In business, it is often easy to determine what separate legal entities should be included in the financial statements of a corporation. It is based on ownership. Often there is no ownership for governments, making it difficult to determine what entities to include. Governments come in all shapes and sizes. Some general-purpose governments provide a full range of services; others provide only limited services. Additional services often are provided by separate special-purpose entities. Under what circumstances should these separate legal entities be included in the financial statements of the general-purpose government? This chapter will try to answer that question.
Governments can provide a range of services in different ways to meet the needs of its citizens. Sometimes, governments establish separate legal entities to provide services that meet certain needs. Alternatively, they may financially support extant separate organizations or may join with other governments in providing a regional approach to providing services. Examples include jails, airports, housing, and building authorities.
Should these separate legal entities be included in the government’s financial reports? If so, how? Traditionally, accountants look to substance over legal form in financial reporting requirements. GASB Statement No. 39, Determining Whether Certain Organizations Are Component Units, relies on a financially accountable criterion to determine which entities should be included in the financial statements of a government.
The reporting entity for a government is defined as the primary government and its component units. To better understand this concept, it is important to clearly understand what a primary government is and what component units of a primary government are.
The primary government is at the core of the financial reporting entity. All state and general-purpose local governments meet the definition of a primary government. Other governmental organizations are considered special-purpose governments. A special-purpose government may also be considered a primary government if they meet all the following criteria:
If a special-purpose government does not meet all the criteria that defines a primary government, it becomes a potential component unit of a primary government. To be classified as a component unit of a primary government, a special-purpose government must first be a legally separate entity. Entities that are not legally separate would normally be included as part of the government that holds the related legal powers.
To be a component unit of a primary government, the legally separate special-purpose government must also be financially accountable to the elected officials of the primary government. How is this determined? If a legally separate special-purpose government meets any of the following three tests, then it is a component unit of the primary government.
The primary government appoints the voting majority of the governing board of the entity.
Governments often appoint the majority of certain entities’ boards. However, just appointing a majority is not enough to determine if the primary government is financially accountable for this entity. One of the following tests must also be met:
Examples of a government being able to impose its will |
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Examples of a financial benefit or burden relationship |
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For entities where the voting majority of the board is not appointed by the government, the following two tests apply.
The entity is fiscally dependent on the primary government.
Separate legal entities sometimes are fiscally dependent on the primary government. The following are examples of fiscal dependency:
In addition, to meet the fiscally dependent test, there must also be an ongoing financial benefit or burden relationship between the primary government and the separate legal entity.
The financial statements would be misleading if data from the entity were not included.
This test requires professional judgment. In most cases, special-purpose governments are reported as component units because they meet the first two tests. However, there may be special circumstances where it would be misleading to exclude a separate legal entity from the financial statements of a primary government. Such determination is based on the nature and significance of the potential component unit’s relationship with the primary government. An example would be a special financing authority created to provide temporary financial assistance to a local government in financial distress; such an entity might not meet the first two tests but nevertheless should be included in the primary government’s financial statements.
Certain other organizations warrant inclusion in the primary government’s financial statements because of their relationship and significance to the primary government, such as foundations and other organizations that support the programs of the primary government. A legally separate, tax-exempt organization1 is considered a component unit of a primary government if it meets all the following three tests:
In addition, other organizations should be evaluated as potential component units if they are closely related to or financially integrated with the primary government. Professional judgment is used to determine whether the relationship and significance of the organization to the primary government warrant inclusion as a component unit.
Some component units issue separate financial statements. These financial statements should also include any component units of the entity producing the financial statement. If a component unit of the primary government has its own component units, these component units must also be included in the financial statements of the primary government. Separately issued financial statements of a component unit should acknowledge that it is a component unit of another government. The notes to the financial statements should identify the primary government in whose financial reporting entity it is included and describe its relationship to the primary government.
Finally, it is important to note that an entity can be included as a component unit by only one primary government. This is true even if the entity passes the tests to be reported as a component unit for more than one government. For example, a state government may appoint an entity’s governing board, but the entity may be fiscally dependent on a local government. Usually, the fiscally dependent test takes precedence over the other tests. In this example, the entity is considered a component unit of the local government, not of the state government.
Once an entity has been determined to be a component unit of the primary government, the next decision is how to report it in the financial statements. There are two different methods: blending and discrete presentation.
Blending combines the financial information of the component unit with the existing funds of the primary government in the financial statements. Essentially, a blended component unit appears as just another fund in the financial statements of the primary government. However, the general fund of a blended component unit should be reported as a special revenue fund; it should not be combined with the general fund of the primary government.
A government is required to blend the financial information of a component unit if any of the following circumstances applies:
If none of the listed circumstances are met, then the component unit will be discretely reported in the financial statements (discrete presentation). Discrete presentation reports the financial information of a component unit in a column separate from the primary government in the government-wide financial statements.
When there is more than one discretely presented component unit, generally accepted accounting principles requires that information about each major component unit be provided in the basic financial statements. There are three ways a government can meet this requirement, as follows:
Component units that are fiduciary activities should not be reported in the government-wide statements. Government-wide statements exclude all fiduciary funds and fiduciary component units. Fiduciary component units are reported only in the fund financial statements along with the primary government’s fiduciary funds.
Lastly, a component unit may have a different fiscal year than the primary government. Such a component unit is presented in the basic financial statements using the component unit’s fiscal year. Generally, component units’ information should not be more than nine months older than the primary government, unless including the newer information would unduly delay issuing the financial statements.
A local government may join with other area governments to provide certain services. These multigovernment arrangements often do not meet the criteria to be treated as a component unit by any individual government. How, then, should each government report their participation in such arrangements? That depends on the nature of the arrangement.
There are two general types of multigovernment arrangements: joint ventures and jointly governed organizations. The main difference between the two is that a joint venture creates an ongoing financial relationship with the participating governments; a jointly governed organization does not create such a relationship. Both types of organizations are included in note disclosures by the participating governments.
For joint ventures, the arrangement may create an explicit, measurable equity interest for the participating governments in some or all the resources of the joint venture. In this case, a government should report its interest in the joint venture in the government-wide statements as a single line item. For the fund financial statements, governmental funds should report an interest in joint ventures only to the extent that the interest represents financial assets. For proprietary funds, the “investment in joint venture” account reported in a proprietary fund should report the participating government’s equity interest calculated in accordance with the joint venture agreement.
A government’s reporting entity includes the primary government and its component units. Component units are separate legal entities that are financially accountable to the elected officials of the primary government. In addition, certain other tax-exempt organizations warrant inclusion in the primary government’s financial statements as component units because of their relationship and significance to the primary government. A variety of tests is used to determine whether an entity is a component unit.
Component units are either blended or discretely presented in the financial statements of the primary government. Blending reports component units as funds of the primary government. Discrete presentation reports component units in separate columns of the government-wide statements. Other related organizations, such as joint ventures and jointly governed organizations, should be disclosed in the notes to the financial statements.
Please note that the following practice questions are not required reading material.
A county transit authority. The authority is a separate legal entity; however, the governing board of the authority is made up of members of the county’s board of supervisors. The authority receives no financial support from the county. The county does guarantee the debt of the authority.
A tax-exempt foundation. The foundation supports the county’s public library by raising funds for the purchase of books. The foundation receives requests for the director of the county’s library systems and routinely funds those requests based on the amount of donations raised that year. The amount of resources raised and held each year is not significant to the overall county.
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