, a government unit must publish an easily readable and efficiently organized comprehensive annual financial report, whose contents conform to program standards. The CAFR must satisfy both generally accepted accounting principles and applicable legal requirements. A Certificate of Achievement is valid for a period of one year only. We believe our current report continues to conform to the Certificate of Achievement program requirements, and we are submitting it to GFOA. In conclusion, we believe this report provides useful data to all parties using it in evaluating the financial activity of the State of North Carolina. We in the Office of the State Controller express our appreciation to the financial officers throughout State government and to the Office of the State Auditor for their dedicated efforts in assisting us in the preparation of this report. Any questions concerning the information contained in this Comprehensive Annual Financial Report should be directed to the Office of the State Controller at ( 919) 981- 5454. Respectfully submitted, Robert L. Powell State Controller December 8, 2004 Risk Management Independent Audit Certificate of Achievement Acknowledgments State of North Carolina 17 THIS PAGE INTENTIONALLY LEFT BLANK. CERTIFICATE OF ACHIEVEMENT 20 State of North Carolina ORGANIZATION OF NORTH CAROLINA STATE GOVERNMENT INCLUDING PRINCIPAL STATE OFFICIALS EXECUTIVE BRANCH Council of State Governor Michael F. Easley Lieutenant Governor Beverly E. Perdue Secretary of State Elaine F. Marshall State Auditor Ralph Campbell, Jr. State Treasurer Richard H. Moore Superintendent of Public Instruction Dr. Michael E. Ward Attorney General Roy A. Cooper, III Commissioner of Agriculture Britt Cobb, Jr. Commissioner of Labor Cherie K. Berry Commissioner of Insurance James E. Long Cabinet Secretaries — Appointed by the Governor Administration Gywnn T. Swinson Correction Theodis Beck Crime Control and Public Safety Bryan E. Beatty Cultural Resources Lisbeth C. Evans Commerce James T. Fain Environment & Natural Resources William G. Ross, Jr. Health and Human Services Carmen Hooker Odom Revenue E. Norris Tolson Transportation W. Lyndo Tippett Appointed by Governor, confirmed by Legislature Office of the State Controller Robert L. Powell State Controller State Board of Education Howard N. Lee Chairman H. Martin Lancaster President Molly C. Broad President Appointed by University Board of Governors Appointed by State Board of Community Colleges Juvenile Justice and Delinquency Prevention George L. Sweat State of North Carolina 21 LEGISLATIVE BRANCH JUDICIAL BRANCH Component Units State of North Carolina Web Page http:// www. ncgov. com North Carolina Supreme Court Chief Justice I. Beverly Lake, Jr. Associate Justices Edward Thomas Brady Robert H. Edmunds, Jr. Paul Newby Mark D. Martin Sarah Parker George L. Wainwright, Jr. Administrative Office of the Courts Judge Ralph A. Walker Director University of North Carolina System Community Colleges State Education Assistance Authority General Assembly Senate House of Representatives Co- Speakers James B. Black Richard T. Morgan Democratic Leader Joe Hackney Republican Leader Joe Kiser President Lieutenant Governor President Pro Tempore Marc Basnight Deputy Pres. Pro Tempore Charlie Smith Dannelly Majority Leader Tony Rand Minority Leader James Forrester The Golden LEAF, Inc. NC Housing Finance Agency Other Component Units 22 State of North Carolina THIS PAGE INTENTIONALLY LEFT BLANK. FINANCIAL SECTION 24 State of North Carolina State of North Carolina 25 26 State of North Carolina THIS PAGE INTENTIONALLY LEFT BLANK. MANAGEMENT’S DISCUSSION AND ANALYSIS 28 State of North Carolina Financial Highlights MANAGEMENT'S DISCUSSION AND ANALYSIS ( MD& A) The following is a discussion and analysis of the State of North Carolina’s ( the State’s) financial performance, providing an overview of the activities for the fiscal year ended June 30, 2004. Please read it in conjunction with the transmittal letter at the front of this report and with the State's financial statements, which follow this section. Government- wide Financial Statements: ⎯ The State’s total net assets increased slightly as a result of this year’s operations. While net assets of governmental activities increased by $ 613.2 million, or nearly 2.7 percent, net assets of business- type activities decreased by $ 204.5 million, or about 21.3 percent ( decline related to the Unemployment Compensation Fund). At year- end, net assets of governmental activities and business- type activities totaled $ 22.98 billion and $ 754.1 million, respectively. ⎯ Component units reported net assets of $ 10.66 billion, an increase of $ 1.08 billion or 11.3 percent from the previous year. The majority of the increase ($ 762 million) is due to the net increase in capital assets for the University of North Carolina System and community colleges ( component units). The capital asset additions were financed in part by State debt proceeds. ⎯ GASB Statement No. 39 became effective during the fiscal year ( see Notes 20 and 21 to the financial statements). The beginning net assets of the University of North Carolina System and community colleges were increased by $ 713 million to include nongovernmental component unit foundations. Fund Financial Statements: ⎯ As of the close of the fiscal year, the General Fund reported a total fund balance of negative $ 196.3 million, with reserves of $ 197.4 million, and an unreserved fund balance of negative $ 393.7 million. The total fund balance of the General Fund decreased from the prior year balance of negative $ 167.1 million. ⎯ The Highway Fund and the Highway Trust Fund reported total fund balances of $ 227.8 million and $ 266.1 million, respectively. ⎯ The State’s two major enterprise funds, the Unemployment Compensation Fund and the EPA Revolving Loan Fund, reported net assets of $ 20.1 million and $ 640.5 million, respectively. The net assets of the Unemployment Compensation Fund decreased by 93 percent from the prior fiscal year- end. Capital Assets: ⎯ The State’s investment in capital assets ( net of accumulated depreciation) was $ 25.61 billion, which represents an increase of 7.7 percent from the previous fiscal year. ⎯ The largest component of capital assets, the State highway system, includes roadway surfaces, bridges, signage, railings, markings, traffic signals, and other structures related to the State’s motor vehicle transportation system. The system includes 78,615 miles of roadway, constituting the second largest highway system in the nation. The system also includes 17,250 bridges spanning 380 miles. At year- end, the State reflected $ 13.28 billion ( net of accumulated depreciation) of highway system infrastructure. ⎯ Major capital asset activity included additions to the State highway system ($ 1.2 billion), right- of-way acquisitions ($ 510 million) and the acquisition/ construction of correctional facilities ($ 239 million). Long- term Debt: ⎯ The State had long- term debt outstanding of $ 5.54 billion, an increase of 34.9 percent from the previous fiscal year- end. The long- term debt balance includes $ 519.6 million of special obligation ( non- voted) debt issued for governmental activities. ⎯ The State maintained its AAA bond rating with Standard and Poor’s and Fitch. In August 2002, Moody’s downgraded the State’s credit rating for general obligation debt from “ AAA” to “ Aa1”, representing the first time since 1960 that North Carolina had less than a “ AAA” rating. In September 2004, Moody’s revised the State’s outlook to positive from stable. State of North Carolina 29 OVERVIEW OF THE FINANCIAL STATEMENTS This discussion and analysis is an introduction to the State’s basic financial statements, which comprise three components: 1) government- wide financial statements, 2) fund financial statements, and 3) notes to the financial statements. This report also contains additional required supplementary information ( General Fund budgetary schedule, pension funding progress and contributions) and other supplementary information ( combining financial statements) in addition to the basic financial statements. These components are described below. Government- wide Financial Statements The Statement of Net Assets and the Statement of Activities are two financial statements that report information about the State, as a whole, and about its activities that should help answer this question: Is the State, as a whole, better off or worse off as a result of this year’s activities? These statements include all non- fiduciary assets and liabilities using the accrual basis of accounting. The current year’s revenues and expenses are taken into account regardless of when cash is received or paid. The Statement of Net Assets ( page 52) presents all of the State’s assets and liabilities, with the difference between the two reported as “ net assets”. Over time, increases and decreases in net assets measure whether the State’s financial position is improving or deteriorating. The Statement of Activities ( pages 54 and 55) presents information showing how the State’s net assets changed during the most recent fiscal year. All changes in net assets are reported as soon as the underlying events giving rise to the change occur, regardless of the timing of related cash flows. Therefore, revenues and expenses are reported in these statements for some items that will only result in cash flows in future fiscal periods ( e. g. uncollected taxes and earned but unused vacation leave). Both statements report three activities: Governmental Activities – Most of the State’s basic services are reported under this category. Taxes and intergovernmental revenues generally fund these services. Business- type Activities – The State charges fees to customers to help it cover all or most of the cost of certain services it provides. The State’s Unemployment Compensation Fund and the EPA Revolving Loan Fund are the predominant business- type activities. Discretely Presented Component Units – Component units are legally separate organizations for which the elected officials of the primary government are financially accountable. A description of the component units and an address for obtaining their separately issued financial statements can be found beginning on page 70. All component units are combined and displayed in a separate discrete column in the government- wide financial statements to emphasize their legal separateness from the State. In addition, financial statements for major component units are presented in the notes to the financial statements ( pages 137 and 138). Fund Financial Statements The fund financial statements begin on page 58 and provide detailed information about the major individual funds. A fund is a fiscal and accounting entity with a self- balancing set of accounts that the State uses to keep track of specific sources of funding and spending for a particular purpose. In addition to the major funds, page 160 begins the individual fund data for the non- major funds. The State's funds are divided into three categories, governmental, proprietary, and fiduciary, and they use different accounting approaches. Governmental funds -- Most of the State's basic services are reported in the governmental funds, which focus on how money flows into and out of those funds and the balances left at year- end that are available for future spending. The governmental fund financial statements provide a detailed short- term view of the State's general government operations and the basic services it provides. Governmental fund information helps determine whether there are more or fewer financial resources that can be spent in the near future to finance the State's programs. These funds are reported using modified accrual accounting, which measures cash and all other financial assets that 30 State of North Carolina can readily be converted to cash. Governmental funds include the general, special revenue, capital project, and permanent funds. Because the focus of governmental funds is narrower than that of the government- wide financial statements, it is useful to compare the information presented for governmental funds with similar information presented for governmental activities in the government- wide financial statements. By doing so, readers may better understand the long- term impact of the government’s near- term financing decisions. Both the governmental fund balance sheet and the governmental fund statement of revenues, expenditures, and changes in fund balances provide a reconciliation to facilitate this comparison between governmental funds and governmental activities. Proprietary funds -- When the State charges customers for the services it provides, whether to outside customers or to other agencies within the State, these services are generally reported in proprietary funds. Proprietary funds ( enterprise and internal service) utilize accrual accounting; the same method used by private sector businesses. Enterprise funds are used to report activities for which fees are charged to external users for goods and services. The Unemployment Compensation Fund and the EPA Revolving Loan Fund are our most significant enterprise funds. Internal service funds are used to report activities that provide goods and services to the State’s other programs and activities on a cost- reimbursement basis. - such as the State's State Property Fire Insurance Fund, the Motor Fleet Management Fund, Computing Services Fund, and Telecommunications Services Fund. Internal service funds are reported as governmental activities on the government- wide statements. Fiduciary funds -- The State acts as a trustee or fiduciary, for its employee pension plans. It is also responsible for other assets that, because of a trust arrangement, can be used only for the trust beneficiaries. The State's fiduciary activities are reported in separate Statements of Fiduciary Net Assets and Changes in Fiduciary Net Assets. These funds, which include pension and other employee benefits, private- purpose, investment trust, and agency funds, are reported using accrual accounting. The government- wide financial statements exclude fiduciary fund activities and balances because these assets are restricted in purpose and cannot be used to support the State’s own programs. Notes to the Financial Statements The notes provide additional information that is essential to a full understanding of the data provided in the government- wide and fund financial statements. The notes to the financial statements can be found beginning on page 68 of this report. Additional Required Supplementary Information Following the basic financial statements and note disclosures is additional Required Supplementary Information that further explains and supports the information in the financial statements. The Required Supplementary Information includes General Fund budgetary comparison schedules reconciling the statutory and generally accepted accounting principles ( GAAP) fund balances at fiscal year- end, and pension plan trend information related to funding progress and contributions. Supplementary Information Supplementary information includes the introductory section, and the combining financial statements for non- major governmental, proprietary, and fiduciary funds and for non- major discretely presented component units. These funds are added together, by fund type, and presented in single columns in the basic financial statements, but are not reported individually, as with major funds, on the governmental fund financial statements. State of North Carolina 31 FINANCIAL ANALYSIS OF THE STATE AS A WHOLE The State’s combined net assets increased $ 408.7 million or 1.8 percent over the course of this fiscal year’s operations. The net assets of the governmental activities increased $ 613.2 million or 2.7 percent and business- type activities had a decrease of $ 204.5 million or 21.3 percent. The following table was derived from the government- wide Statement of Net Assets: Net Assets June 30, 2004 and 2003 ( dollars in thousands) 2004 2003 2004 2003 2004 2003 Current and other non-current assets.......................................... $ 1 0,668,632 $ 9 ,882,858 $ 1,217,551 $ 1,161,973 $ 1 1,886,183 $ 1 1,044,831 Capital assets, net....................................... 25,556,896 23,719,972 49,507 46,272 25,606,403 23,766,244 Total assets................................................ 36,225,528 33,602,830 1,267,058 1,208,245 37,492,586 34,811,075 Long- term liabilities...................................... 5,970,092 4,376,222 10,242 10,270 5,980,334 4,386,492 Other liabilities............................................. 7,274,030 6,858,429 502,697 239,375 7,776,727 7,097,804 Total liabilities........................................... 13,244,122 11,234,651 512,939 249,645 13,757,061 11,484,296 Net assets: Invested in capital assets, net of related debt.................................... 24,706,355 23,449,373 40,277 38,450 24,746,632 23,487,823 Restricted.................................................... 1,454,729 1,068,233 665,547 863,426 2,120,276 1,931,659 Unrestricted................................................. ( 3,179,678) ( 2,149,427) 48,295 56,724 ( 3,131,383) ( 2,092,703) Total net assets......................................... $ 2 2,981,406 $ 2 2,368,179 $ 754,119 $ 958,600 $ 2 3,735,525 $ 2 3,326,779 Governmental Business- type Total Primary Activities Activities Government The largest component of the State’s net assets ($ 24.75 billion) reflects its investment in capital assets ( land, buildings, machinery and equipment, State highway system, and other capital assets), less related debt still outstanding that was used to acquire or construct those assets. Restricted net assets are the next largest component ($ 2.12 billion). Net assets are restricted when constraints placed on their use are either externally imposed or are imposed by law through constitutional provisions or enabling legislation. The remaining portion, unrestricted net assets, consists of net assets that do not meet the definition of “ restricted “ or “ invested in capital assets, net of related debt.” The government- wide statement of net assets for governmental activities reflects a negative $ 3.18 billion unrestricted net asset balance. The State of North Carolina, like many other state and local governments, issues general obligation debt and distributes the proceeds to local governments and component units. The proceeds are used to construct new buildings and renovate and modernize existing buildings on the State’s community college and university campuses, assist county governments in meeting their public school building capital needs, and to provide grants and loans to local governments for clean water and natural gas projects. Of the $ 5.54 billion of total long- term debt outstanding at June 30, 2004, $ 4.57 billion is attributable to debt issued as State aid to component units ( universities and community colleges) and local governments. The balance sheets of component unit and local government recipients reflect ownership of the related constructed capital assets without the burden of recording the debt obligation. The policy of selling general obligation bonds and funneling the cash proceeds to non- primary government ( non- State) entities has been in place for decades. However, by issuing such debt, the State is left to reflect significant liabilities on its statement of net assets ( reflected in the unrestricted net asset component) without the benefit of recording the capital assets constructed or acquired with the proceeds from the debt issuances. Additionally, as of June 30, 2004, the State’s governmental activities have significant unfunded liabilities for compensated absences in the amount of $ 327 million and a $ 7.5 million cost settlement payable to the federal government ( see Note 7 to the financial statements). These unfunded liabilities also contribute to the negative unrestricted net asset balance for governmental activities. 32 State of North Carolina Governmental Activities The following financial information was derived from the government- wide Statement of Activities and reflects how the State’s net assets changed during the fiscal year: Changes in Net Assets For the Fiscal Years Ended June 30, 2004 and 2003 ( dollars in thousands) Governmental Business- type Total Primary Activities Activities Government 2004 2003 2004 2003 2004 2003 Revenues: Program revenues: Charges for services............................................. $ 1 ,505,090 $ 1 ,339,016 $ 926,891 $ 688,786 $ 2 ,431,981 $ 2 ,027,802 Operating grants and contributions........................ 10,108,124 9,042,843 305,053 504,550 10,413,177 9,547,393 Capital grants and contributions............................ 884,345 527,498 892 1,241 885,237 528,739 General revenues: Taxes Individual income tax......................................... 7,407,455 7,122,099 — — 7,407,455 7,122,099 Corporate income tax........................................ 760,180 921,611 — — 760,180 921,611 Sales and use tax.............................................. 4,293,040 4,029,403 — — 4,293,040 4,029,403 Gasoline tax...................................................... 1,276,627 1,154,986 — — 1,276,627 1,154,986 Franchise tax..................................................... 560,708 584,584 — — 560,708 584,584 Highway use tax................................................ 578,346 552,759 — — 578,346 552,759 Insurance tax..................................................... 432,975 417,126 — — 432,975 417,126 Beverage tax..................................................... 213,271 198,848 — — 213,271 198,848 Inheritance tax................................................... 128,352 112,150 — — 128,352 112,150 Other taxes........................................................ 313,985 289,261 — — 313,985 289,261 Tobacco settlement............................................... 147,224 173,256 — — 147,224 173,256 Federal grants not restricted to specific programs.............................................. 136,859 136,859 — — 136,859 136,859 Unrestricted investment earnings.......................... 77,225 103,987 — — 77,225 103,987 Miscellaneous....................................................... 62,601 41,137 3 — 62,604 41,137 Total revenues..................................................... 28,886,407 26,747,423 1,232,839 1,194,577 30,119,246 27,942,000 Expenses: General government.............................................. 807,248 773,807 — — 807,248 773,807 Primary and secondary education......................... 7,223,766 6,865,921 — — 7,223,766 6,865,921 Higher education................................................... 3,140,794 2,814,375 3,140,794 2,814,375 Health and human services................................... 11,729,904 10,611,537 — — 11,729,904 10,611,537 Economic development......................................... 536,055 489,111 — — 536,055 489,111 Environment and natural resources....................... 599,575 538,032 — — 599,575 538,032 Public safety, corrections and regulation............... 2,093,404 2,029,233 — — 2,093,404 2,029,233 Transportation....................................................... 1,870,578 1,640,007 — — 1,870,578 1,640,007 Agriculture............................................................. 82,394 73,974 — — 82,394 73,974 Interest on long- term debt..................................... 191,228 151,258 — — 191,228 151,258 Unemployment compensation............................... — — 1,389,266 1,603,796 1,389,266 1,603,796 EPA Revolving Loan............................................. — — 5,342 4,266 5,342 4,266 Other business- type activities................................ — — 43,014 30,750 43,014 30,750 Total expenses.................................................... 28,274,946 25,987,255 1,437,622 1,638,812 29,712,568 27,626,067 Increase ( decrease) in net assets before contributions and transfers................................ 611,461 760,168 ( 204,783) ( 444,235) 406,678 315,933 Contributions to permanent funds......................... 2,068 1,806 — — 2,068 1,806 Transfers............................................................... ( 302) 4,918 302 ( 4,918) — — Increase ( decrease) in net assets....................... 613,227 766,892 ( 204,481) ( 449,153) 408,746 317,739 Net assets - beginning - restated........................... 22,368,179 21,601,287 958,600 1,407,753 23,326,779 23,009,040 Net assets - ending............................................... $ 2 2,981,406 $ 2 2,368,179 $ 754,119 $ 958,600 $ 2 3,735,525 $ 2 3,326,779 As a result of this year’s operations, the net assets of governmental activities increased by $ 613.2 million or 2.7 percent. The net asset increase is primarily related to the overall growth in tax revenues ( e. g., individual income, sales and use, and gasoline taxes) and spending reversions realized during the current fiscal year. The major exception to the growth in taxes was corporate taxes, which declined 17.5 percent from the previous fiscal year- end. Key factors in the decline in corporate taxes were reduced collections, an overall increase in the estimated refund rate, and the legislative suspension in the prior year of required distributions to special revenue funds. Although corporate profits were up, corporate tax collections were down because of tax code changes that allowed businesses to write- off expenses more quickly and the utilization of tax breaks and other incentives designed to attract new jobs to the State. Also, in the prior year, a portion of corporate income taxes, required to be distributed to special revenue funds, were retained by the General Fund to manage a budget shortfall. State of North Carolina 33 Total expenses of governmental activities grew by 8.8 percent during the current period ( compared to total revenues growth of 8.0 percent). The majority of the spending growth was the result of funding increases in the State’s two largest functional areas, education and health and human services. The increase in education spending is related to enrollment increases at the State’s universities and community colleges and funding increases for the State’s public schools. The growth in health and human services is the result of increased spending for Medicaid, which is the State’s largest public assistance program. The growth in Medicaid is explained by an increase in individuals eligible for Medicaid services, a large increase in payments for dental services due to a lawsuit settlement that raised dental rates, and a significant increase in prescription drug payments and Disproportionate Share Hospital payments. There were also significant increases in the Electronic Benefits program due to higher client participation as a result of the recent economic downturn. The following chart depicts revenue sources of governmental activities as percentages of total revenues for the fiscal year: Revenues - Governmental Activities Fiscal Year Ended June 30, 2004 Charges for services 5% Capital grants and contributions 3% Individual income and corporate income taxes 28% Gasoline and highway use taxes 6% Other taxes 6% Miscellaneous 1% Sales and use tax 15% Operating grants and contributions 36% The following chart depicts the total expenses and total program revenues of the State’s governmental functions. This format identifies the extent to which each governmental function is self-financing through fees and intergovernmental aid or draws from the general revenues of the State. 34 State of North Carolina Business- type Activities Expenses - Governmental Activities Fiscal Year Ended June 30, 2004 — $ 1,000 $ 2,000 $ 3,000 $ 4,000 $ 5,000 $ 6,000 $ 7,000 $ 8,000 $ 9,000 $ 10,000 $ 11,000 $ 12,000 $ 13,000 General government Primary and secondary education Higher education Health and human services Economic development Environment and natural resources Public safety, corrections, and regulation Transportation Agriculture Interest on long-term debt Expenses Program Revenues ( excluding Capital Grants) Millions The following chart reflects the dollar change in the functional expenses of governmental activities between fiscal years 2003 and 2004: Dollar Change in Governmental Activities Functional Expenses Between Fiscal Years 2003 and 2004 $ 40 $ 8 $ 231 $ 64 $ 62 $ 47 $ 1,118 $ 326 $ 358 $ 33 $— $ 200 $ 400 $ 600 $ 800 $ 1,000 $ 1,200 Interest on long- term debt Agriculture Transportation Public safety, corrections and regulation Environment and natural resources Economic development Health and human services Higher education Primary and secondary education General government ( dollars in millions) Business- type activities reflect a decrease in net assets of $ 204.5 million or 21.3 percent. The key reason for the decline was the Unemployment Compensation Fund’s significant operating loss, which was financed by the proceeds of short- debt. At year- end, the net assets of the Unemployment Compensation Fund were $ 20.1 million, a decrease of $ 257.4 million or 92.7 percent from the prior fiscal year- end. The Unemployment Compensation Fund and the EPA Revolving Loan Fund are the predominant activities, comprising 87.6 percent of the total net assets of business- type activities. A more detailed discussion of the State’s enterprise funds is provided in the following section. State of North Carolina 35 Governmental Funds FINANCIAL ANALYSIS OF THE STATE’S FUNDS The State uses fund accounting to ensure and demonstrate compliance with finance- related legal requirements The focus of the State’s governmental funds is to provide information on near- term inflows, outflows, and balances of spendable resources. As of the end of the fiscal year, the State’s governmental funds reported combined ending fund balances of $ 3.0 billion, a 14.7 percent increase from the prior fiscal year- end ( as restated). The majority of the increase was related to debt proceeds recognized in other governmental funds for the N. C. Infrastructure Finance Corporation ( Corporation), a blended component unit of the State. The Corporation issued debt for the repair and renovation of State facilities and for the acquisition and construction of correctional facilities. The major governmental funds are discussed individually below. General Fund The General Fund is the chief operating fund of the State. The fund balance of the General Fund decreased from a negative $ 167.139 million at June 30, 2003 ( as restated) to a negative $ 196.287 million at June 30, 2004. A key factor in the decline was the Department of Revenue’s revision of the refund rate for corporate taxes, which resulted in a $ 45.8 million reduction in corporate tax revenues for the 2004 fiscal year ( Note: GAAP requires tax revenues to be reported net of estimated refunds). In addition, the total fund deficit continues to be influenced by the excess of accrued expenditures over accrued revenues for the State’s Medicaid program. A more detailed analysis of the General Fund is provided in the budgetary highlights section ( see next section). 2003- 2004 General Fund Budgetary Highlights The General Fund budget for fiscal year 2003- 04 was signed into law on June 30, 2003. The enacted budget was founded upon an overall nominal ( real growth plus inflation) economic growth rate of 3.5 percent for 2003- 04. The appropriated budget included provisions that were designed to increase General Fund revenues. The most significant revenue adjustment was the continuation of two temporary tax increases that were scheduled to expire in 2003. In 2001, the General Assembly temporarily raised the State sales tax rate by a half- cent to 4.5 percent and the highest individual income tax rate from 7.75 percent to 8.25 percent. The budget continues the State sales tax rate at 4.5 percent and the 8.25 percent income tax bracket. In addition, several streamlining and conformity provisions, as well as departmental fees, were authorized that increase General Fund availability. Finally the Department of Revenue was given broader authority and resources to collect unpaid tax liabilities. The following table summarizes the 2004 revenue enhancements ( amounts expressed in millions). Revenue Enhancements – 2004 Fiscal Year Maintain State sales tax at 4.5%................................................... $ 341.8 Maintain top income tax bracket.................................................... 37.5 Streamline tax revisions................................................................ 78.5 Department of Revenue - Project Tax Collect................................ 90.2 Tobacco settlement funds ............................................................ 66.8 Fee increases and trust fund transfers.......................................... 87.0 Tax reductions for federal conformity............................................. ( 70.0) Federal fiscal relief........................................................................ 136.9 Federal disaster relief funds.......................................................... 108.8 Total 2004 enhancements.................................................... $ 877.5 The majority of funding increases for 2004 were in the education and human service areas. The budget provided full funding for enrollment increases in the University of North Carolina System ($ 46.6 million), the community college system ($ 32 million), and private colleges and universities ($ 2.8 36 State of North Carolina million). In addition, the budget includes funds to hire additional public school teachers to reduce class size in the second grade ($ 25.3 million) and to expand the Governor’s More- at- Four Program ($ 8.4 million), which helps prepare at risk four- year- old children for success in school. It also provides funds for the annual step increase for public school teachers ($ 48.1 million) and for ABC bonuses earned in the 2002- 03 school year ($ 96 million). The budget provides additional funding for the Health Insurance Program for Children ($ 12.2 million), which allows all eligible children to receive health care insurance ( see Note 14C to the financial statements). In addition, expansion funds are provided for the Mental Health Trust Fund ($ 12.5 million) to facilitate the progress toward mental health reform. The budget provided over $ 200 million in 2003- 04 to support employee benefit programs. Specifically, it authorized a $ 550 one- time compensation bonus for State employees not included on the teacher salary schedule. In addition, the State Health Plan received sufficient funds to cover increased employee- related health care costs without reduction in benefits. The budget also began repayment of the funds withheld from the Retirement System in 2000- 01 due to the budget shortfall ( Note: the total obligation to the Retirement System was $ 129.9 million plus accrued interest). Legislation was enacted in 2001 to formalize the General Assembly’s intent to repay the debt, subject to the availability of funds, over a five- year period beginning July 1, 2003. The budget authorized the payment of $ 10 million to partially repay the debt to the Retirement System. At year- end, the General Assembly authorized an additional payment of $ 20 million to the Retirement System. General Fund Budget Variances The original General Fund budget, including State appropriations and appropriations supported by departmental receipts, serves as a starting point or plan for the Governor to execute the General Fund budget pursuant to the powers granted by the Executive Budget Act. At the state level in North Carolina, it is not unusual for the budget to change during the fiscal year in relation to budget adjustments made to accommodate departmental receipts. The General Fund budget supported by State appropriation, is a subset of the General Fund financial schedule presented in the CAFR as required supplementary information. The current CAFR schedule reflects all spending required to support the State’s General Fund activities and the funding to support those activities, including State tax and non-tax revenues, federal revenues, student tuition, and other fees, licenses, and fines. Under current State budget management practice, particularly related to departmental federal receipts, primary emphasis is placed on comparisons of the final authorized budget and actual spending. At the State level, budgetary cuts related to State appropriations are implemented by decreasing allowable actual expenditures, as opposed to decreasing the State appropriation through a formal legislative process. The Governor and State agencies maintain legal authority to spend the dollars originally appropriated to them, however, in recent years the actual spending has been limited by the collection of tax and nontax revenue. In extremely rare cases, the General Assembly has held special sessions to formally amend the State appropriation budget. The portion of the original budget comprising departmental receipts is not intended to be the sole controlling point to manage the State’s General Fund budget. The final budget includes amendments for departmental receipts collected during the fiscal year as allowed by law. General Fund departmental receipts are typically authorized for expenditure within the activity that generated the receipt. Historically, final estimated receipts have varied significantly from the original estimate at the beginning of the fiscal year. State agencies by law must spend departmental receipts prior to spending tax and nontax supported appropriations. If departmental receipts are higher than expected, appropriated dollars may go unspent and be re- appropriated in a subsequent fiscal year. State of North Carolina 37 Variances – Original and Final Budget The budget variance between original and final budget for federal funds revenue is attributable to the awarding of new federal funds during the fiscal year and funds being drawn down to reimburse unanticipated expenditures. The budget variance for intra- governmental transactions revenue is attributable primarily to the following: $ 81.5 million of statewide encumbrance carry forward amounts from fiscal year 2002- 2003, $ 126.4 million of Medicaid Disproportionate Share, $ 8.3 million of Department of Health and Human Services ( DHHS)- cost report settlement, $ 272.9 million of DHHS- intra- governmental transfers within a DHHS general fund budget code, $ 351.2 million of DHHS funds transferred from various budget codes within DHHS, and $ 14.8 million of Mental Health Trust Fund intra- governmental transfers. The budget variance for contributions, gifts and grants revenue is attributable primarily to the decision by the Division of Medical Assistance to change an accounting process to go on cost allocation, leading to the unexpected budgeting of $ 129.1 million for the State match. For expenditures, the variances between the original budget and final budget are related to the corresponding revenue budget variances. As revenue budget accounts are increased, a corresponding increase occurs in the expenditure budget accounts. In addition to those increases, agency expenditure budgets were also increased by the allocation of statewide reserves such as the legislative salary increase, health insurance, and retirement reserves. There was also an additional appropriation of $ 88.1 million authorized for fiscal year 2003- 2004 as a result of special sessions of the General Assembly. Variances - Final Budget and Actual Results The budget variance between final budget and actual revenues for corporate income taxes occurred because the growth in corporate profits exceeded the forecast. Investment Income was below the final budget because market interest rates were below the forecast. Departmental federal funds actually received by agencies were $ 741.9 million less than the final budget. Of this variance, $ 357.2 million was attributable to the Department of Public Instruction. Actual federal draw downs are reflective of the actual expenditures of these federal funds. In addition, $ 190.8 million of the Federal funds variance is attributable to the Department of Health and Human Services not incurring qualifying costs as budgeted. For expenditures, the variances between final budget and actual expenditures for primary and secondary education and public safety, corrections, and regulation occurred because actual revenues were less than the budgeted revenues; therefore, expenditures that depended on the receipt of these funds could not be made. The State ended fiscal year 2003- 04 with an over- collection of tax revenues of $ 242.4 million. The major tax categories that exceeded the budgeted forecast were individual income ( 1.1%), corporate income ( 9.2%), and sales and use ( 4.1%). In addition, unexpended appropriations or reversions of $ 159 million were realized. The State fiscal year 2003- 04 closed out with a $ 289.4 million unreserved fund balance after transferring $ 116.7 million to the Rainy Day Fund and $ 76.8 million to the Repair and Renovation Reserve. 38 State of North Carolina Highway Fund The Highway Fund dates back to 1921, which is when the N. C. General Assembly first imposed the gasoline tax. It accounts for most of the activities of the North Carolina Department of Transportation, including the maintenance and construction of the State’s primary, secondary, and urban road systems, the State Highway Patrol, the Division of Motor Vehicles, and transit and rail. The primary revenue sources of the Highway Fund are federal funds, three- fourths of gasoline taxes, vehicle registration fees, and driver’s license fees. The fund balance of the State Highway Fund decreased from $ 299.9 million at June 30, 2003 to $ 227.8 million at June 30, 2004, a decrease of 24 percent. The decline was the result of total expenditures exceeding total revenues for the current period. Over the past three years, the North Carolina Department of Transportation has used excess cash to advance construction projects and to accelerate contract resurfacing. Unbudgeted emergency relief expenditures for Hurricane Isabel and several ice storms also impacted cash flow. However, the excess of expenditures over revenues of $ 185.3 million in 2004 was smaller than the previous fiscal year because total revenues grew at a faster rate than total expenditures. Total revenues increased by $ 252.2 million or 11.7 percent primarily because of increases in gasoline taxes and federal funds. A 4 percent increase in taxable gallons sold combined with a 3 percent boost in the average fuel tax per gallon raised fuel tax revenues by $ 89.2 million. Federal billings rose $ 180.7 million due to increased Federal Highway Administration construction. Total expenditures increased by $ 207.7 million or 8.7 percent due to increased maintenance and construction expenditures. In addition, operating transfers to other funds increased by $ 24.4 million. During the fiscal year, the Highway Fund also received an advance of $ 15.4 million from a municipality for roadway and pedestrian improvements. In September 2004, the State Board of Transportation approved a new long- range plan that prioritizes transportation investment for the next 25 years. The Statewide Transportation Plan provides a blueprint for greater investment in maintenance, preservation, and modernization of the State’s existing highway system as well as other transportation options such as rail and public transportation. The share of transportation dollars spent on new highway projects will drop from 45 percent to 26 percent. The highway needs of the State’s growing population will be accommodated in part by maintaining and upgrading existing roads and by increasing anti- congestion measures such as synchronized traffic signals. The centerpiece of the plan is the Recommended Investment Scenario, which outlines priorities from the estimated $ 55 billion, in today’s dollars, expected to be available over the next 25 years for transportation investment. Based on this scenario, the Department of Transportation ( NCDOT) will be able to meet an additional 10 percent of its maintenance and preservation needs and nearly 25 percent more modernization infrastructure needs. Additionally, the scenario proposes increasing NCDOT’s investment in other transportation modes. The plan also identifies $ 84 billion in total transportation needs and states that NCDOT will only be able to meet two- thirds of the State’s 25- year transportation needs at its current funding levels, regardless of how NCDOT’s resources are allocated. Full implementation of the Recommended Investment Scenario will be gradual. Highway Trust Fund Legislation creating the Highway Trust Fund was passed by the General Assembly in 1989. It was established to provide a dedicated funding mechanism to meet highway construction needs in North Carolina. The Highway Trust Fund also provides extra money for the State’s municipalities to adequately maintain their streets and pays the debt service on the State’s general obligation bonds issued for highway purposes. The principal revenue sources of the Highway Trust Fund are highway use taxes, one- fourth of gasoline taxes, and various title and registration fees. From the proceeds of the highway use tax, $ 252.4 million was transferred to the general fund for the 2003- 04 fiscal year and thereafter, the transfer amount is scheduled to be $ 240 million per year subject to adjustment for inflation. The General Fund intends to repay by June 30, 2009 the $ 125 million ( plus interest) advanced from the Highway Trust Fund during the 2002- 03 fiscal year ( see Note 9 to the financial statements). State of North Carolina 39 Enterprise Funds The fund balance of the Highway Trust Fund increased from $ 208.2 million at June 30, 2003 to $ 266.1 million at June 30, 2004, an increase of 27.8 percent. The increase was attributable, in part, to $ 400 million of highway bonds issued on November 2003. The proceeds of these bonds were used to reimburse highway expenditures of prior years. These bonds constitute a portion of the $ 950 million highway bond authorization approved by the voters in November 1996 ( Note: $ 250 million of such bonds were issued in 1997). At year- end, the remaining highway bond authorization was $ 300 million. Total revenues increased by $ 54.0 million or 5.7 percent, primarily because of increases in the gasoline tax and the highway use tax. Gasoline taxes rose $ 29.5 million due primarily to a 4 percent increase in taxable gallons sold combined with a 3 percent rise in the average fuel tax per gallon. Highway use taxes on vehicle registrations grew $ 25.6 million or 4.6 percent. Total expenditures increased by $ 220.9 million or 36.3%. The increase is due to a significant rise in contract lettings for the Transportation Improvement Program and N. C. Moving Ahead projects to address transportation infrastructure needs. The 2003 General Assembly passed the Governor’s “ Moving Ahead” transportation initiative to allow, over two years, the use of $ 630 million of Highway Trust Fund cash balances for highway preservation, modernization, and maintenance. Additionally, it allows $ 70 million for public transit, rail, ferry, bicycle, and pedestrian projects. The State’s enterprise funds or business- type activities provide the same type of information found in the government- wide financial statements, but in more detail. The major enterprise funds are discussed individually below. Unemployment Compensation Fund The net assets of the Unemployment Compensation Fund decreased by $ 257.4 million during the current fiscal year, which is a 92.7 percent decrease from the prior fiscal year- end. The decrease is explained primarily by the fund’s significant operating loss ( excess of operating expenses over operating income), which was financed by the proceeds of short- term debt. The operating loss was $ 509.6 million this year versus $ 956.1 million in 2003. At June 30, 2004, the short- term debt balance was $ 251.8 million compared to zero for the previous year- end. To ensure timely payment of unemployment benefits, the State received repayable advances from its Federal Unemployment Account and issued tax anticipation notes ( see Note 6 to the financial statements). The State estimated that it will save millions of dollars in interest payments by selling tax anticipation notes instead of borrowing exclusively from the federal government. Unemployment benefit expenses decreased 13.4 percent in fiscal year 2004 to $ 1.39 billion. These expenses were lower because the State’s unemployment rate fell during the second half of the fiscal year. North Carolina’s seasonally adjusted unemployment rate was 5.5 percent in June 2004, making four consecutive months that the rate was below the national average. While manufacturing jobs declined since January 2004, all other sectors of the economy gained jobs during the second half of the fiscal year. Job gains were especially large in professional and business services and in educational and health services. In fiscal years 2003 and 2002, the State also received funding for extended unemployment benefits. In March 2002, the U. S. Congress signed into law the Temporary Extended Unemployment Compensation Act of 2002. This program, which is financed entirely by federal funds, provided extended benefits to claimants who had exhausted their regular State unemployment benefits. This program ended during the 2004 fiscal year because of the decrease in the State’s average unemployment rate. The 2003 Session of the General Assembly enacted legislation to help preserve the integrity of the unemployment insurance tax system. Session Law 2003- 67 ( Senate Bill 326) clarifies that an employer cannot avoid an undesirable unemployment insurance rate by shifting employees to a newly created company with a more desirable tax rate. This practice is known as State unemployment tax avoidance or “ SUTA dumping” ( i. e., since the bulk of the old company’s employees are moved to a new company and the higher tax rate of the older company is “ dumped”). 40 State of North Carolina Starting January 1, 2005, a 20 percent surcharge will be in effect for unemployment insurance contributions, as required by State statute. The surcharge will be in effect because of the fund’s low reserves. The proceeds of the surcharge will be credited to the Employment Security Commission Reserve Fund and will improve the solvency of the Unemployment Compensation Fund. EPA Revolving Loan Fund The net assets of the EPA Revolving Loan Fund increased by $ 58.9 million during the current fiscal year, which was a 10.1 percent increase from the prior fiscal year- end. Operating income was $ 9.99 million ( excess of operating revenues over operating expenses). Net nonoperating revenues were $ 42.9 million, consisting primarily of federal capitalization grants and investment earnings. In addition, $ 7.4 million of clean water bond proceeds were transferred in from special revenue funds. State of North Carolina 41 Capital Assets Capital Asset and Debt Administration As of June 30, 2004, the State’s investment in capital assets was $ 25.61 billion, which represents an increase of 7.7 percent from the previous fiscal year- end ( see table below). Capital Assets as of June 30 ( net of depreciation, dollars in thousands) 2004 2003 2004 2003 2004 2003 Land................................................... $ 8 ,300,655 $ 7 ,713,505 $ 2,563 $ 2,563 $ 8 ,303,218 $ 7 ,716,068 Buildings............................................ 1 ,578,963 1 ,369,455 13,231 13,975 1 ,592,194 1 ,383,430 Machinery and equipment.................. 5 62,864 5 51,155 1,314 1,047 5 64,178 5 52,202 Infrastructure: State highway system..................... 1 3,284,267 1 2,444,212 — — 1 3,284,267 1 2,444,212 Other infrastructure......................... 7 6,859 8 0,489 7,866 8,669 8 4,725 8 9,158 Intangible assets................................ 1 06,506 1 08,927 — — 1 06,506 1 08,927 Art, literature, and other artifacts........ 1 ,126 7 — — 1 ,126 7 Construction in progress.................... 1 ,645,656 1 ,452,222 24,533 20,018 1 ,670,189 1 ,472,240 Total........................................... $ 2 5,556,896 $ 2 3,719,972 $ 49,507 $ 46,272 $ 2 5,606,403 $ 2 3,766,244 Total percent change between fiscal years 2003 and 2004 7.7 % 7.0 % 7.7 % Governmental Activities Business- type Activities Total Major capital asset activity includes additions to the State highway system ($ 1.2 billion), right- of- way acquisitions ($ 510 million), and the acquisition/ construction of correctional facilities ($ 239 million). The largest component of capital assets is the State highway system and related right- of- ways. The State has approximately a 78,615- mile highway system, making it the second largest State- maintained highway system in the nation. The system continues to increase as roads are widened and new roads and bridges are constructed. The 2002- 2003 Session of the General Assembly authorized the issuance of up to $ 300 million of special indebtedness to finance the repair and renovation of State facilities and related infrastructure that are supported by the State’s General Fund. Of the $ 300 million, approximately $ 157 million will be allocated to the University of North Carolina System ( component unit). Each of the sixteen constituent institutions of the UNC System will receive a portion of the proceeds for repairs and renovations. The remaining $ 143 million of the proceeds will be used to make repairs and renovations to various State facilities located throughout North Carolina. The State issued $ 125 million in certificates of participation during the 2004 fiscal year to finance repair and renovation projects. At year- end, the remaining authorization was $ 175 million. In addition, the most recent session of the General Assembly ( 2003- 2004) directed the transfer on June 30, 2004, of $ 76.8 million from the unrestricted credit balance of the General Fund in fiscal year 2004 to the Repairs and Renovations Reserve Account, to be applied to the repair and renovation of State and university facilities. In July 2003, the N. C Infrastructure Finance Corporation ( Corporation), a blended component unit of the State, acquired three close security correctional facilities by issuing $ 218.4 million in lease-purchase revenue bonds. Also, during the fiscal year, the Corporation issued $ 158.96 million in certificates of participation to construct and equip two close security correctional facilities and to begin designing a third facility. The Department of Correction is undertaking construction initiatives to address a cell shortfall and to allow for the implementation of sentencing reform. The State’s correctional facility population has more than doubled since 1980. The rapid growth in inmates is attributable to increases in the State’s population, increases in length of stay in correctional facilities, and changes in criminal laws. 42 State of North Carolina As further detailed in Note 19( F) to the financial statements, the State has commitments of $ 1.9 billion for the construction of highway infrastructure, which are expected to be financed by gasoline tax collections and federal funds. Other commitments for the construction and improvement of State government facilities totaled $ 522.9 million, which are expected to be financed primarily by debt proceeds ( certificates of participation), State appropriations, and federal funds. More detailed information about the State’s capital assets is presented in Note 5 to the financial statements. State of North Carolina 43 Long- term Debt At year- end, the State had total long- term debt outstanding of $ 5.54 billion, an increase of 34.9 percent from the previous fiscal year- end ( see table below). Outstanding Debt as of June 30 ( dollars in thousands) 2004 2003 2004 2003 2004 2003 General obligation bonds...................... $ 4,982,860 $ 4,066,990 $ — $ — $ 4,982,860 $ 4,066,990 Revenue bonds.................................... 218,405 — 9 ,325 9 ,570 227,730 9,570 Certificates of participation................... 301,165 17,500 — — 301,165 17,500 Notes payable...................................... 25,008 9,629 — — 25,008 9,629 Total.............................................. $ 5,527,438 $ 4,094,119 $ 9 ,325 $ 9 ,570 $ 5,536,763 $ 4,103,689 Total percent change between fiscal years 2003 and 2004 35.0 % ( 2.6)% 34.9 % Governmental Activities Business- type Activities Total The State’s general obligation bonds are secured by a pledge of the faith, credit, and taxing power of the State. The revenue bonds issued by the State are secured solely by specified revenue sources. The certificates of participation ( COPs) and lease- purchase revenue bonds issued by the N. C. Infrastructure Finance Corporation, a blended component unit of the State, are secured by lease and installment payments made by the State, and in the event of default, by a security interest in the leased facilities pursuant to a leasehold deed of trust ( as applicable). The COPs issued for repair and renovation projects ( see below) are not secured by a lien upon or security interest in the projects or any other property of the State. All payments of the State for the COPs and the lease- purchase revenue bonds are subject to appropriation by the General Assembly. During the 2004 fiscal year, the State issued $ 1.159 billion in general obligations bonds ( excluding refunding issues), $ 218.41 million in lease- purchase revenue bonds, and $ 283.96 million in certificates of participation ( COPs). The new general obligation debt consisted of $ 708 million in public improvement bonds ( consolidation of clean water bonds and higher education bonds), $ 400 million in highway bonds, $ 36 million in natural gas bonds, and $ 15 million in clean water bonds. The proceeds of the lease- purchase revenue bonds were used to acquire three close security correctional facilities in Alexander, Anson, and Scotland counties. The proceeds of the COPs will be used to construct and equip two close security correctional facilities in Greene and Bertie counties and to finance the cost of design and certain additional costs of a third close security correctional facility in Columbus County. The State also issued COPs for the repair and renovation of State facilities and related infrastructure that are supported by the General Fund. The State refinanced $ 336.9 million of its existing debt in 2004 to improve cash flow and to take advantage of lower interest rates. By refinancing the debt, the State will reduce its future debt service payments by approximately $ 13.5 million over the next ten years. Higher Education Authorization The 1999- 2000 Session of the General Assembly authorized the issuance of up to $ 3.1 billion of higher education improvement bonds, which were subsequently approved by the voters of the State. The $ 3.1 billion bond authorization represents the largest debt authorization in the State’s history. The proceeds of these general obligation bonds will be used solely to construct new buildings and to renovate and modernize existing buildings on the State's 58 community college and 16 University of North Carolina campuses. These improvements are needed to meet enrollment demand and to ensure that the State’s college and university buildings meet modern code requirements and are equipped to prepare graduates for twenty- first century jobs. The bond legislation passed by the General Assembly specifies the amount of bond funding that will flow to each community college and university campus. At year- end, the authorized but unissued higher education bonds were $ 1.37 billion. 44 State of North Carolina Recent Legislation and Studies The most recent session of the General Assembly ( 2003- 04 Session) authorized the issuance of up to $ 468 million of special indebtedness to finance vital State facilities for health care and biotechnology. No more than $ 310 million of the special indebtedness may be issued during the 2004- 05 fiscal year. The State is authorized to use special indebtedness to provide: − $ 338 million for constructing five new projects in the University of North Carolina ( UNC) System. These projects consist of a cancer center at UNC- Chapel Hill ($ 180 million), a cardiovascular institute at East Carolina University ($ 60 million), a bioinformatics Center at UNC- Charlotte ($ 35 million), a pharmacy program facility at Elizabeth City State University ($ 28 million), and a health center at UNC- Asheville ($ 35 million). − $ 50 million for land acquisition and planning for five other projects in the UNC System; − $ 35 million for constructing up to five youth development centers; − $ 45 million for capital projects within the State Parks System, including repairs and renovations of park facilities and land acquisition. High priority uses of the debt proceeds include acquiring land near military bases to prevent encroachment. The fiscal impact of the $ 468 million of special indebtedness on the General Fund is expected to be zero because of the annual transfer of revenue from other sources to the General Fund in an amount to cover the estimated debt service. The debt service for the UNC System facilities and the youth development centers will be reimbursed from the Health and Wellness Trust Fund and the Tobacco Trust Fund ( special revenue funds). The debt service for the parks projects is fully funded by the streams of revenue available to the Parks and Recreation Trust Fund, the Natural Heritage Trust Fund, and the Clean Water Management Trust Fund ( special revenue funds). The maximum annual debt service is estimated to be $ 47.4 million in fiscal year 2010- 11. The total interest on the $ 468 million of debt is estimated to be $ 310 million. Special indebtedness is non- voted debt that is generally secured only by an interest in State property being acquired or improved ( e. g., certificates of participation and lease- purchase revenue bonds). With this type of debt, there is no pledge of the State’s faith, credit or taxing power to secure the debt, which is why voter approval is not required. If the State defaulted on its repayments, no deficiency judgment could be rendered against the State, but the State property that serves as security could be disposed of to generate funds to satisfy the debt. Failure to repay the debt would have negative consequences for the State’s credit rating. Article 9 of Chapter 142 of the General Statutes prohibits the issuance of special indebtedness except for projects specifically authorized by the General Assembly. The use of alternative financing methods provides financing flexibility to the State and permits the State to take advantage of changing financial and economic environments. During the 2003- 04 Session, the General Assembly created a Debt Affordability Advisory Committee ( Committee) to annually advise the Governor and the General Assembly on the estimated debt capacity of the State for the upcoming ten fiscal years. The Committee is responsible for preparing an annual debt affordability study and establishing guidelines for evaluating the State’s debt burden. The Committee is required to report its findings and recommendations to the Governor, the General Assembly, and the Fiscal Research Division of the General Assembly by February 1 of each year. In April 2004, the State Treasurer presented to the House and Senate Finance Committees of the General Assembly, the second Debt Affordability Study for North Carolina. It provides a methodology for measuring, monitoring, and managing the State’s debt capacity. The study evaluated the State’s current and projected debt burden using indicators such as tax- supported debt to personal income, debt per capita, debt service to tax revenue, and rapidity of principal repayment ratios. In addition, the report includes several recommendations based on the results of the study. According to the report, all of the State’s debt ratios are below median levels for all fifty states, as compiled by Moody’s Investors Service, and for a peer group of seven states rated triple AAA by all three credit rating agencies. Thus, the study concludes that the State’s debt is considered low and is manageable at the current level. However, due to the projected issuance of $ 2.2 billion of tax- supported debt over the next three years State of North Carolina 45 ( 62 percent for higher education purposes), all of the State’s debt ratios are expected to increase over this period. The State Treasurer noted in the report that credit rating agencies consider a debt affordability study as a positive factor when evaluating issuers and assigning credit ratings. Credit Ratings Credit ratings are the rating agencies’ assessment of a governmental entity’s ability and willingness to repay debt on a timely basis. Credit ratings are an important factor in the public credit markets and can influence interest rates a borrower must pay. The State’s general obligation bonds are rated “ AAA” by Fitch Ratings, “ Aa1” with a positive outlook by Moody’s Investors Service ( Moody’s) and “ AAA” with a stable outlook by Standard & Poor’s Ratings Services. All three agencies base their prime ratings on the State’s strong, diverse economic base, its sound financial management, and low debt levels. In September 2004, Moody’s revised the State’s outlook to positive from stable and noted the following: “ This rating reflects the State’s slowly stabilizing economy, its improving tax revenues, its conservative debt policy, and its effective financial management. While general fund balances remain negative, flexible cash reserves outside the general fund are ample, and pension funding is exceptionally strong. Moody’s expects that the state will continue to take actions to restore structural balance and rebuild reserves.” In August 2002, Moody’s downgraded the State’s credit rating for general obligation debt from “ AAA” to “ Aa1”, representing the first time since 1960 that North Carolina had less than a “ AAA” rating. While Moody’s praised the strength of executive powers available to insure a balanced budget, it advised that the primary reasons for the downgrade were the State’s continued budget pressure, reliance on non- recurring revenues, and weakened balance sheet. Also, Moody’s commented that the task of restoring structural budget balance and rebuilding reserves faces political and economic obstacles. The certificates of participation and lease- purchase revenue bonds issued by the North Carolina Infrastructure Finance Corporation are rated “ AA+” by Standard & Poor’s, “ AA” by Fitch, and “ Aa2” by Moody’s. Limitations on Debt The Constitution of North Carolina ( Article 5, Section 3) imposes limitations upon the increase of certain State debt. It restricts the General Assembly from contracting debts secured by a pledge of the faith and credit of the State, unless approved by a majority of the qualified voters of the State, except for the following purposes: 1. To fund or refund a valid existing debt; 2. To supply an unforeseen deficiency in the revenue; 3. To borrow in anticipation of the collection of taxes due and payable within the current fiscal year to an amount not exceeding 50 percent of such taxes; 4. To suppress riots or insurrections; or to repel invasions; 5. To meet emergencies immediately threatening the public health or safety, as conclusively determined in writing by the Governor; and 6. For any other lawful purpose, to the extent of two- thirds of the amount by which the State’s outstanding indebtedness shall have been reduced during the next preceding biennium. More detailed information about the State’s long- term liabilities is presented in Note 7 to the financial statements. 46 State of North Carolina Budget and Economic Update The General Fund budget for 2004- 05 was signed into law on July 20, 2004. The enacted budget was founded upon an overall nominal ( real growth plus inflation) economic growth rate of 5.5 percent for 2004- 05. The budget continues the State sales and use tax rate at 4.5 percent and the 8.25 percent income tax bracket for fiscal year 2004- 05 ( Note: the half- cent sales tax increase and the high income tax bracket are scheduled to sunset at the end of the year), diverts a portion of the national tobacco settlement payments ($ 60 million), and uses monies left over at the end of the 2003- 04 fiscal year ($ 289.4 million). It also earmarked an additional $ 116.7 million for the Rainy Day Fund and $ 76.8 million for the Repair and Renovation Reserve, indicating the State’s intention to continue to replenish its reserves. The 2004 hurricane season produced six tropical systems that directly impacted North Carolina. Federal, State, and local emergency management officials estimate that these storms caused over $ 200 million in damages that are eligible for governmental assistance. Assistance is for a variety of services including emergency protective measures, repair and replacement of homes, debris removal, stream clearance, and bridge repair and replacement. In order to match federal funds available to North Carolina for federal disaster recovery services, the Governor ordered State agencies to revert 0.75 percent of their 2004- 05 budgets to provide an estimated $ 120 million for storm relief. Special exemptions are allowed for constitutionally mandated programs as well as emergency situations related to law enforcement, health care, and public safety. North Carolina’s seasonally adjusted unemployment rate as of September 2004 was 4.8 percent, more than a half a percentage point lower than the national unemployment rate of 5.4 percent. September was the seventh consecutive month that the State’s unemployment rate was below the national average. For comparison, the State and national unemployment rates as of September 2003 were 6.4 percent and 6.1 percent, respectively. 2004- 05 Revenue Update ( Cash Basis) For the first three months of the 2004- 05 fiscal year, General Fund revenues, ( tax and non- tax revenues) came in $ 74.3 million higher than the $ 3.5 billion forecast for the period. A continuation of the current trend would lead to revenue growth of 7.6 percent for the full year versus the 5.5 percent economic growth rate built into the budget. However, an analysis of the collection detail reveals that the improvement is not broad- based. Of the extra collections, $ 65.1 million came from one source, corporate income taxes. While other taxes are also increasing, the net surplus from other revenues is only $ 8.8 million. Additionally, $ 30 million of the extra corporate collections is the result of a one- time settlement in August 2004 of a long- standing corporate tax dispute not directly related to the economy. Also, $ 31.8 million of the corporate surplus came from a 33 percent rise in September 2004 payments. This rise is in contrast to the 10.2 percent decline in June and the 2.7 percent drop in April ( April, June, and September are major corporate collection months). Because of the volatility of the corporate income tax, it will be difficult for the State to maintain this growth as higher interest rates and increased energy costs impact the economy Other taxes are increasing but at different rates. The withholding of individual income tax receipts are $ 18.2 million behind schedule for the first quarter ( 4.6 percent growth versus budgeted rate of 5.7 percent). The primary factor is sluggish job growth. State and local sales tax collections rose by 8.2 percent for the July to September 2004 quarter versus the 6.1 percent projection for the period. However, the rate of growth slowed to 6.7 percent for September from almost 10 percent in August. The impact of recent hurricanes has taken a severe toll on certain areas of the State. The effect on State and local revenues is hard to measure. In a typical disaster event, the front- end loss in withholding and sales tax revenue is eventually offset by gains during the recovery period due to reconstruction efforts and the makeup of lost production. The improving revenue picture, though not as broad- based or as strong during prior recoveries, is dampened by the State’s $ 1.1 billion structural budget gap for the 2005- 06 fiscal year. The gap is due to a combination of tax increases that will expire ($ 525 million), one- time transfers used to balance the 2003- 04 and the 2004- 05 budgets, and one- time budget cuts. The budget gap numbers for North Carolina are typical of other states following the severe 2001- 03 recession. State of North Carolina 47 Conditions Expected to Impact Future Operations The North Carolina Retirement System has identified major issues that will have a significant impact on the State’s fiscal condition. Demographic Factors: The Baby Boomers The process of retirement for the demographic cohort known as the “ Baby Boomers” will have tremendous economic, social, and political impact in North Carolina. Two critical areas in which the “ Boomer” retirement will be significantly consequential are: A) public sector workforce, and B) the cost to the State of providing retirement benefits. Workforce Impact: • The Baby Boomers are an eighteen- year cohort, currently between forty ( 40) and fifty- eight ( 58) years of age. • In North Carolina this cohort constitutes approximately 59 percent of the State’s public workforce. Impact: the State’s public sector workforce will have to be replenished as this cohort moves into retirement. • Further, replacement personnel will be drawn from a shrinking pool of workers made up of considerably smaller generations than the boomer predecessors. Impact: the State will be faced with an increasingly competitive labor market. • Implications: North Carolina will have to address these impacts by one or more of the following: expand its efforts to retain aging boomers in the public sector and thus slow the rate of retirement, or become more competitive in the labor market in order to recruit workers to State employment or reduce the number of public sector positions. Providing Retirement Benefits: • The first year of the eighteen ( 18) year boomer cohort has just reached the average age of retirement in the State system for 2003, which is aged 58 ½ . Impact: the first of the Boomer cohort is on the cusp of retirement, marking the beginning of boomer retirement from the North Carolina public sector. • The total number of retirees in the North Carolina Teachers’ and State Employees’ Retirement System will increase 135% through 2022 ( the total increase for both the State and the Local government systems is 141%). Impact: the cost to the State of providing retirement benefits will increase. ( Note: Increasing costs are not driven by the cost of providing an actual pension as employees and employers fund the pension over the employee’s service career. The increase in cost will come from administrative expenses and the cost of providing Cost of Living Adjustments ( COLAs) for a significantly larger retiree pool.) • While a set rate for Cost of Living Adjustments ( COLA) is not specified in statute, the State has historically provided retirees with an annual COLA that matches the Consumer Price Index ( CPI). Impact: if the State continues to provide a COLA to retirees, expenditures from the General Fund will have to increase to cover the cost of providing such COLAs for an increasing pool of retirees. • Implications: to be competitive in tomorrow’s labor market, North Carolina will have to continue to provide attractive benefits such as the State’s retirement plan; this will occur during a time when system administration and COLAs costs will increase significantly as the number of retirees exponentially expands. Retiree Health Care The Governmental Accounting Standards Board ( GASB) reporting guidelines that will require disclosure of the State’s liabilities for retiree health care costs ( i. e., GASB Statements No. 43 and 45) is one of the State’s largest looming fiscal items. The Retirement System facilitates the benefit by making the deduction for the State Health Plan from retirees’ pension checks. The Retirement System is also the front line organization for retirees who want to voice their concerns about changes, or potential changes, to benefits. Ultimately, the provision of health care for the State’s public sector retirees is the responsibility of the State Health Plan. The unfunded actuarial liability for retiree health care is substantial because of the State’s policy of funding these benefits on a pay- as- you- go basis. 48 State of North Carolina In preparation for the new GASB standards on other postemployment benfits, the North Carolina General Assembly enacted legislation in 2004 establishing a Retiree Health Benefit Fund. The State’s contributions to this fund are irrevocable, and the assets of the fund are not subject to the claims of the State’s creditors. More detailed information about the State’s obligations for Retiree Health Care is presented in the Letter of Transmittal. In addition, the announcement of a new computer manufacturing facility by Dell, Inc. is expected to impact future operations. Dell Manufacturing Facility In November 2004, Governor Michael F. Easley announced that Dell, Inc. ( Dell) will build a computer manufacturing facility in North Carolina. Dell, a leading manufacturer and distributor of computers and related products, plans to build and equip a state- of- the- art, 400,000- square- foot manufacturing and distribution facility in the Piedmont Triad region. Dell currently has two U. S. factories in Nashville, Tennessee and Austin, Texas. The North Carolina General Assembly convened a one- day special session on November 4, 2004 an approved an economic incentive for computer manufacturing companies that in the case of Dell, will provide up to $ 225 million in tax credits over the next fifteen years. For each year in which Dell meets the required performance targets, the State will provide a grant equal to 75 percent of the State personal income withholding taxes derived from the creation of new jobs. Requests for Information This financial report is designed to provide our citizens, taxpayers, customers, and investors and creditors with a general overview of the State’s finances and to demonstrate the State’s accountability for the money it receives. If you have questions about this report or need additional financial information, contact the North Carolina Office of the State Controller, Accounting and Financial Reporting Section, 1410 Mail Service Center, Raleigh, N. C. 27699- 1410. In addition, this financial report is available on the Office of the State Controller’s Internet home page at http:// www. ncosc. net/ financial/ financial. html. BASIC FINANCIAL STATEMENTS 50 State of North Carolina THIS PAGE INTENTIONALLY LEFT BLANK. GOVERNMENT- WIDE FINANCIAL STATEMENTS 52 State of North Carolina STATEMENT OF NET ASSETS June 30, 2004 Exhibit A- 1 ( Dollars in Thousands) Primary Government Governmental Business- type Component Activities Activities Total Units ASSETS Cash and cash equivalents ( Note 3)................................ $ 4,105,858 $ 249,802 $ 4,355,660 $ 2,700,361 Investments ( Note 3)........................................................ 499,164 38,409 537,573 2,050,256 Securities lending collateral ( Note 3)................................ 3,426,369 193,909 3,620,278 — Receivables, net ( Note 4).................................................. 2,051,983 297,705 2,349,688 735,038 Due from component units ( Note 17)................................ 18,202 — 18,202 55,833 Due from primary government ( Note 17).......................... — — — 276,402 Internal balances............................................................... ( 58) 58 — — Inventories......................................................................... 150,730 485 151,215 69,786 Prepaid items.................................................................... 12,337 1,845 14,182 13,854 Advances to component units ( Note 17)........................... 24,242 — 24,242 — Notes receivable, net ( Note 4).......................................... 282,678 435,220 717,898 2,890,667 Endowment investments ( Note 3)..................................... 55,211 — 55,211 1,715,044 Investment in joint venture................................................ — — — 8,319 Deferred charges.............................................................. — 118 118 20,661 Securities held in trust....................................................... 41,638 — 41,638 — Pension assets ( Note 11).................................................. 278 — 278 — Capital assets- nondepreciable ( Note 5)............................ 9,947,437 27,096 9,974,533 1,608,640 Capital assets- depreciable, net ( Note 5)........................... 15,609,459 22,411 15,631,870 5,068,825 Total Assets ..................................................................... 36,225,528 1,267,058 37,492,586 17,213,686 LIABILITIES Accounts payable and accrued liabilities.......................... 1,239,924 24,067 1,263,991 549,345 Medical claims payable..................................................... 762,427 — 762,427 7,308 Unemployment benefits payable....................................... — 20,048 20,048 — Tax refunds payable.......................................................... 1,056,880 — 1,056,880 — Obligations under securities lending................................. 3,426,369 193,909 3,620,278 — Interest payable................................................................. 57,931 35 57,966 24,201 Short- term debt ( Note 6)................................................... — 251,759 251,759 2 |
OCLC number | 21060442 |