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ITEM 3.8 City of Otsego - 2016 Communications Letter City of Otsego Wright County, Minnesota Communications Letter December 31, 2016 City of Otsego Table of Contents Report on Matters Identified as a Result of the Audit of the Financial Statements 1 Material Weakness 3 Significant Deficiency 4 Required Communication 5 Financial Analysis 9 1 BerganKDV, Ltd. bergankdv.com Report on Matters Identified as a Result of the Audit of the Financial Statements Honorable Mayor, Members of the City Council and Management City of Otsego Otsego, Minnesota In planning and performing our audit of the financial statements of the governmental activities, business-type activities, and the aggregate remaining fund information of the City of Otsego, Minnesota, as of and for the year ended December 31, 2016, in accordance with auditing standards generally accepted in the United States of America, we considered the City's internal control over financial reporting (internal control) as a basis for designing audit procedures that are appropriate in the circumstances for the purpose of expressing our opinions on the financial statements, but not for the purpose of expressing an opinion on the effectiveness of the City's internal control. Accordingly, we do not express an opinion on the effectiveness of the City's internal control. Our consideration of internal control was for the limited purpose described in the preceding paragraph and was not designed to identify all deficiencies in internal control that might be material weaknesses or significant deficiencies and, therefore, material weaknesses or significant deficiencies may exist that were not identified. In addition, because of inherent limitations in internal control, including the possibility of management override of controls, misstatements due to error, or fraud may occur and not be detected by such controls. However, as discussed below, we identified certain deficiencies in internal control that we consider to be a material weakness and an other deficiency that we consider to be a significant deficiency. A deficiency in internal control exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent, or detect and correct, misstatements on a timely basis. A material weakness is a deficiency, or a combination of deficiencies in internal control, such that there is a reasonable possibility that a material misstatement of the City's financial statements will not be prevented or detected and corrected, on a timely basis. The material weakness identified is stated within this letter. A significant deficiency is a deficiency, or a combination of deficiencies, in internal control that is less severe than a material weakness, yet important enough to merit attention by those charged with governance. The significant deficiency identified is stated within this letter. 2 The accompanying memorandum also includes financial analysis provided as a basis for discussion. The matters discussed herein were considered by us during our audit and they do not modify the opinion expressed in our Independent Auditor's Report dated May 24, 2017, on such statements This communication is intended solely for the information and use of management, the City Council, others within the City and state oversight agencies and is not intended to be, and should not be, used by anyone other than these specified parties. St. Cloud, Minnesota May 24, 2017 3 City of Otsego Material Weakness MATERIAL AUDIT ADJUSTMENT During the course of our engagement, we proposed a material audit adjustment that would not have been identified as a result of the City's existing internal control system and, therefore, could have resulted in a material misstatement of the City's financial statements. The material misstatement detected as a result of audit procedures was corrected by management. We recommend that the City review the internal control process over the year-end closing process to ensure there are no adjustments needed. 4 City of Otsego Significant Deficiency LACK OF SEGREGATION OF ACCOUNTING DUTIES The City had a lack of segregation of accounting duties due to a limited number of office employees. Adequate segregation of accounting duties is in place when the following four areas of a transaction have been separated: authorization, custody, recording, and reconciliation. Examples of functions within the City that demonstrate this lack of segregation of accounting duties include, but are not limited to, the following: • Cash Receipts – The Utility Billing Clerk and Accountant have access to initiate and record receipts. The Utility Billing Clerk is also responsible for depositing cash receipts. The Accountant is also involved in the reconciliation process and has full access to the general ledger. • Utility Billing Process – The Utility Billing Clerk is responsible for handling customer payments, depositing payments received, and recording adjustments to accounts. • Disbursements – Due to small staff the City allows access to other employees to perform disbursement related activities in order to fill in for normal roles and responsibilities in the absences of other staff. The Accountant has access to record and cut checks, access to blank checks, can enter manual adjustments to the general ledger and is involved in the reconciliation of cash. • Financial Reporting and Journal Entry Process – The Finance Director and Accountant have full access to the general ledger and can make adjustments without review during the monthly and yearend financial closing process. Management and the City Council must remain aware of this situation and management should continually monitor internal control, including changes that occur. 5 City of Otsego Required Communication We have audited the financial statements of the governmental activities, business-type activities, each major fund, and the aggregate remaining fund information of the City as of and for the year ended December 31, 2016, and have issued our report thereon dated May 24, 2017. Professional standards require that we provide you with the following information related to our audit. OUR RESPONSIBILITY UNDER AUDITING STANDARDS GENERALLY ACCEPTED IN THE UNITED STATES OF AMERICA AND GOVERNMENT AUDITING STANDARD As stated in our engagement letter, our responsibility, as described by professional standards, is to express opinions about whether the financial statements prepared by management with your oversight are fairly presented, in all material respects, in conformity with accounting principles generally accepted in the United States of America. Our audit of the financial statements does not relieve you or management of your responsibilities. As part of our audit, we considered the internal control of the City. Such considerations were solely for the purpose of determining our audit procedures and not to provide any assurance concerning such internal control. As part of obtaining reasonable assurance about whether the financial statements are free of material misstatement, we performed tests of the City's compliance with certain provisions of laws, regulations, contracts, and grants. However, the objective of our tests was not to provide an opinion on compliance with such provisions. Generally accepted accounting principles provide for certain required supplementary information (RSI) to supplement the basic financial statements. Our responsibility with respect to the RSI, which supplement(s) the basic audit financial statements, is to apply certain limited procedures in accordance with generally accepted auditing standards. However, the RSI was not audited and, because the limited procedures do not provide us with sufficient evidence to express an opinion or provide any assurance, we do not express an opinion or provide any assurance on the RSI. Our responsibility for the supplementary information accompanying the financial statements, as described by professional standards, is to evaluate the presentation of the supplementary information in relation to the financial statements as a whole and to report on whether the supplementary information is fairly stated, in all material respects, in relation to the financial statements taken as a whole. PLANNED SCOPE AND TIMING OF THE AUDIT An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements; therefore, our audit involved judgment about the number of transactions to be examined and the areas to be tested. 6 City of Otsego Required Communication PLANNED SCOPE AND TIMING OF THE AUDIT (CONTINUED) Our audit included obtaining an understanding of the City and its environment, including internal control, sufficient to assess the risks of material misstatement of the financial statements and to design the nature, timing, and extent of further audit procedures. Material misstatements may result from (1) errors, (2) fraudulent financial reporting, (3) misappropriation of assets, or (4) violations of laws or governmental regulations that are attributable to the City or to acts by management or employees acting on behalf of the City. QUALITATIVE ASPECTS OF ACCOUNTING PRACTICES Management is responsible for the selection and use of appropriate accounting policies. The significant accounting policies used by the City are described in the notes to financial statements. The City adopted a new capital asset policy that increased the capitalization threshold for the year ending December 31, 2016. We noted no transactions entered into by the City during the year for which there is a lack of authoritative guidance or consensus. All significant transactions have been recognized in the proper period. Accounting estimates are an integral part of the financial statements prepared by management and are based on management's knowledge and experience about past and current events and assumptions about future events. Certain accounting estimates are particularly sensitive because of their significance to the financial statements and because of the possibility that future events affecting them may differ significantly from those expected. The most sensitive estimates affecting the financial statements were: Depreciation – The City is currently depreciating its capital assets over their estimated useful lives, as determined by management, using the straight-line method. Expense Allocation – Certain expenses are allocated to programs based on an estimate of the benefit to that particular program. Examples are salaries, benefits, and supplies. Net Pension Liability, Deferred Outflows of Resources Related to Pensions, and Deferred Inflows of Resources Related to Pension Activity – These balances are based on allocation by the pension plans using estimates based on contributions. We evaluated the key factors and assumptions used to develop the accounting estimates in determining that they are reasonable in relation to the financial statements taken as a whole. The financial statement disclosures are neutral, consistent, and clear. DIFFICULTIES ENCOUNTERED IN PERFORMING THE AUDIT We encountered no significant difficulties in dealing with management in performing and completing our audit. 7 City of Otsego Required Communication CORRECTED AND UNCORRECTED MISSTATEMENTS Professional standards require us to accumulate all known and likely misstatements identified during the audit, other than those that are clearly trivial, and communicate them to the appropriate level of management. Management did not identify, and we did not notify them of any, uncorrected financial statement misstatements. The following material misstatement detected as a result of audit procedures was corrected by management. • Contracts payable and related expenditures DISAGREEMENTS WITH MANAGEMENT For purposes of this letter, a disagreement with management is a financial accounting, reporting, or auditing matter, whether or not resolved to our satisfaction that could be significant to the financial statements or the auditor's report. We are pleased to report that no such disagreements arose during the course of our audit. MANAGEMENT REPRESENTATIONS We requested certain representations from management that are included in the management representation letter. MANAGEMENT CONSULTATIONS WITH OTHER INDEPENDENT ACCOUNTANTS In some cases, management may decide to consult with other accountants about auditing and accounting matters, similar to obtaining a "second opinion" on certain situations. If a consultation involves application of an accounting principle to the City's financial statements or a determination of the type of auditor's opinion that may be expressed on those statements, our professional standards require the consulting accountant to check with us to determine that the consultant has all the relevant facts. To our knowledge, there were no such consultations with other accountants. OTHER AUDIT FINDINGS OR ISSUES We generally discuss a variety of matters, including the application of accounting principles and auditing standards, with management each year prior to retention as the City's auditors. However, these discussions occurred in the normal course of our professional relationship and our responses were not a condition to our retention. 8 City of Otsego Required Communication OTHER MATTERS We applied certain limited procedures to the RSI that supplements the basic financial statements. Our procedures consisted of inquiries of management regarding the methods of preparing the information and comparing the information for consistency with management's responses to our inquiries, the basic financial statements, and other knowledge we obtained during our audit of the basic financial statements. We did not audit the RSI and do not express an opinion or provide any assurance on the RSI. With respect to the supplementary information accompanying the financial statements, we made certain inquiries of management and evaluated the form, content and methods of preparing the information to determine that the information complies with accounting principles generally accepted in the United States of America, the method of preparing it has not changed from the prior period and the information is appropriate and complete in relation to our audit of the financial statements. We compared and reconciled the supplementary information to the underlying accounting records used to prepare the financial statements or to the financial statements themselves. 9 City of Otsego Financial Analysis The following pages provide graphic representation of select data pertaining to the financial position and operations of the City for the past five years. Our analysis of each graph is presented to provide a basis for discussion of past performance and how implementing certain changes may enhance future performance. We suggest you view each graph and document if our analysis is consistent with yours . A subsequent discussion of this information should be useful for planning purposes. GENERAL FUND The following graph summarizes the past five years of General Fund revenues, expenditures, and fund balance. For the year ended December 31, 2016, revenues for the City's General Fund totaled $5,791,496. This represents an increase of $702,154, or 13.8%, from 2015. General Fund expenditures totaled $4,712,360 in 2016, which is an increase of $287,541, or 6.5%, from 2015. Revenue and expenditure activity, combined with other financing sources resulted in a increase in fund balance of $755,679 in 2016. The ending General Fund balance of $3,646,202 is further broken down into spending categories; $110,973 of the fund balance has already been spent on prepaid items while $192,408 is assigned for insurance funding. This leaves $3,342,821 available for spending on any purpose, which is considered unassigned fund balance. The City's policy is to maintain a minimum fund balance in the General Fund of 45.0% of the subsequent years' expenditures. The fund balance at December 31, 2016, represents 72.3% of 2017 budgeted expenditures of $5,040,565. 2012 2013 2014 2015 2016 Total Revenues $3,697,348 $3,779,808 $5,307,292 $5,089,342 $5,791,496 Total Expenditures 3,521,355 3,654,491 4,165,186 4,424,819 4,712,360 Fund Balance 1,764,591 1,912,075 3,393,638 2,890,523 3,646,202 $- $1,000,000 $2,000,000 $3,000,000 $4,000,000 $5,000,000 $6,000,000 General Fund 10 City of Otsego Financial Analysis GENERAL FUND REVENUES Trends for each of the City's major revenue classifications over the past five years are graphically portrayed in the bar chart below. As stated earlier, General Fund revenues increased $702,154, or 13.8%, from 2015. The most significant increase was in licenses and permits which increased $482,429 from 2015 to 2016, due to increased building and development in 2016. The second most significant increase was taxes, which increased $181,718. This increase was due to an increase in levy in 2016. Intergovernmental revenue decreased $125,796 due to recording local government aid (LGA) in the Street Management Fund in 2016. Other revenue sources were similar to the prior year. 2012 2013 2014 2015 2016 Taxes $3,245,677 $3,449,691 $3,442,280 $3,444,175 3,625,893 Intergovernmental 208,822 217,630 337,779 195,363 69,567 Licenses and Permits 33,915 36,455 1,238,823 1,179,136 1,661,565 Charges for Services 59,996 38,321 192,168 174,878 286,614 Investment Income 93,509 (5,403)37,427 15,015 21,233 Other 55,429 43,114 58,815 80,775 126,624 $- $1,000,000 $2,000,000 $3,000,000 $4,000,000 $5,000,000 $6,000,000 General Fund Revenues 11 City of Otsego Financial Analysis GENERAL FUND REVENUES (CONTINUED) The allocation of revenues by source within each major classification is presented below for 2016 and 2015. The City continues to rely on tax revenue as the majority of its General Fund revenue, accounting for 62.6% of its total revenue in 2016. Sources of revenue were fairly consistent with the prior year, with the exception of licenses and permits making up a larger proportion of total revenues in 2016 due to increased building and development. Taxes 62.6% Intergovernmental 1.2% Licenses and Permits 28.7% Charges for Services 4.9% Investment Income 0.4%Other 2.2% 2016 General Fund Revenues Taxes 67.7%Intergovernmental 3.8% Licenses and Permits 23.2%Charges for Services 3.4% Investment Income 0.3% Other 1.6% 2015 General Fund Revenues 12 City of Otsego Financial Analysis GENERAL FUND REVENUES (CONTINUED) The graph below outlines the budget and actual results for General Fund revenues. Taxes Intergovernmental Licenses and Permits Charges for Services Investment Income Other Budget $3,651,352 $343,590 $641,565 $57,000 $50,000 $- Actual 3,625,893 69,567 1,661,565 286,614 21,233 126,624 $- $200,000 $400,000 $600,000 $800,000 $1,000,000 $1,200,000 $1,400,000 $1,600,000 $1,800,000 $2,000,000 $2,200,000 $2,400,000 $2,600,000 $2,800,000 $3,000,000 $3,200,000 $3,400,000 $3,600,000 $3,800,000 2016 General Fund Revenues Budget and Actual Overall, actual revenue exceeded budgeted revenue by $1,047,989, or 22.1%. The largest variance was for licenses and permits which was $1,020,000 over budget. This was the result of budgeting conservatively for building and commercial construction permits for 2016. The second largest variance was in charges for services which was $229,614 over budget due to budgeting conservatively for commercial development and building activity in 2016. The third largest variance was in other revenue, which was $126,624 over budget due to the City not budgeting for other revenue. Other revenue includes Special Assessments, Fines and Forfeitures, and Contributions and Donations. Investment income was budgeted at $50,000 based on past results while actual investment earnings and changes in fair market value were only $21,233. 13 City of Otsego Financial Analysis GENERAL FUND EXPENDITURES As discussed previously, total General Fund expenditures increased $287,541, or 6.5%, from 2015. Public safety expenditures increased $162,779, which was across several departments. The increase was also across all expenditure types (personal services, supplies, and other services and charges) largely due to the fire contracts increasing which are based on the City's tax capacity, as well as a large increase in building inspections. 2012 2013 2014 2015 2016 General Government $920,619 $973,051 $1,188,802 $1,150,130 1,240,005 Public Safety 1,235,982 1,263,881 1,496,112 1,666,509 1,829,288 Public Works 998,144 1,109,949 1,014,937 1,034,524 1,010,620 Parks and Recreation 277,605 304,324 461,240 477,445 534,122 Economic Development 89,005 3,286 4,095 96,211 98,325 $- $500,000 $1,000,000 $1,500,000 $2,000,000 $2,500,000 $3,000,000 $3,500,000 $4,000,000 $4,500,000 $5,000,000 General Fund Expenditures 14 City of Otsego Financial Analysis GENERAL FUND EXPENDITURES (CONTINUED) The following charts illustrate the allocation of General Fund expenditures by program/function. The allocation of total expenditures by program has fluctuated between the past two years as a result of the changes in expenditures as discussed on the previous page. General Government 26.3% Public Safety 38.8%Public Works 21.5% Parks and Recreation 11.3% Economic Development 2.1% 2016 General Fund Expenditures General Government 26.0% Public Safety 37.7% Public Works 23.3% Parks and Recreation 10.8%Economic Development 2.2% 2015 General Fund Expenditures 15 City of Otsego Financial Analysis GENERAL FUND EXPENDITURES (CONTINUED) The graph below outlines the budget and actual results for General Fund expenditures. General Government Public Safety Public Works Parks and Recreation Economic Development Budget $1,255,768 $1,757,000 $1,098,952 $535,652 $105,300 Actual 1,240,005 1,829,288 1,010,620 534,122 98,325 $- $200,000 $400,000 $600,000 $800,000 $1,000,000 $1,200,000 $1,400,000 $1,600,000 $1,800,000 $2,000,000 2016 General Fund Expeditures Budget and Actual Overall, actual expenditures were under budgeted amounts by $40,312, or 0.8%. The public works program had the largest variance, coming in $88,332 under budget. This variance is primarily due to conservative budgeting and less sand and salt needed in 2016. 16 City of Otsego Financial Analysis ANALYSIS OF TAX LEVY INFORMATION The chart below graphs the tax capacity, certified tax levy, and City tax rate for 2012 through 2016. Comparing 2012 through 2016, the City's tax capacity has increased $2,959,876, or 28.8%, to $13,238,424. The City's certified levy increased $759,274, or 17.8%, over the same time frame. As a result, the City's tax capacity rate has decreased from 41.45% in 2012 to 37.92% in 2016. When comparing 2015 to 2016 the chart indicates that even with a levy increase of $340,167 the tax rate decreased from 41.20% to 37.90% due to a $1,879,809 increase in the total tax capacity. $4,260,869 $4,378,021 $4,500,188 $4,679,976 $5,020,143 $10,278,548 $9,470,288 $10,095,765 $11,358,615 $13,238,424 41.45% 46.23% 44.58% 41.20% 37.92% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00% 45.00% 50.00% $- $2,000,000 $4,000,000 $6,000,000 $8,000,000 $10,000,000 $12,000,000 $14,000,000 2012 2013 2014 2015 2016 Tax Capacity, Levy, and Rates Tax Levy Total Tax Capacity Tax Capacity Rate 17 City of Otsego Financial Analysis WATER FUND 2012 2013 2014 2015 2016 Operating Revenues $986,597 $1,195,892 $1,114,528 $1,163,963 $1,266,379 Operating Expenses 877,076 907,185 853,551 911,243 943,066 Operating Income (Loss) with Depreciation 109,521 288,707 260,977 252,720 323,313 Operating Income without Depreciation 582,900 763,931 733,738 726,399 805,049 $(200,000) $- $200,000 $400,000 $600,000 $800,000 $1,000,000 $1,200,000 $1,400,000 Water Fund The Water Fund experienced operating income of $323,313 in 2016. This is the fifth consecutive year with an operating income. We have also illustrated the operating income for the past five years with depreciation, a non-cash expense, factored out of operating expenses. In 2016, the City experienced operating income of $805,049 with depreciation expense factored out of operating expenses. Depreciation expense amortizes the original cost of fund capital assets over their total useful lives. In 2016, operating revenues increased $102,416, or 8.8%, while operating expenses increased $31,823, or 3.5%. The increase in operating revenues was due to an increase in usage. Operating expenses increased primarily as a result of increased professional services and supplies. After factoring in non-operating items and capital contributions, in the form of connection fees, and transfers the net position in this fund increased by $1,548,083 18 City of Otsego Financial Analysis SEWER FUND 2012 2013 2014 2015 2016 Operating Revenues $1,043,570 $1,186,523 $1,325,181 $1,477,603 $1,590,795 Operating Expenses 1,571,150 1,529,321 1,458,714 1,612,830 1,888,280 Operating Loss with Depreciation (527,580)(342,798)(133,533)(135,227)(297,485) Operating Income without Depreciation 298,662 481,694 689,589 689,210 542,132 $(1,000,000) $(500,000) $- $500,000 $1,000,000 $1,500,000 $2,000,000 Sewer Fund In 2016, the Sewer Fund continued to generate an operating loss. In 2016, the Sewer Fund experienced an operating loss of $297,485 with depreciation. Operating revenues increased $113,192 or 7.7% over the prior year, while operating expenses increased $275,450, or 17.1%. The increase in operating revenues is due to an increase in rates, as well as an increase in users. The increase in operating expenses was a result of engineering costs related to projects and additional chemical purchases to address an odor issue. The increase in operating loss in 2016 is an indication that this Fund has not effectively established rates to cover all operating expenses. Without depreciation, operating income totaled $542,132. We recommend the City continue to monitor operations and fee structures of this Fund to ensure positive operating results. After factoring in non-operating items, capital contributions, in the form of connection fees, and transfers, the net position in this fund increased $2,173,131. 19 City of Otsego Financial Analysis STORM WATER FUND 2012 2013 2014 2015 2016 Operating Revenues $37,231 $41,831 $45,570 $45,066 $46,811 Operating Expenses 69,834 72,944 57,977 95,533 42,342 Operating Income (Loss) with Depreciation (32,603)(31,113)(12,407)(50,467)4,469 Operating Income (Loss) without Depreciation (14,845)(13,355)5,376 (29,051)28,520 $(70,000) $(50,000) $(30,000) $(10,000) $10,000 $30,000 $50,000 $70,000 $90,000 $110,000 Storm Water Fund Operating revenues increased slightly from the prior year while operating expenses decreased, as shown in the graph above. The Storm Water Fund experienced a small increase in operating revenues of $1,745 or 3.9% from 2015. Operating expenses decreased $53,191 or 55.7% from 2015 to 2016. The Fund experienced operating income of $4,469 in 2016. Without depreciation included in operating expenses, the Fund experienced operating income of $28,520. After factoring in non-operating items and transfers, this Fund's net position increased by $388,643.