The governmental financial reporting entity: inclusion and display. (includes definition of the financial reporting entity and criteria for blending componnent units)by Chaney, Barbara A.
What's in and what's out of the governmental financial reporting entity? The GASB issued a standard to define the financial reporting entity and to determine the display of component units and joint ventures.
Is the New York City Library part of The City of New York? Is the City University of New York part of the city, or is it part of the state? Why has Penn State University not been considered a state school, while Bloomsburg State University is?
The GASB Addresses Reporting Entity Issues
These and other thought-provoking questions are part of the governmental financial reporting entity quagmire. After four years of deliberation, the GASB project on the reporting entity ended in June 1991 with the promulgation of Statement 14, The Financial Reporting Entity. Statement 14 addresses what should be included in a governmental financial reporting entity and how it should be included. In addition, it addresses accounting for interests in joint ventures. Statement 14 is applicable to all governmental organizations--primary governments, component units, joint ventures, governmental colleges and universities, and any other governmental organizations under the purview of the GASB. These governmental organizations must evaluate their relationships with other organizations to determine whether they have component units or joint ventures to include in their entities.
Statement 14 is effective for periods beginning after December 15, 1992, but earlier application is encouraged. The adjustment necessary to implement the standard should be treated as a prior period adjustment. The effective date of Statement 14 is not the same as that of Statement 11, Measurement Focus and Basis of Accounting-Governmental Fund Operating Statements, which is for periods beginning after June 15, 1994. (The GASB is currently proposing to delay the effective date of Statement 11 indefinitely while it deliberates reporting model issues.) The GASB believes that the provisions of Statement 14 can be implemented in the current financial reporting model or in a future model developed to operationalize Statement 11. Therefore, there was no compelling reason to delay the implementation of Statement 14 any longer than is reasonably necessary to allow preparers to evaluate their entities and develop systems for gathering data. Because of the complexities that are involved, the GASB provided approximately a year and a half for constituents to begin implementing Statement 14.
The reporting entity information-gathering process may be more complicated than it has been in the past because of the requirement to apply the standard from the bottom up. Statement 14 should be applied in layers, starting with the lowest layer. For example, a state may have determined that it has a number of component units, one of which might be a financing authority. The authority may have evaluated its relationships with a variety of organizations and determined that it too has component units to include. Before the financing authority is included in the state's financial reporting entity, it must include its own component units. Those "subsidiaries" are not component units of the state. However, they will be included in the state's financial reporting entity by virtue of the fact that they are included in the financing authority's entity.
The National Council on Governmental Accounting (NCGA) preceded the GASB as a standard setter. Two of its Statements were reexamined as part of the GASB's due process of Statement 14. One Statement defined the entity by providing a number of criteria to consider when evaluating a potential component unit. Some of the criteria were fairly subjective, such as "ability to significantly influence operations." All the criteria were supposed to be considered, but inclusion could be warranted if only one of the criteria were met. Alternatively, exclusion could be warranted even if all the criteria were met. Uniformity was lacking.
The other NCGA Statement reexamined during Statement 14's due process addressed display of the financial reporting entity. It required that all component units (except colleges and universities) be "blended;" that is, included with the funds of the primary government. Many constituents (particularly investment analysts) considered it inappropriate to blend component units that were not closely related to the primary government.
Definition and Display
The GASB decided that definition and display issues could not be decided independently from each other. What to include depends on how it will be included, and how to include depends on the relationship between the primary government and the component unit. Before settling on the details of definition and display, the GASB agreed 1) to base the definition of the entity on the concept of accountability and 2) to base the display of the entity in a manner that clearly separates the legally constituted primary government from its legally constituted component units.
Definition of the Governmental Financial Reporting Entity
Starting with accountability as an objective of financial reporting, the GASB explored ways of defining the reporting entity in such a way as to report accountability. The basic premise is that elected officials should be held accountable for their actions. In Statement 14, it is presumed that they are also accountable for the actions of their appointees. Therefore, a primary government is accountable for an organization if the government appoints a voting majority of the organization's governing body. However, accountability in this sense does not lead to the inclusion of an organization in a financial reporting entity. Sometimes appointments are ministerial and lack accountability and sometimes accountability exists without appointment. Under Statement 14, an organization is a component unit only if the primary government is financially accountable for it.
Financial accountability exists under any one of these three conditions:
1. The primary government appoints a voting majority and a) is able to impose its will on the organization, or b) receives a financial benefit from or accepts a financial burden for the organization.
2. The organization is fiscally dependent on the primary government. (See Exhibit 1 for a description of these terms and the definition of the financial reporting entity.)
Although the definition of financial accountability appears very structured and easy to apply, there are many elements of subjectivity inherent in the criteria. For example, one of the manifestations of imposition of will is the ability to modify or approve an organization's budget. Sometimes, a primary government's approval authority is more ministerial than substantive, the so-called "rubber stamp of approval." A rubber stamp does not constitute imposition of will.
In another example, a payment in lieu of taxes by a component unit may or may not be evidence of a "financial benefit" to the primary government. If the transaction is quasi-external in nature and is reasonable in amount and calculation, it should probably not be considered a "financial benefit." However, if the amount is calculated based on surplus operating revenue or kilowatt hour sales, the primary government is reaping a financial benefit from what appears to be a subsidy of the primary government.
In yet another example, the ability to approve rates or charges is not evidence of fiscal dependence if the approval is indirect through the setting of a ceiling. A community college (whose officials are appointed by the county) whose tuition rates cannot exceed an amount set by the state legislature is not fiscally dependent on the state for its rates, because the state is not directly approving its tuition.
One More Measure
An even more subjective aspect of the definition of the financial reporting entity is the requirement to include a component unit if the nature and significance of the relationship between the primary government and the component unit are such that exclusion would cause the reporting entity's financial statements to be misleading or incomplete. This provision was written with organizations like the Municipal Assistance Corporation of New York (MAC) in mind. MAC was created in 1975 as a financing mechanism for the City. Under the previously mentioned GASB Statement 14 definition of financial accountability, the MAC would not qualify for inclusion in New York City's entity because the state appoints the MAC's board. But the MAC is so inextricably linked to New York City's finances that its exclusion would render the City's financial statements misleading.
This particular provision may have interesting ramifications for certain not-for-profit organizations affiliated with colleges and universities and hospitals. Today, this provision maintains the status quo in reporting affiliated organizations such as university fund-raising foundations. Some foundations are currently included, but many others are excluded. The GASB has on the back burner a project to interpret how this provision should be applied to affiliated organizations. It is possible that the GASB will provide specific guidance on how to determine whether it is misleading to exclude an affiliated organization.
The GASB's definition of the financial reporting entity is intended to make it easier to determine when an organization does or does not qualify for inclusion. The inherent subjectivity of the relevant factors has been held to a minimum, wherever possible. This is hoped to be an improvement over the existing entity definition standard.
The Primary Government
The GASB's reporting entity display methodology is intended to provide an overview of the primary government and all organizations for which it is financially accountable. However, the TABULAR DATA OMITTED overview strives to maintain a separateness between the primary government and the component units. The only exception to the separation is the blending of certain component units that are so closely related to the primary government that they should be treated as though they are part of the primary government. (See Exhibit 2 for a description of the blending criteria.) Far fewer component units are expected to be blended under Statement 14 than are blended under existing guidance. Many of the currently blended component units will instead be discretely presented.
All the organizations that meet the definition of a component unit (and do not meet the criteria for blending) should be discretely presented. Before Statement 14, only colleges and universities were discretely presented. This method of presentation is an ideal way to provide an overview of the entity without implying that the resources of all the component units are owned or controlled by the primary government and without losing sight of the financial data of the legally constituted primary government. The financial data of the component units are presented in a column or columns to the right of the primary government's financial data, and details about the major component units are supplementary.
Statement 14 allows flexibility in discrete presentation. Appropriate discrete presentation formats exist on a wide spectrum of aggregation/disaggregation possibilities. At one extreme, each component unit could be presented individually in a separate column. This disaggregation approach works well if the primary government has few component units. However, if there are numerous component units, the presentation could get unwieldy.
At the other extreme, all component units could be aggregated into a single column. For example, assume that a primary government has six component units using different fund-type models: two use governmental fund accounting, two use proprietary fund accounting, and two use college and university accounting. All the assets, liabilities, and equity of the six would be combined into a single column on the combined balance sheet of the reporting entity. The governmental funds' general fixed assets would be combined with the proprietary funds' capitalized assets and the universities' property, plant, and equipment. Likewise, debt would be combined, regardless of whether the component unit presents it in a general long-term debt account group or in a plant fund's liabilities. The format is irrelevant for aggregation purposes.
The operating statements under this highly aggregated approach may not be as aggregated as the balance sheet because, while there is only one combined balance sheet in the governmental reporting model, there are usually at least two combined operating statements. In the example introduced above, aggregation in the operating statements would be limited. The two governmental fund component units would be aggregated and presented in a single column in the combined statement of revenues, expenditures, and changes in fund balance. The proprietary fund component units would be aggregated in a column in the combined statement of revenues, expenses, and changes in retained earnings. The university component units would be aggregated in a separate statement of changes in fund balances and a statement of current funds revenues, expenditures, and other changes.
The most frequent criticism of the highly aggregated format is the obfuscation of component unit data. Therefore, Statement 14 requires specific disclosures to mitigate this criticism, even though the reporting entity's financial statements would not normally be the place to look for information about individual component units. Statement 14 requires condensed financial statements for each major component unit to be presented in the notes (similar to segment information for enterprise funds). Alternatively, the combining statements for the component units could be presented in the general purpose financial statements (GPFS), rather than as supporting detail in the comprehensive annual financial report (CAFR). (The GPFS is the liftable portion of the CAFR.) In effect, the combining statements would provide financial statements for each individual component unit. Fund level data (if a component unit has more than one fund) is not required by Statement 14 unless the component unit has not published a financial report containing that information.
There is wide flexibility in deciding how to aggregate. It may be by fund-type (governmental, proprietary), by industry (utilities, health care, finance authorities, etc.), or by any other appropriate characteristic of the component units. The possibilities for aggregation or presentation of detail on the face of the combined balance sheet or operating statements are limited only by imagination and available white space. The flexibility permits the preparer to aggregate/disaggregate in such a way as to provide maximum benefit to the financial statement user.
Focus of the Notes to the Financial Statements
The separation of the primary government from discretely presented component units has interesting ramifications for the notes to the financial statements. Under Statement 14, the primary government is the focus of the financial reporting entity. It follows that the primary government should also be the focus of the notes. However, this does not mean that component unit disclosures will never be required. Note disclosures related to discretely presented component units might be required, considering the component unit's significance relative to the total discretely presented component units and the nature and significance of the component unit's relationship to the primary government. Also, in keeping with the separation of financial data, component unit disclosures should be distinguished from primary government disclosures.
The decision whether or not a component unit disclosure is necessary requires the use of professional judgment. For example, disclosure of the credit and market risks of a component unit's deposits and investments (in compliance with GASB Statement 3) depends on the surrounding circumstances. If deposits and investments are significant in amount and the component unit is significant in comparison with total component units, the disclosure should probably be made. Also, if the component unit is being included because the primary government is responsible for financing its deficits, disclosure of credit and market risks is probably warranted.
A primary government is the nucleus of a financial reporting entity. Although primary governments usually are state governments or municipalities, any organization that is legally separate and has a separately elected governing body is a primary government if it is fiscally independent (see Exhibit 4). One type of special purpose government that often meets the definition of a primary government is a school district. For example, many of the school districts in small and medium-sized communities in the State of New York probably meet the definition of a primary government.
There may be governmental organizations that meet neither the definition of a primary government nor a component unit. For example, Statement 14 labels as a "related organization" any organization for which a primary government is accountable (because it makes appointments) but is not financially accountable. Even though a related organization is not a "primary government," it should apply Statement 14 in its separate financial statements as if it were a primary government. If it has any component units, they should be included in its financial reporting entity. The nature of an accountability relationship between a primary government and a related organization should be explained in both the primary government's and the related organization's financial statements.
Under existing entity guidance, there is the ability to present limited "oversight unit" or "component unit" financial statements that omit information about the overall financial reporting entity. These financial statements are more similar to financial statements of a department than the financial statements of a reporting entity. Statement 14 makes it clear that the financial report of a primary government or a component unit is not in conformity with GAAP unless Statement 14 has been applied to it. Because the primary government is the nucleus of a financial reporting entity, its GAAP financial report would be the GAAP financial report for the entire financial reporting entity. A component unit's GAAP financial report should include all of its component units, and it should acknowledge that it is a component unit of a named primary government. Special reports, similar to departmental financial statements, may be prepared if more limited reporting is desired.
Governmental "joint ventures" vary widely in structure and purpose--from regional utilities to landfills to economic development authorities. Some ventures are distinct, autonomous, legal entities. Others are undivided interests or cost-sharing arrangements. In an attempt to provide relevant guidance for such a multitude of situations, the current literature is vague. Statement 14 attacks this problem by defining a joint venture and describing other organizations that are similar to joint ventures.
Statement 14 defines a joint venture as a legal entity that is owned, operated, or governed by two or more participants. No single participant controls the operation. Such a jointly governed organization is a joint venture only if the participants retain a) an ongoing financial interest (direct or indirect access to the assets) or b) an ongoing financial responsibility (an obligation for debt or for continued funding). Pools, undivided interests, and cost-sharing arrangements may resemble joint ventures but do not meet the definition. Therefore, they should not be accounted for as joint ventures.
If a participant has an identifiable equity interest in a joint venture, it should account for that interest using an equity method of accounting. The specific mechanics depend on whether the interest is owned by a governmental or proprietary fund. However, just as in the private sector, the equity method begins with an investment being recorded at the original cost of the joint venture to the participant. Subsequently, that interest is adjusted for income accruals, distributions, and inter-entity eliminations. If a participant cannot identify (because it is not explicit and measurable) an equity interest in an organization that meets the definition of a joint venture, it should, nonetheless, provide the required joint venture disclosures. Those disclosures focus on the description of the relationship and information about whether the joint venture is accumulating significant financial resources or experiencing fiscal stress that could affect the participant. The specificity of the required disclosures should promote uniformity and brevity in financial reporting.
Statement 14 does not require joint venture disclosures for any jointly governed organization that does not meet the definition of a joint venture. However, related organization or related party disclosures may be appropriate. This aspect of Statement 14 is expected to reduce the volume of disclosure currently made for "joint ventures." Under the existing guidance, many provide voluminous disclosure as a fail-safe because the reporting requirements are vague.
Statement 14's Immediate Effects
It is anticipated that state governments will have more component units to evaluate than local governments and that local governments may have more joint ventures to evaluate than state governments. If they have not already done so, preparers should plan now to gather the documentation necessary to evaluate relationships with potential component units and joint ventures, and then allow ample time to gather the financial data to be included in the entity's financial report.
In the year and a half since Statement 14's issuance, a number of local governments have early-implemented its provisions. Some were allured by the ability to "unblend" component units that they had been forced to combine with their primary governments; they couldn't wait for Statement 14's effective date. And that is the most expected result of Statement 14--the discrete presentation of component units that were previously blended.
Statement 14 may cause the inclusion of some previously excluded organizations. Alternatively, some previously included component units may become related organizations under Statement 14. However, in general the scope of reporting entities is not expected to change significantly. On the other hand, the method for displaying component units will change because most of the blended component units will have to be separated from the primary government. In most instances, the task will not be daunting because most component units are currently treated as enterprise funds. Each of the enterprise funds can be easily moved from the enterprise fund column to a discrete presentation column. Blended component units with general fixed assets and long-term debt using the governmental fund model, however, will be more difficult to separate from the primary government and present discretely.
Another expected ramification of Statement 14 is the reduction of entity disclosure "boilerplate." Paragraph 61 of Statement 14 calls for a brief description of the component units and their relationships to the primary government. An interesting twist is the requirement to disclose where separate component unit financial statements can be obtained.
It is hoped that entity disclosures and related organization disclosures will be brief. In the past there has been a predilection to provide more information rather than less, erring in the direction of volume when in doubt. By focusing on the primary government, the GASB is calling for discretion in disclosure.
Barbara Chaney is a doctoral student at the University of Georgia and was formerly an assistant project manager at the GASB. The opinions in this article are those of Ms. Chaney.
EXHIBIT 1 DEFINITION OF THE FINANCIAL REPORTING ENTITY
The financial reporting entity consists of:
The primary government
Legally separate organizations for which the primary government is financially accountable.
Other organizations for which the nature and significance of their relationship with the primary government are such that exclusion would cause the reporting entity's financial statements to be misleading or incomplete.
Financial accountability exists under any one of these scenarios:
Imposition of will
The primary government appoints a voting majority and is able to impose its will on the organization. Imposition of will exists if the primary government can significantly influence programs, projects, activities, or level of services. Statement 14 provides a list of conditions that clearly demonstrate imposition of will; for example, the ability to veto, overrule, or modify the decisions of the organization's governing body.
Financial benefit or burden
The primary government appoints a voting majority and receives a financial benefit from or accepts a financial burden for the organization. A financial benefit exists if the primary government is legally entitled to or can otherwise access the organization's resources. A financial burden exists if the primary government is obligated to finance the deficits of, or provide financial support to, the organization, or is obligated in some manner for the debt of the organization.
The organization is fiscally dependent on the primary government (even though the primary government does not appoint a voting majority). Fiscal dependency occurs if the primary government has the authority to (a) approve and modify the organization's budget, (b) levy taxes or set rates or charges for the organization, or (c) approve the organization's bond issuances.
EXHIBIT 2 CRITERIA FOR BLENDING COMPONENT UNITS
The component unit's governing body is substantively the same as the governing body of the primary government. There must be sufficient representation to allow the primary government to completely control the component unit's activities, such as when a city council serves ex- officio as the governing body of a municipal authority.
The component unit provides services entirely, or almost entirely, to the primary government or otherwise exclusively, or almost exclusively, benefits the primary government even though it does not provide services directly to it. A component unit of this type operates, essentially, as an internal service fund. A typical example would be a building finance authority.
EXHIBIT 4 FISCAL INDEPENDENCE
A special-purpose government is fiscally independent if it has the authority to do all three of the following:
* Determine its budget without another government's having the authority to approve and modify that budget;
* Levy taxes or set rates or charges without approval by another government;
* Issue bonded debt without approval by another government.
Note: Receipt of financial assistance does not preclude fiscal independence.
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