CONFIDENTIAL: NOT FOR RELEASE
TO UNAPPROVED PARTIES,
THE PUBLIC OR THE PRESS
IASB MEETING – DECEMBER 2005
IASB AGENDA PAPER 2B
FASB MEETING – 14 DECEMBER 2005
FASB MEMORANDUM 20
Conceptual Framework
Reporting Entity: Preliminary Staff Research
Staff contacts:
NZ FRSB: Kimberley Crook, kimberley.crook@nzica.com Tel +64 3 961 2413
FASB: Kevin McBeth, khmcbeth@fasb.org Tel +1 203 956 3440
INTRODUCTION
1.
In December, the Boards will begin their deliberations on the reporting entity phase of the
project (Phase D).
2.
As discussed in earlier staff papers, neither of the Boards‘ existing frameworks contains a
robust reporting entity concept.1 The IASB Framework defines the reporting entity in one
sentence with no further explanation.2 The FASB framework does not contain a definition,
although some of its commentary is similar to that in the IASB Framework.3
Hence, this
represents a gap in both frameworks.
3.
However, the existence of that gap in the frameworks does not mean that a reporting entity
concept does not exist. The September 2005 staff paper on planning issues for the
reporting entity project phase commented that the reason why the Boards have been able to
discuss issues relating to the objectives of financial reporting and qualitative characteristics
of financial information, without having an explicit reporting entity concept, is that an
implicit reporting entity concept already exists. In other words, the reporting entity phase
of the project will not seek to invent a new concept; rather, the project phase will seek to
examine, refine, and clearly articulate a concept that already exists. For example, the
project phase will hopefully eliminate some of the ―fuzziness‖ surrounding the concept, so
we have a better understanding of what constitutes a reporting entity (IASB Agenda Paper
15, FASB Memorandum 10, paragraphs 8 and 9).
4.
Hence, in approaching this topic, the staff has not sought to start from scratch. A more
comprehensive approach would have entailed conducting research into all possible
1
For example, October 2004, IASB Agenda Paper 10, FASB Memorandum 1 of 2.
IASB Framework, paragraph 8.
3
For example, FASB Concepts Statement No. 1, Objectives of Financial Reporting by Business Enterprises,
paragraph 28.
2
approaches to the reporting entity concept, with each examined in detail, including an
analysis of the pros and cons of each possible approach.
5.
Rather, the staff has focused on what are likely to be the most fruitful areas of research,
based on the objective of examining, refining and clearly articulating a concept that already
exists. This does not imply that the project phase will not consider new ideas. Nor does it
prevent the Boards from deciding to explore other approaches. It simply provides what
seems to be a reasonable starting point. The reactions from Board members to that starting
point will determine the direction of future staff work in this project phase.
6.
As proposed in the September 2005 staff paper on planning issues for the project phase, the
staff research begins with an analysis of SAC 1, Definition of the Reporting Entity, from
the Australian conceptual framework. SAC 1 contains the longest and most developed
discussion of the reporting entity concept to be found in standard setters‘ frameworks. The
staff analysis also covers the ASB Statement of Principles for Financial Reporting, which
includes some discussion of the reporting entity concept. Furthermore, in the 1980s, the
FASB had a project on its agenda to develop a concept of the reporting entity as part of its
project on consolidation and other related matters. Although the FASB never reached
definitive conclusions or issued a Concepts Statement, a partial draft was developed.
Hence, that draft document also is considered in the staff analysis.
7.
There are also other literature resources relevant to the project phase. That other literature
includes:
a.
Literature that relates to issues to be considered later in the project phase, in
particular, issues relating to the concept of control.
b.
Literature that discusses the reporting entity concept in the context of the proprietary
theory and the entity theory, along with a variety of related theories. These theories
were discussed, to some extent, during Phase A of the conceptual framework project.
The Boards tentatively concluded that general purpose financial reports should reflect
the perspective of the entity rather than the perspective of existing common
shareholders or any other single user group. However, the staff will continue to
examine the literature that discusses these theories, as it may provide helpful insights.
8.
Therefore, as the first step in the project phase, the staff has analysed the documents
outlined in paragraph 6 above. The insights gained from that analysis is then used to
discuss the first set of cross-cutting issues relating to the reporting entity project phase:
2
RE1:
When is a legal entity, or an economic unit, a reporting entity? (e.g., branch
versus entity, business versus entity) Are there two questions—what is an entity
and what is a reporting entity?
RE2:
Aggregation versus disaggregation—which is the most useful information? For
example, when should a legal entity be divided into several reporting entities?
When should consolidation occur?
RE3:
What is the purpose of consolidated accounts? Why do some jurisdictions require
parent-only statements, others require consolidations, and yet others may want
combinations?4
RE4:
9.
Is control the right basis for consolidation?
Finally, the staff has developed a partial proposed approach to the reporting entity concept,
based on the staff analysis of the key literature and discussion of the above cross-cutting
issues, to provide a focus for the Boards‘ discussions. The proposed approach is
incomplete because there are significant outstanding issues, as mentioned below.
However, if the Boards are generally supportive of the proposed approach, it will be
developed further as the project phase progresses.
10.
It might seem that this staff paper covers a lot of ground. However, it should be borne in
mind that the conclusions reached, in particular, about Issues RE1–RE4 and in preparing
the proposed approach, are preliminary only. For example, Issue RE4 asks about whether
control is the right basis for consolidation. Although the preliminary analysis indicates that
the control concept should be retained, there are important outstanding issues about
control. In particular, Issues RE5–RE8 (yet to be addressed) all relate to the control
concept. Therefore, no matter what conclusions (if any) are reached now, those
preliminary conclusions may need to be revisited, if future work in the project phase
indicates that it is necessary to do so.
11.
The primary purpose of presenting to the Boards the staff research conduced to date is to
establish whether the Boards are satisfied that the project phase is on the right track. This
will help to focus staff and Board resources on approaches that appear worthy of further
investigation and avoid wasting time on possible approaches that Board members do not
support. Therefore, the reactions of the Boards to the staff analysis and proposed approach
will be used to direct future staff research.
4
The second question was added in response to Board members‘ comments during the discussion of the September
2005 staff plan.
3
ANALYSIS OF KEY LITERATURE
12.
This section analyses the following key literature resources:
a.
SAC 1, Definition of the Reporting Entity
b.
ASB Statement of Principles for Financial Reporting, Chapter 2 The Reporting Entity
c.
FASB partial draft document, Reporting Entity—Tentative Conclusions.
SAC 1, Definition of the Reporting Entity
13.
SAC 1 was issued in 1990. As noted above, SAC 1 contains the longest and most
developed discussion of the reporting entity concept to be found in standard setters‘
conceptual frameworks.
14.
SAC 1 applies to all reporting entities, including both business and not-for-profit entities,
whether in the private (i.e., non-government) or public (i.e., government) sector. Because
the Boards have agreed to focus first on concepts applicable to business entities in the
private sector, this analysis focuses on the discussion in SAC 1 of the reporting entity in
the context of business entities in the private sector.
15.
SAC 1 first defines an ―entity‖, an ―economic entity‖, ―control‖ and ―general purpose
financial report‖:
“control” means the capacity of an entity to dominate decision-making, directly or
indirectly, in relation to the financial and operating policies of another entity so as to
enable that other entity to operate with it in achieving the objectives of the controlling
entity;
―economic entity” means a group of entities comprising a controlling entity and one or
more controlled entities operating together to achieve objectives consistent with the
controlling entity;
“entity” means any legal, administrative or fiduciary arrangement, organisational
structure or other party (including a person) having the capacity to deploy scarce
resources in order to achieve objectives;
“general purpose financial report” means a financial report intended to meet the
information needs common to users who are unable to command the preparation of
reports tailored so as to satisfy, specifically, all of their information needs. [SAC 1,
paragraph 6]
16.
These definitions are reproduced above for the information of Board members because the
definitions are an integral part of the SAC 1 definition of the reporting entity. Each
definition shown above will be discussed at some stage, either in this paper or in a later
staff paper.
4
17.
SAC 1 defines a reporting entity as follows:
Reporting entities are all entities (including economic entities) in respect of which
it is reasonable to expect the existence of users dependent upon general purpose financial
reports for information which will be useful to them for making and evaluating decisions
about the allocation of scarce resources. [SAC 1, paragraph 40]
18.
The following issues are discussed below:
a.
Possible circularity in the definition.
b.
The relationship between the definition of a reporting entity and the objective of
financial reporting, as set out in SAC 2, Objective of General Purpose Financial
Reporting.
c.
Reporting entities are a subset of the wider pool of ‗entities‘, ie not all entities are
reporting entities.
d.
The relationship between the concept of control and the reporting entity concept
Possible Circularity in the Definition
19.
Under SAC 1, for a reporting entity to exist, the following circumstances must occur:
a.
An entity (as defined in SAC 1) must exist.
b.
It is reasonable to expect that people (including other entities) who want information
about that entity that is useful to them in making or evaluating resource allocation
decisions exist.
c.
Of the group of people in (b) above, at least some of them must be dependent upon
general purpose financial reports to obtain that information.
20.
The first two parts above ((a) and (b)) seem reasonable enough, in terms of a workable
definition of a reporting entity. SAC 1 defines an entity, so presumably one could apply
that definition to the real world to identify an entity. (Economic entities are discussed
further below.) Similarly, it should not be too difficult to establish that there are people
who want information about particular entities that will be useful to them in making and
evaluating resource allocation decisions. (The relationship between the objectives of
financial reporting and the definition of a reporting entity is discussed further below.)
21.
But consider the third condition—the existence of users dependent upon general purpose
financial reports (GPFRs). SAC 1 notes that in many instances it will be readily apparent
that there exist users that are dependent upon general purpose financial reports (SAC 1,
paragraph 19). Furthermore, for those entities for which it is not readily apparent whether
5
dependent users exist, it sets out primary factors to be considered in determining whether
dependent users exist:
a.
Separation of management from owners (the greater the spread of ownership and the
extent of separation between owners and management, the more likely it is that
dependent users exist, e.g., a listed company).
b.
Economic or political influence (the greater the influence, the more likely it is that
dependent users exist, e.g., entities with a dominant market position).
c.
Financial characteristics, e.g., the size or indebtedness of an entity (the larger the size
or the greater the indebtedness, the more likely it is that dependent users exist).
22.
Although the above guidance seems helpful, the phrasing of the third condition—that users
must exist that are dependent upon GPFRs—might be regarded as creating a circularity in
the definition. It could imply that, to identify a reporting entity, there must be entities that
already prepare GPFRs. In other words, if the existence of a reporting entity is established
by identifying the existence of people who are dependent upon GPFRs, then to identify
those users, the object of their dependency—GPFRs—must already exist. If the
identification of reporting entities entails identifying entities that prepare GPFRs, this
results in a circular definition, i.e., ―a reporting entity is an entity that reports‖.
23.
Having said that, although the definition might appear to be circular, it is clearly not
intended to be, because SAC 1 requires reporting entities to prepare GPFRs.
24.
To avoid the appearance of circularity, the notion that a reporting entity is an entity that
prepares GPFRs could be removed from the reporting entity definition. Essentially,
GPFRs are a way of satisfying the information needs of users who are unable to command
the information they require.5 In other words, GPFRs are a means to an end, but are not an
essential part of defining a reporting entity.
25.
Instead, the third condition above could be rephrased to focus on the existence of users
who unable to command the information they require, rather than users dependent upon
GPFR. In short, it should focus on user information needs, not the means of satisfying
those information needs.
5
The preparation of GPFR is not the only way in which user information needs might be satisfied. As discussed in
an earlier staff paper on the objectives of financial reporting (April 2005, IASB Agenda Paper 4, FASB
Memorandum 3), user information needs could be satisfied in other ways, such as using XBRL to provide a range of
information from which particular users could assemble their own reporting packages to satisfy their particular
information needs. For various reasons, the Boards decided to retain the notion of GPFR as the means of providing
information to users unable to command the information they require from the entity.
6
Relationship between the Reporting Entity Concept and the Objectives of Financial Reporting
26.
The reporting entity concept in SAC 1 is based on user information needs. For example, it
begins by explaining and rejecting two alternative reporting entity concepts: the legal
entity concept (which has been employed in the private sector), and the fund concept
(which has been employed in the public sector). As noted in paragraph 14, this analysis
focuses on SAC 1‘s discussion of business entities in the private sector; therefore, no
further comment is made on SAC 1‘s discussion of the fund concept.
27.
Under the legal entity concept, the identification of reporting entities would be determined
by legal considerations, such as a legal requirement for companies to prepare financial
reports. This concept is rejected because it does not give adequate consideration to user
information needs:
…it is possible that users exist in respect of reporting entities which are not legal
entities and for which legalisation requiring the preparation of general purpose financial
reports does not exist, for example, partnerships, most trusts and associations. [SAC 1,
paragraph 11]
28.
More specifically, the SAC 1 reporting entity concept is based on particular user
information needs, namely information ―which will be useful to them for making and
evaluating decisions about the allocation of scarce resources‖ (SAC 1, paragraph 40).
This wording is consistent with SAC 2 Objective of General Purpose Financial Reports,
which was issued at the same time as SAC 1. SAC 2 states the objective of general
purpose financial reports is to provide users with information about the reporting entity
which is useful for making and evaluating decisions about the allocation of scarce
resources (SAC 2, paragraph 43).
29.
The inclusion of the objective of financial reporting in the definition of a reporting entity
indicates that the reporting entity concept in SAC 1 is dependent upon the objective of
financial reporting in SAC 2. At first sight, this might seem to be the wrong way around.
That is, one might expect that a reporting entity should be identified first, before
establishing the objectives of the financial reports prepared by that entity.
30.
However, because the SAC 1 definition of a reporting entity is based on user information
needs, it seems necessary to first specify which particular information needs are relevant,
which then provides the basis for determining which entities should prepare financial
reports to satisfy those information needs.
31.
However, it means that if the objective of financial reporting was changed, so too would
the determination of which entities are reporting entities.
In other words, under SAC 1,
7
the objective of financial reporting drives the identification of a reporting entity, not the
other way around. SAC 1 is not alone is this respect, as discussed further below.
Reporting Entities are a Subset of the Wider Pool of „Entities‟
32.
As discussed above, under the SAC 1 definition of a reporting entity, users who are
dependent upon general purpose financial reports must exist. Hence, there might be some
entities for which no such users exist. For example, in the context of the private (nongovernment) sector, SAC 1 notes that there are entities for which the members (owners)
and management are an identical group (e.g., sole traders, partnerships, small private
companies, and wholly-owned subsidiaries). In such cases, there might not be any users
who are unable to demand the information they require about the entity. If so, these
entities would not be reporting entities. [SAC 1, paragraph 26]
33.
However, the status of an entity could change. For example, an entity might become a
reporting entity if it seeks to raise debt or equity funds from the public. Similarly, a
company established for the conduct of a family business might become a reporting entity
if some shareholders become distanced from the company or new, non-family shareholders
become shareholders. [SAC 1, paragraph 26 and 28]
34.
SAC 1 also notes that an entity might not be a reporting entity itself, but it might form part
of a reporting entity. For example, a wholly-owned subsidiary of another entity might not
be a reporting entity itself, but the group entity comprising the parent entity and its
subsidiary entity (or entities) might be a reporting entity. (Issues relating to the boundaries
of the reporting entity, including the concept of control, are discussed later.) Also, for a
reporting entity that comprises a group of entities, some of those entities within the group
might be reporting entities themselves. In other words, the group might be a reporting
entity, and so might one or more of the entities within the group. [SAC 1, paragraphs 26
and 27]
35.
In summary, the above discussion indicates that reporting entities are drawn from the wider
pool of entities, either individually or in combination, that is:
a.
Some entities are also reporting entities.
b.
Some entities are not reporting entities.
c.
A reporting entity might comprise a group of entities, some of which also might be
reporting entities in their own right, while others might not be reporting entities.
36.
In the context of the business entities in the private sector, much of the discussion in SAC
1 about a reporting entity that consists of a group of entities, comprising a controlling
8
entity and one or more controlled entities (which SAC 1 refers to as an economic entity),
focuses on groups of companies, i.e., a parent company and its subsidiary companies. This
raises the question of whether a particular component of a group entity, which is not a
company, could be a reporting entity. For example, could a segment or a branch, which is
not a separate legal entity, be a reporting entity? According to SAC 1, the answer seems to
be ―no‖ in most cases:
…a segment of an economic entity is unlikely to be regarded as a reporting entity
because information about a segment is usually directed at improving the knowledge of
users of the general purpose financial reports for the whole reporting entity, rather than
catering for the needs of those users interested only in information about that segment.
[SAC 1, paragraph 27]
37.
The staff observes that although current accounting practice might intend segment
information to be used by users of the financial reports of the group entity, of which the
segment is a part, this does not seem to be a good reason for concluding that a segment is
not a reporting entity. In the staff‘s view, it would be more consistent with the definition
of a reporting entity in SAC 1 to conclude that a segment would be a reporting entity if
users who want information about the segment exist, but are unable to command the
information they require.
38.
However, for a segment to be a reporting entity under SAC 1, it must first be an entity, that
is, a legal, administrative or fiduciary arrangement, organisational structure, or other party
(including a person) that has the capacity to deploy scarce resources in order to achieve
objectives. (This issue is discussed further in the next section, in paragraphs 92-94.)
39.
In summary, it should be possible for a segment (or branch) that is not a separate legal
entity to be a reporting entity under SAC 1, when (a) the segment (or a branch) is
structured in such a way that it satisfies the definition of an entity and (b) there exist users
who require, but are unable to demand, information about the segment that is useful to
them in making or evaluating resource allocation decisions.
The Concept of Control is an Integral Part of the Reporting Entity Concept in SAC 1
40.
As noted earlier, the reporting entity definition in SAC 1 includes an ―economic entity‖,
which is a group of entities comprising a controlling entity and one or more controlled
entities. Hence, the concept of control is used to determine when two or more entities
should be combined to form a single ―economic entity‖.
41.
This seems a reasonable approach, given that the SAC 1 reporting entity concept focuses
on user information needs, in particular, information that is useful in making or evaluating
decisions about the allocation of scarce resources:
9
The disclosure of the resources that an entity has the capacity to deploy, and the
results of their deployment, will assist users to determine the performance and financial
position of the entity. Such information will assist users in making resource allocation
decisions and is necessary for the evaluation of past decisions. For these purposes,
information about all resources able to be deployed by a reporting entity is relevant,
whatever the legal or administrative structure established to manage those resources.
Thus, where an entity controls other entities, there should be disclosed information
regarding the resources of controlled entities as well as the resources of the controlling
entity because all of these resources may be deployed by the controlling entity for its own
advantage. [SAC 1, paragraph 16, emphasis added]
42.
In other words, if one accepts that users require information about resources that the entity
has the capacity to deploy, then it seems logical that those users require information about
all the resources that the entity has the capacity to deploy, including those resources that it
can deploy through its control over another entity.
43.
The meaning of control will be addressed in a future staff paper. Therefore, no further
comment is made here about the definition or discussion of control in SAC 1. For now, the
important point to note is that control is used to define the boundaries of a group reporting
entity.
Statement of Principles, Chapter 2, The Reporting Entity
44.
In the Statement of Principles for Financial Reporting (SoP), Chapter 2 sets out two
principles relating to the reporting entity:

An entity should prepare and publish financial statements if there is a legitimate
demand for the information that its financial statements would provide and it is a
cohesive economic unit.

The boundary of the reporting entity is determined by the scope of its control. For this
purpose, first direct control and, secondly, direct plus indirect control are taken into
account.
Legitimate Demand for the Information That the Financial Statements would Provide
45.
Similar to SAC 1, the first principle shown above seems focused on user information
needs, as the identification of a reporting entity depends upon there being a ―legitimate
demand‖ for information.
46.
The word legitimate presumably means that there is a reasonable level of demand, not that
the demand is ―lawful‖. If so, this implies that there might be situations in which some
demand for information exists, but the level of demand is insufficient for the entity to be
identified as a reporting entity. If this analysis is correct, then the SoP seems to contrast
with SAC 1, as the latter does not appear to place any minimum level on the extent of
demand for information that must exist for the purposes of identifying a reporting entity.
10
47.
There is little elaboration on what information the financial statements would (or should)
provide, other than the information will need to be ―useful‖ and the benefits of providing
the financial statements must exceed the costs of doing so (SoP, paragraph 2.2). However,
the chapter on the reporting entity follows the chapter on the objective of financial
statements, which contains discussion of what information is useful, and to whom. Thus,
the ordering in the SoP reverses the order in the Australian framework, where SAC 1 on
the reporting entity concept precedes SAC 2 on the objective of financial reporting.
However, as discussed above (paragraphs 28 to 31), the SAC 1 definition of a reporting
entity is derived from the SAC 2 objective of financial reporting. Hence, in both
conceptual frameworks, it seems that the objective of financial reporting represents a
higher level concept than the reporting entity concept, in that the identification of a
reporting entity depends upon the objective of financial statements/reports. Therefore, the
ordering in the SoP seems more logical.
Cohesive Economic Unit
48.
The second aspect of the first principle shown above (paragraph 44) is that the entity is a
―cohesive economic unit‖. The SoP states:
…if the information provided by the financial statements is to be useful, the entity
that is the subject of the financial statements (the reporting entity) needs to be a cohesive
economic unit. This ensures accountability—the reporting entity is held to account for
all the things it can control—and it gives the reporting entity a determinable boundary—
because activities and resources are either within its control or outside its control. [SoP,
paragraph 2.3]
49.
The references to the reporting entity‘s ―boundary‖, and to activities and resources within
or outside its control, link to the discussion that follows on the boundary of the reporting
entity. That discussion includes commentary on both (a) a group of entities, comprising a
parent entity and other entities under its control and (b) a single entity. Hence, comparing
the term cohesive economic unit to the terms used in SAC 1, it seems that the term
encompasses both an ―entity‖ and an ―economic entity‖.
Boundary of the Reporting Entity—Direct Control and Indirect Control
50.
As noted above, the SoP states that the boundary of the reporting entity is determined by
the scope of its control, including both direct control and indirect control. The SoP notes
that:
(a) An entity has direct control of an asset if it has the ability in its own right to obtain the
future economic benefits embodied in that asset and restrict others‘ access to those
benefits. An entity has direct control over its activities and resources but does not have
direct control of any other activities and resources.
11
(b) An entity indirectly controls an asset if it has control of an entity that has direct
control of the asset. A parent company therefore has indirect control of the activities and
resources of its subsidiary. [SoP, paragraph 2.4, emphasis added, footnote omitted]
51.
The SoP goes on to explain that direct control determines the boundary of an entity that
prepares single entity financial statements. Hence, both a parent entity and a subsidiary
entity could be reporting entities. Direct control plus indirect control determines the
boundary of an entity that prepares consolidated financial statements (SoP, paragraph 2.6).
52.
Comparing the SoP to SAC 1, it is clear that both conceptual frameworks use the concept
of control to determine the boundaries of the reporting entity. However, SAC 1 does not
explicitly distinguish between direct and indirect control, unlike the SoP. This raises the
question of whether the division of control into direct and indirect control affects the
identification of a reporting entity.
53.
First, consider a wholly-owned subsidiary. SAC 1 makes it clear that a wholly-owned
subsidiary might not be a reporting entity, as discussed above (paragraph 32), whereas
under the SoP, that subsidiary appears to be a reporting entity because it has direct control
over assets. However, both frameworks also focus on user information needs (the
existence of ―legitimate demand‖ for information under the SoP and the existence of users
dependent upon GPFR under SAC 1). Therefore, similar to SAC 1, presumably a whollyowned subsidiary would not be a reporting entity under the SoP if there is no ―legitimate
demand‖ for information about that subsidiary.
54.
Second, consider a parent entity. Under the SoP, a parent entity has direct control over
assets and indirect control over assets. SoP states that the boundary of the reporting entity
can be determined by direct control alone, and both direct control and indirect control.
Hence, it seems that a parent-only entity could be a reporting entity. This seems to contrast
with SAC 1—under SAC 1, it appears that a parent-only entity alone would not be a
reporting entity because the parent entity‘s separate financial reports would omit resources
that could be deployed by that parent entity, namely the resources that the parent can
control through its control over its subsidiary (as can be seen from the commentary in
paragraph 16 of SAC 1, reproduced in paragraph 41 above).
55.
In summary, by dividing control into direct and indirect control and, more importantly,
drawing a reporting boundary using direct control alone, the SoP reporting entity concept
differs from that of SAC 1. This issue will be explored further in a future staff paper,
including whether control should be divided into direct and indirect control, and whether a
parent-only entity could (or should) be a reporting entity.
12
56.
In other respects, in particular, in the context of a reporting entity that comprises a group of
entities, both the SoP and SAC 1 use the control concept in a similar way. In both cases,
the concept of one entity controlling another is used to ―look through‖ the legal or
organisational structure that separates the controlling entity and the controlled entity, so
that the group entity reports all resources under its control:
An entity indirectly controls an asset if it has control of an entity that has direct
control of the asset…Direct plus indirect control is used to determine the boundary of the
reporting entity that prepares consolidated financial statements. Those financial
statements will deal with the gains, losses, assets and liabilities directly controlled or
borne by the entity as well as those that are indirectly controlled or borne by the entity
through its control of other entities.‖ [SoP, paragraphs 2.4(b) and 2.6(b), footnote
omitted]
…information about all resources able to be deployed by a reporting entity is relevant,
whatever the legal or administrative structure established to manage those resources.
Thus, where an entity controls other entities, there should be disclosed information
regarding the resources of controlled entities as well as the resources of the controlling
entity because all of these resources may be deployed by the controlling entity for its own
advantage. [SAC 1, paragraph 16]
57.
Hence, for both the SoP and SAC 1, it seems that the control concept is an integral part of
the reporting entity concept.
58.
The rest of the SoP chapter explains the meaning of control and gives guidance on
determining when one entity controls another. The meaning of control, and issues relating
to determining when one entity controls another, will be addressed in future staff papers.
Therefore, no further analysis of Chapter 2 of the SoP is given here.
FASB Draft Document Reporting Entity—Tentative Conclusions
59.
For many years, the FASB had a project on its agenda to develop a concept of the reporting
entity, as part of its project on consolidation and other related matters. A partial draft was
developed, but the FASB never reached definitive conclusions or issued a Concepts
Statement. (The staff understands this was because the Board had difficulties resolving
issues relating to the boundaries of the reporting entity, including issues relating to the
concept of control.) The discussion below is based on the partial draft document, which
was distributed to FASB members in April 1986 (referred to below as the draft document).
The staff acknowledges that the draft document is exactly that—a draft—and therefore
likely would have been revised further had it been completed and published. Also, it does
not have the status of a published document, unlike SAC 1 and the SoP. However, given
that the FASB staff and Board spent considerable time on the project, the draft document
seems worthy of attention.
13
60.
The draft document refers to ―economic entities‖, which it distinguishes from ―legal
entities‖. It explains that some economic entities comprise two or more legal entities, and
some economic entities are not legal entities (eg a sole proprietorship).6 Hence, comparing
the draft document‘s use of the term economic entity to the terms used in SAC 1, it seems
that the term used in the draft document is a broader term, which encompasses both the
terms entity and economic entity used in SAC 1.
61.
The draft document also refers to a business enterprise, which appears to a particular type
of economic entity. The draft document then states:
A business enterprise is a reporting entity if it presents general purpose financial
statements and other financial information designed for use by investors, creditors, and
others who lack the authority to prescribe the financial information they want and
therefore must use the information that management communicates to them. General
purpose financial reporting is directed toward the common interest of potential users in
assessing the amounts, timing, and uncertainty of future cash flows from a business
enterprise to them. [Paragraph 201, footnote omitted]
A reporting entity for general purpose external financial reporting is an economic unit—a
circumscribed area of economic interest consisting of a group of resources and the
claims to or interests in them—that is a discrete source of future cash flows to an
identifiable group of investors, creditors and others. [Paragraph 202]
62.
The above description of a reporting entity begins with a focus on user information needs,
similar to the SoP and SAC 1. Furthermore, the inclusion of a description of the objective
of general purpose financial reports (i.e., that GPFR ―…is directed toward the common
interest of potential users in assessing the amounts, timing, and uncertainty of future cash
flows from a business enterprise to them‖) suggests that there is a relationship between the
reporting entity concept adopted in the draft document and the objective of financial
reporting.
63.
The condition that a reporting entity must be an ―economic unit‖ appears similar to the
condition in the SoP that a reporting entity be a ―cohesive economic unit‖. However, in
the draft document, the ―economic unit‖ condition seems much more clearly separated
from the ―user information needs‖ condition, as shown in the explanation that follows:
The existence of a reporting entity involves two necessary conditions: (1) a set of
assets, liabilities, equity, and changes in them that are associated with a particular area of
economic interest, that is, an identifiable collection of resources and the claims to or
interests in them that constitute an economic unit, and (2) an identifiable group of
investors, creditors, or others to whom that economic unit is a discrete source of future
cash flows and who either do not have the authority to prescribe the information they
want or who request general purpose financial statements. [Paragraph 203]
6
FASB draft document, paragraph 200.
14
64.
Not only are the two conditions clearly separated, but is interesting to note that the
―economic unit‖ condition is specified first, followed by the ―user information needs‖
condition. This ordering might not have been intended to be significant (e.g., it might
simply be to facilitate drafting). However, irrespective of what was intended, it is
interesting to consider whether the ordering of the conditions could have implications for
determining the boundaries of the reporting entity. Under the draft document, it appears
that one must first identify the economic unit, and only then identify users who want
information about that economic unit, for the purposes of identifying a reporting entity. In
contrast, under SAC 1, one starts with a pool of ―entities‖, and then it is the existence of
user information needs that drives the determination of which of these entities should be
selected or combined, for the purposes of identifying a reporting entity.
65.
As with SAC 1 and the SoP, the draft document uses the concept of control to determine
the boundaries of the reporting entity that comprises a group of two or more entities:
The reporting entity for a business enterprise that is a consolidated group includes
both the legal entity that is the direct source of cash flows to investors, creditors, and
others—the parent company—and all subsidiaries of that entity.
The distinguishing feature of a consolidated group is that it is united by the control of one
member over the other members of that group…. [Paragraphs 205 and 206, footnote
omitted]
66.
Even though this approach is consistent with SAC 1 and the SoP, the control concept
appears less integral to the reporting entity concept. In particular, under the draft
document, the ordering of the two conditions suggests that it might be possible to adopt
some other approach (i.e., something other than the control concept) to determine the
boundaries of the reporting entity.
67.
Before concluding on this point, it is important to also consider the second condition in the
draft document, i.e., the ―user information needs‖ condition. That condition includes a
requirement that the economic unit be ―a discrete source of future cash flows‖ to investors,
creditors, and others who require information about that economic unit. The cash flows to
investors and creditors from a parent entity are often affected by the cash flows of its
subsidiaries to its parent:
Because of a parent‘s control of a subsidiary, future cash flows to the parent, and
eventually to the parent‘s investors and creditors, depend significantly on the parent‘s
actions concerning the subsidiary‘s individual assets and liabilities rather than on the
more limited actions that can be taken by the owner of an investment in another entity.
[Paragraph 208]
15
68.
Hence, users are likely to be interested in information about the group, not merely the
parent entity. If this analysis is correct, it suggests that the two conditions in the draft
document—the ―economic unit‖ condition and the ―user information needs‖ condition—
are not two separate, independent conditions, but are related.
69.
Nevertheless, there remains the question of whether the control concept is the only way of
determining which entities should be combined into a group reporting entity. Aside from
the above discussion on the ordering of the two conditions, it is important to note that the
user information needs‘ condition in the draft document seems much broader (i.e., less
specific), compared with SAC 1 and the SoP, which focus more specifically on reporting
information about resources under the entity‘s control. If the reporting entity concept is
based upon a broader objective of providing information that helps users assess the
amounts, timing, and uncertainty of future cash flows, one could envisage other
approaches.
70.
For example, for many entities, transactions with customers are a major source of cash
flows. Perhaps a group comprising an entity and its major customers would provide useful
information to investors and creditors. The fact that the draft document uses the control
concept to determine the boundaries of the reporting entity suggests that such an approach
should be rejected. Nevertheless, the relationship between the control concept and the
reporting entity concept is not clear, compared with the SoP and SAC 1. (This issue is
discussed further in the next section, in the discussion of RE4.)
71.
The draft document then goes on to discuss the meaning of control, and application of the
control concept in various situations. The meaning of control, and issues relating to
determining whether one entity controls another, will be addressed in future staff papers.
Therefore, no further analysis of the draft document is given here.
Summary of SAC 1, the SoP, and the FASB Draft Document
72.
The reporting entity concepts in SAC 1, the SoP, and the FASB draft document are similar,
but not identical:
a.
All three adopt a user information needs focus; however, user information needs
have a central role in SAC 1 and the SoP, but seem to have a somewhat lesser role in
the draft document.
b.
In SAC 1 and the SoP, the relevant user information needs, for the purposes of
identifying a reporting entity, are those specified in the objective of financial
16
reporting. Therefore, the identification of a reporting entity is dependent upon the
objective of financial reporting.
c.
All three use the control concept to determine the boundaries of the reporting entity,
in particular, when one entity should be combined with other entities to form a group
reporting entity.
d.
The control concept is an integral part of the reporting entity concept under SAC 1
and the SoP, i.e., it is used to look through the legal or administrative structure
separating one entity from another, to identify a group reporting entity, so as to
provide information about all of the resources under its control. It is less clear
whether the control concept is an integral part of the reporting entity concept in the
FASB draft document.
e.
The SoP divides control into direct control and indirect control, unlike SAC 1 and the
FASB draft document, which could have implications for drawing the boundary of a
reporting entity, in particular, whether a parent-only entity represents a reporting
entity.
f.
There are differences in terminology, e.g., the SoP and the FASB draft document
refer to a ―cohesive economic unit‖ or an ―economic unit‖, which appears to
encompass both an ―entity‖ and an ―economic entity‖ under SAC 1.
ISSUES RE1-RE4
73.
This section considers the first four cross-cutting issues identified for the reporting entity
project phase:
RE1:
When is a legal entity, or an economic unit, a reporting entity? (e.g., branch
versus entity, business versus entity) Are there two questions—what is an entity
and what is a reporting entity?
RE2:
Aggregation versus disaggregation—which is most useful information? For
example, when should a legal entity be divided into several reporting entities?
When should consolidation occur?
17
RE3:
What is the purpose of consolidated accounts? Why do some jurisdictions
require parent-only statements, others require consolidations, and yet others
may want combinations?7
RE4:
74.
Is control the right basis for consolidation?
The discussion below is based primarily on the staff analysis of key literature in the
previous section and the Boards‘ preliminary conclusions on the objectives of financial
reporting. The conclusions drawn in the discussion below are summarised in the following
section. However, it should be noted that the conclusions drawn are necessarily
preliminary. In particular, there are significant issues relating to the control concept and
the boundaries of the reporting entity that are yet to be considered, all of which affect the
issues discussed below.
RE1: “Entity” and “Reporting Entity”
75.
The questions in RE1 raise various issues, including:
a.
Boundary issues, such as how to determine what constitutes an ―entity‖ and a
―reporting entity‖.
b.
Whether there is (or should be) a difference between an ―entity‖ and a ―reporting
entity‖.
76.
These issues are considered below.
Is There a Difference Between an “Entity” and a “Reporting Entity”?
77.
In the staff analysis of key literature in the previous section, various terms were used, in
addition to reporting entity, such as entity, economic entity, legal entity, [cohesive]
economic unit and business enterprise.
78.
In SAC 1, an entity is defined, and a reporting entity is a drawn from the wider pool of
entities (either individually or in combination with other entities). Hence, not all entities
are reporting entities, and some reporting entities comprise a group of entities. Therefore,
it is clear that there is a distinction between an entity and a reporting entity.
79.
Also, in the SoP and the FASB draft document, it is clearly contemplated that there would
be entities (including legal or economic entities, economic units, business enterprises, etc.)
that are not reporting entities because in all cases the existence of user information needs is
a determining factor (to a greater or lesser extent), when identifying a reporting entity. For
7
The second question was added to RE3 in response to Board members‘ comments during the discussion of the
September 2005 staff plan.
18
example, under the SoP, ―legitimate demand‖ for information about an entity must exist,
for that entity to be a reporting entity.
80.
Similarly, in the Boards‘ initial deliberations on the objectives of financial reporting, the
Boards concluded that the scope of the conceptual framework should be limited to the
information needs of external users who lack the authority to prescribe the financial
information they need from an entity, and who therefore must rely upon the information
provided by management. Specialised information needs of management and other
potential users, such as taxing authorities, who are able to prescribe the information they
need from an entity, are beyond the scope of the conceptual framework.
81.
Given that there could be entities for which there are no external users who lack the
authority to prescribe the information they need, there seems little point in defining a
reporting entity in such a way that it encompasses all entities. In other words, in the staff‘s
view, a distinction should be drawn in the conceptual framework between an entity and a
reporting entity.
82.
In summary, the answer to the second question in RE1 above is ―yes‖, there are two
questions: what is an entity and what is a reporting entity? In other words, a reporting
entity is a particular type of entity. Hence, to define a reporting entity, one must first
define an entity, and then establish a basis for determining which entities (either
individually or in combination) should be identified as reporting entities.
What is an Entity?
83.
Although the word entity is commonly used in IASB and FASB literature, it is not defined,
as far as the staff is aware. There is some description of an entity, for example, in FASB
Concepts Statement No. 6, Elements of Financial Statements:
All elements are defined in relation to a particular entity, which may be a business
enterprise, an educational or charitable organization, a natural person, or the like….An
entity may comprise two or more affiliated entities and does not necessarily correspond
to what is often described as a ―legal entity.‖… [Concepts Statement No. 6, paragraph
24]
84.
The SAC 1 definition of an entity is discussed further below:
…any legal, administrative or fiduciary arrangement, organisational structure or
other party (including a person) having the capacity to deploy scarce resources in order to
achieve objectives…. [SAC 1, paragraph 6]
Capacity to Deploy Resources
85.
The SAC 1 definition refers to an arrangement or structure that has the capacity to deploy
scare resources. In other words, the arrangement or structure must be capable of ―doing
19
something‖, i.e., performing or functioning in some manner. It is interesting to compare
the SAC 1 definition to the definition of a business in the Boards‘ recent Exposure Drafts
on business combinations:
A business is an integrated set of activities and assets that is capable of being
conducted and managed for the purpose of providing either:
(1) A return to investors, or
(2) Dividends, lower costs, or other economic benefits directly and proportionately
to owners, members or participants.
[IASB Exposure Draft, Proposed Amendments to IFRS 3—Business Combinations,
paragraph 3; FASB Exposure Draft, Business Combinations, paragraph 3(d)]
86.
That definition refers to the ―activities and assets‖ that could be conducted or managed,
rather than who does the conducting or managing of those activities and assets. Hence,
this implies that a ―business‖ is not, in itself, an ―entity‖. Rather, for something to be both
a business and an entity—a business entity—the business must be part of an organisation
or structure that has some sort of operating capacity or ability to act, such as the ability to
engage in transactions with other parties. That ability to act might be established by law
(e.g., a company) or by the presence of people (e.g., the proprietor in a sole proprietorship
entity), who conduct or manage the business, or appoint others to do so on their behalf.
87.
Also, there seem to be some common themes among (i) the reference in the SAC 1
definition of an entity to an arrangement, structure or party having the capacity to deploy
resources, (ii) the reference to ―an integrated set of activities and assets that is capable of
being conducted or managed‖ in the above definition of a business, and (iii) the SoP
discussion of a cohesive economic unit, which is bounded by the activities and resources
within its control. It suggests that the concept of control is relevant to determining what
constitutes an entity—not just for determining when one or more entities should be
combined into a group entity. The above discussion suggests that an entity comprises a
controlling party (e.g., the directors of a company or the proprietor in the case of a sole
proprietorship) and the resources and activities under the control of that party. This issue
will be considered further in a future staff paper.
Entity Boundary: Broader than a Legal Entity
88.
It is clear that, under the SAC 1 definition, what constitutes an entity is not limited to
something that is a legal entity.
89.
Similarly, the FASB draft document notes that economic entities often do not correspond
to legal entities. Some economic entities comprise two or more legal entities (e.g., a
consolidated group) and some are not legal entities (e.g., a sole proprietorship).
20
90.
Also, in accounting practice, financial reports are commonly prepared for entities that do
not correspond to legal boundaries. For example, the Boards‘ standard-setting activities
include developing and revising accounting standards on the preparation of consolidated
financial statements for a group entity, which in many instances will comprise two or more
legal entities.
91.
It therefore seems clear that the boundary of an ―entity‖ need not correspond to legal
boundaries. Rather, as stated in the SAC 1 definition, an entity encompasses other types of
organisations, structures or arrangements.
Entity Boundary: Can a Branch or Segment Be an Entity?
92.
In the staff analysis of SAC 1, when discussing whether a branch or segment could be a
reporting entity, it was noted that the branch or segment must first be an entity (paragraph
38).
93.
For a branch or segment to be an entity, the above analysis suggests that the following
conditions must exist:
a.
The branch or segment must be organised or structured in such a way that it is
possible to distinguish it from the rest of the wider entity, of which that branch or
segment is a part. For example, IAS 14, Segment Reporting, defines a segment as a
―…distinguishable component of an entity…‖ (IAS 14, paragraph 9).
b.
The branch or segment must have the capacity to act, such as the ability to engage in
transactions with other parties.
94.
The staff will explore the boundary of an entity further in future staff papers. For example,
the analysis above noted that the control concept seems relevant to determining the
boundary of an entity (paragraph 87). In the interim, it should be noted that, even if one
concluded that a branch or segment is itself an entity, this does not necessarily mean that it
is a reporting entity.
What is a Reporting Entity?
95.
The staff analysis of key literature concluded that SAC 1, the SoP, and the FASB draft
document all adopt a reporting entity concept that focuses on user information needs,
especially SAC 1. In the staff‘s view, this seems a reasonable approach, given the Boards‘
tentative conclusions on the objectives of financial reporting. In particular, the Boards‘
conclusion that those objectives should focus on the information needs of external users
who lack the authority to prescribe the information they require from the entity. It seems
21
reasonable to define the reporting entity in terms of those entities for which such external
users exist.
96.
The staff analysis of key literature also found that in SAC 1 and the SoP, the relevant user
information needs, for the purposes of identifying a reporting entity, are those specified in
the objective of financial reporting. Again, this seems a reasonable approach. If the
purpose of financial reports is to provide particular information (such as information that is
useful to investors and creditors in making economic decisions), then it seems reasonable
for reporting entities to be identified as those entities for which there are users who want
that particular type of information. This ensures a matching of demand (users who want
particular information) and supply (the production of financial reports which contain that
information).
97.
Therefore, in the staff‘s view, the reporting entity concept should adopt a user information
needs focus and be based upon the objectives of financial reporting.
98.
Before reaching any further conclusions about the reporting entity concept, it is first
necessary to consider the other cross-cutting issues relating to the project phase, some of
which are discussed below.
RE2: Aggregation versus Disaggregation
99.
On a broad level, the question of disaggregation is essentially answered in the previous
analysis (assuming that one accepts the conclusions drawn in that analysis). That is, a
legal entity (or any other type of entity) should be divided into two or more reporting
entities if:
a.
The entity comprises more than one component, each of which is itself an ―entity‖,
and
b.
For each component, there exists external users who want information about that
component, which will be useful to them in making economic decisions,8 but who
lack the authority to prescribe the information they require.
100. To answer the question of aggregation, it is first necessary to answer the remaining crosscutting issues RE3 and RE 4, about the purpose of consolidated financial statements and
whether control is the right basis for consolidation.
8
This wording is loosely drafted; it is intended to be merely indicative of a ‗user information needs‘ focus that is
consistent with the objectives of financial reporting, as discussed above.
22
RE3: What Is the Purpose of Consolidated Accounts?
101. It should be noted that the discussion of RE3 below does not address the issue of what the
basis of consolidation should be. In particular, it does not address the issue of whether
consolidated financial statements should relate to a group of entities comprising a parent
entity and other entities under its control. Therefore, although the discussion below refers
to ―the group‖, it does not address the issue of determining which entities should be
included in the group‘s consolidated financial statements. Those issues are discussed in
RE4.
102. Furthermore, the term ―consolidation‖ is used today to refer to a particular way of
combining or integrating the results and activities of several entities, to produce the
financial statements of a group entity. Whether or not those existing accounting practices
are appropriate at a conceptual level depends on the conclusions reached about the
composition of a group entity for financial reporting purposes. Therefore, until
conclusions are reached about the composition of a group entity, it is somewhat premature
to reach conclusions about what should be the purpose of consolidated financial
statements. Hence, the discussion below begins the process of considering issue RE3, and
will continue at a later date.
103. One could establish the purpose of consolidated accounts by reviewing existing accounting
standards. For example, FASB literature includes the following statement:
The purpose of consolidated statements is to present, primarily for the benefit of
the shareholders and creditors of the parent company, the results of operations and the
financial position of the parent company and its subsidiaries essentially as if the group
were a single company with one or more branches or divisions. There is a presumption
that consolidated statements are more meaningful than separate statements and that they
are usually necessary for a fair presentation when one of the companies in the group
directly or indirectly has a controlling financial interest in other companies. [ARB No.
51, Consolidated Financial Statements, paragraph 1, emphasis added]
104. However, to base the answer to RE3 on existing literature results in an answer that
represents how the question is answered at present, in accounting practice, rather than how
the question should be answered, in concept.
105. For example, the staff observes that the stated purpose reproduced above—to present
information primarily for the benefit of the shareholders and creditors of the parent
company—is inconsistent with the Boards‘ initial conclusions on the objectives of
financial reporting. Consolidated financial statements are a type of financial reporting, and
therefore the purpose of consolidated financial statements should be consistent with the
objectives of financial reporting. The Boards have tentatively concluded that the
23
information provided by financial reporting is directed to the needs of a wide range of
users rather than to the needs of a single group of users, such as common shareholders, or
common shareholders of the parent company in consolidated financial statements.
Furthermore, the Boards concluded that the financial reports should reflect the perspective
of the entity rather than the perspective of existing common shareholders or any other
single user group.
106. This raises the question of whether the Boards‘ decisions on the objectives of financial
reporting preclude the preparation of consolidated financial statements using the ―parent
entity perspective‖, which entails:
a.
Presenting non-controlling interests outside of equity, either as part of liabilities or as
a separate category, between liabilities and equity.
b.
Recognising gains or losses in the consolidated income statement that relate to
transactions between the parent entity and non-controlling interests.
107. If one accepts that the financial reports should reflect the perspective of the entity rather
than the perspective of existing common shareholders or any other single user group, then
it follows that the consolidated financial statements should reflect the perspective of the
entity (i.e., the group), not the perspective of one particular entity within the group (such as
the parent), or one particular group of users (such as the parent entity‘s common
shareholders).
108. However, the above conclusion does not necessarily mean that non-controlling interests
are an equity interest. The classification of non-controlling interests, or any other type of
financial interest in the assets of the entity, depends upon the distinction between liabilities
and equity. Applying the entity perspective simply means that one doesn‘t ―change the
rules‖ when preparing consolidated financial statements. In other words, the definitions of
elements are applied consistently to all entities, including both to individual entities and to
group entities.
109. For example, if the distinction between liabilities and equity is based upon whether the
entity has a present obligation to transfer cash or other assets of the entity to another party,
then that distinction is applied consistently, both in consolidated financial statements and
in the financial statements of individual entities. Under that debt/equity distinction, noncontrolling interests (typically) do not represent a liability of the group.9 Furthermore,
9
There are exceptions, such as when the non-controlling interests include financial instruments with a right to put
the instrument back to an entity within the group (the subsidiary entity or the parent entity).
24
because gains and losses of an entity arise from changes in the entity‘s net assets, then
transactions between the entity and its equity holders do not result in gains or losses.
110. However, it would be possible to distinguish between liabilities and equity in other ways,
which might result in different conclusions about the treatment of non-controlling interests.
In other words, applying an entity perspective rather than a parent entity perspective does
not preclude the possibility that non-controlling interests could be classified as a liability—
it all depends on how the distinction between liabilities and equity is drawn. (Nor does it
preclude providing information about different components of equity.) The debt/equity
distinction is an issue to be addressed in Phase B of the project (which covers issues
relating to the definitions of elements). Therefore, no further comment is made here on
this issue.
111. There remains the question of what the purpose of consolidated financial statements should
be. As noted above, consolidated financial statements are a type of financial reporting, and
therefore the purpose of consolidated accounts should be consistent with the objectives of
financial reporting. Accordingly, based on the Boards‘ tentative conclusions about the
objectives of financial reporting, the purpose of consolidated financial statements should
be to provide information about the group that is useful to present and potential investors
and creditors and other users of the financial reports of the group, in making rational
investment, credit and similar economic decisions.
112. This leads to the question of what the group comprises and, in particular, whether control
is the right basis for consolidation, which is discussed below in the section on issue RE4.
113. Before turning to that question, there is a supplementary question relating to the purpose of
consolidated financial statements, namely why some jurisdictions require parent-only
statements, others require consolidated financial statements, and yet others may want
combinations of both parent-only financial statements and consolidated financial
statements.
114. Based on the staff analysis to date, a possible explanation is that a different reporting entity
concept is being applied:
a.
Some jurisdictions may have adopted a legal entity concept. If a reporting entity is
defined by its legal boundary, it would not be appropriate to ―look through‖ the legal
boundary between one legal entity and another, and hence it would not be
appropriate to prepare consolidated financial statements. Instead, parent-only
financial statements should be prepared.
25
b.
Some jurisdictions may have a reporting entity concept similar to SAC 1, under
which the reporting entity includes a group entity comprising a controlling entity and
one or more controlled entities, and whereby a reporting entity should report
information about all the resources it can deploy ―…whatever the legal or
administrative structure established to manage those resources‖ (SAC 1, paragraph
16). Under this concept, it is appropriate to prepare consolidated financial
statements, rather than parent-only financial statements. Parent-only financial
statements would be inappropriate under the SAC 1 reporting entity concept because
the financial statements would omit resources that the parent entity can deploy,
namely the resources that the parent can control through its control over its
subsidiaries.
c.
Some jurisdictions may have a reporting entity concept similar to the SoP, which
draws a distinction between direct control and indirect control, and uses both to draw
the boundary of the reporting entity. That is, direct control is used to draw the
boundary of single entity financial statements—which appears to include parent-only
financial statements—and direct control plus indirect control is used to draw the
boundary of consolidated financial statements. Under this concept, both parent-only
and consolidated financial statements should be prepared. Another possibility is that
there may be legal or tax reasons for preparing parent-only financial statements, in
addition to consolidated financial statements.10
115. The staff has yet to investigate this issue, to determine if the above suggested explanation
is correct, or whether there are other reasons for the differences in the requirements of
various jurisdictions. However, before undertaking that investigation, the staff asks Board
members to advise whether they are aware of other reasons and whether they wish this
issue to be investigated further, or whether the above suggested explanation is sufficient.
RE4: Is Control the Right Basis for Consolidation?
116. The staff analysis of the key literature in the previous section found that under SAC 1 and
the SoP, the control concept is an integral part of the reporting entity concept.
117. That analysis also found that, in both SAC 1 and the SoP, the concept of one entity
controlling another is used to ―look through‖ the legal or organisational structure that
separates the controlling entity and the controlled entity, so that the group (or economic
entity, in SAC 1 terminology) reports all resources under its control:
10
For example, legislation relating to the distribution of dividends or payment of taxes may be based on a legal
entity concept.
26
…information about all resources able to be deployed by a reporting entity is
relevant, whatever the legal or administrative structure established to manage those
resources. Thus, where an entity controls other entities, there should be disclosed
information regarding the resources of controlled entities as well as the resources of the
controlling entity because all of these resources may be deployed by the controlling entity
to its advantage. [SAC 1, paragraph 16]
An entity indirectly controls an asset if it has control of an entity that has direct control of
the asset…
Direct plus indirect control is used to determine the boundary of the reporting entity that
prepares consolidated financial statements. Those financial statements will therefore deal
with the gains, losses, assets and liabilities directly controlled or borne by the entity as
well as those that are indirectly controlled or borne by the entity through its control of
other entities. [SoP, paragraph 2.4(b) and 2.6(b), footnote omitted]
118. The control concept seems appropriate, if one accepts that the reporting entity concept
should be based on user information needs and, in particular, if one accepts that, to satisfy
those information needs, the financial reports should provide information about resources
under the reporting entity‘s control.
119. The control concept also is used in the FASB draft document, although it is less clear
whether the control concept is an essential part of the reporting entity concept.
Furthermore, the staff analysis notes that the user information needs condition in the draft
document seems much broader (i.e., less specific), compared with SAC 1 and the SoP. If
the reporting entity concept is based upon a broader objective of providing information that
helps users assess the amounts, timing and uncertainty of future cash flows, one could
envisage other bases for consolidation.
120. With this point in mind, the staff observes that the Boards‘ draft document for Phase A of
the project discusses the following objectives of financial reporting, proceeding from the
more general to the more specific:
a.
Information that is useful to present and potential investors and creditors and other
users in making rational investment, credit and similar economic decisions.
b.
Information to help present and potential investors and creditors and other users
assess the amounts, timing, and uncertainty of prospective net cash inflows to the
entity.
c.
Information about economic resources of the entity (its assets), the claims to those
resources (its liabilities and owners‘ equity), and the effects of transactions, other
events, and circumstances that change resources and claims to them.
121. The SAC 1 and SoP reporting entity concepts, and their use of a control concept, are
consistent with a reporting entity concept that focuses on the third objective above
27
(information about economic resources, etc). To paraphrase SAC 1 and the third objective
above—information about all the entity‘s economic resources is relevant, whatever the
legal or administrative structure established to manage those resources. Therefore, if an
entity controls other entities, information should be disclosed about the economic resources
of the controlled entities as well as the economic resources of the controlling entity,
because all of these resources may be deployed by the controlling entity to its advantage.
122. The reporting entity concept under the FASB draft document is more consistent with a
reporting entity concept that focuses on the second objective above (information to help
assess the amounts, timing, and uncertainty of future cash flows). As noted above,
adopting a broader focus leaves open the possibility of other bases for consolidation, ie
other ways in which the boundary of a group entity could be drawn.
123. Assuming that the Boards agree that the reporting entity concept should be based upon user
information needs and, more specifically, the particular user information needs identified
in the objectives of financial reporting, the reporting entity concept adopted in the
framework should be consistent with all of the objectives set out in paragraph 120 above.
In other words, if the financial reports of a group entity are to satisfy the third objective of
providing information about its economic resources (and claims to those resources, etc),
then if an entity within the group controls another entity, the economic resources of the
controlled entity should be included in the group financial reports; otherwise the group
financial reports might omit some of its economic resources.
124. Although the above analysis suggests that the control concept should be retained, it does
not preclude supplementing that concept in some way, or perhaps developing a higher level
concept of which control is one component, so that the boundary of a group entity is drawn
more broadly, to include not only a controlling entity and other entities under its control,
but also some non-controlled entities. In other words, it might be possible to develop an
approach that is consistent with the third objective above, but also results in the provision
of additional information, to help to further satisfy the first and second objectives set out
above.
125. For example, suppose there are two entities that are related (e.g., under common
management or with common shareholding), but neither entity controls the other. The
control concept alone would not require these two entities to be combined into a single
reporting entity. Nevertheless, there might be external users who would find it useful to
have financial reports that combine the two entities into one reporting entity.
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126. Similarly, in accounting practice, difficulties are sometimes encountered when applying
the control concept in particular situations, for example, in the context of special purpose
entities. If a reporting entity concept could be developed in which the control concept is
supplemented in some way, or is a component of a higher level concept, this approach
might prove helpful in the context of special purpose entities.
127. Before reaching any conclusions about whether the control concept should be retained
(either alone, supplemented in some way, or as a component of a higher level concept), for
the purposes of drawing the boundary of a group entity that comprises two or more entities,
there are some significant issues to be addressed. In particular, cross-cutting issues RE5–
RE8 for the reporting entity project phase all relate to control: 11
RE5: What does control mean? Should this be defined at the concepts level or
standards level?
RE6: Is there a difference between control over an entity and control over assets?
Which should provide the basis for consolidation?
RE7: Joint ventures—concept of joint control; joint control over entity or assets?
What about ‗significant influence‘—how does that fit in with the control
concept?
RE8: Does it matter if one has control today but might lose control later (e.g.,
control today only because of dispersion of other shareholdings)? What if one
does not have control today, but could gain control tomorrow (e.g., by
exercise of an option)?
128. Therefore, although the above analysis suggests the control concept should be retained,
there are significant outstanding issues, and therefore the staff proposes to leave open the
question of whether the control is the right basis for consolidation. The staff also proposes
to leave open the related question raised above, as to whether the control concept should be
supplemented in some way, or be a component of a higher level concept. Further work on
the control concept might provide some insights into whether such an approach is worth
exploring. In the meantime, the staff asks for Board members‘ initial reactions to this idea.
11
Some of the questions that appeared in the September 2005 staff plan for the reporting entity project phase have
been revised in response to Board members‘ comments made during the discussion of that plan.
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PROPOSED APPROACH TO THE REPORTING ENTITY CONCEPT
129. Based upon the staff analysis in the previous two sections, the staff proposes that the
reporting entity concept be based upon the following approach (cross-references to earlier
staff discussion of these points are given in brackets):
a.
A distinction should be made between an entity and a reporting entity, such that not
all entities are reporting entities. In other words, a reporting entity is drawn from a
wider pool of entities, either individually or in combination (paragraphs 77–82).
b.
For an organisation, arrangement, or structure to be an entity (including a reporting
entity), it need not be a legal entity. In other words, the boundaries of an entity
should not be limited to legal boundaries. Therefore, what constitutes an entity
includes not only legal entities, but other types of organisations, arrangements or
structures, such as sole proprietorships, partnerships, trusts, associations, and group
entities (paragraphs 88–91).
c.
For an organisation, arrangement or structure to be an entity, it must have the
capacity to act, i.e., be able to engage in activities, including undertaking transactions
with other parties. The capacity to act is not limited to legal capacity (such as the
ability to transact in the organisation‘s name rather than the name of its owners).
Rather, it simply means that the organisation must have some form of management
function, which is responsible for conducting or managing the activities of the
organisation (paragraphs 85–87).
d.
The reporting entity concept should be based upon user information needs, ie user
information needs should be the key determining factor, for the purposes of
establishing which entities (or combinations of entities) should be identified as
reporting entities (paragraph 95).
e.
The user information needs referred to in (d) above should be those specified in the
objectives of financial reporting (paragraphs 96 and 97).
f.
At a general level, the purpose of consolidated financial statements should be to
provide information about the group that is useful to present and potential investors
and creditors and other users of the financial reports of the group, in making rational
investment, credit, and similar economic decisions (paragraphs 101–115).
130. The above analysis also suggests that determining which entities should be combined to
form a group entity should be based upon the concept of control, as a minimum. However,
further work is needed on the control concept before concluding on this issue. Whether the
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control concept should be supplemented in some way, or be a component of a higher level
concept, is also an open question (paragraphs 116–128).
QUESTION FOR THE BOARDS
131. Do the Boards agree with the above proposed approach? If not, with which aspects of the
above approach do Board members disagree?
132. Do the Boards wish the staff to conduct further research into the idea that, for the purposes
of drawing the boundary of a reporting entity that comprises a group of entities, the control
concept should be supplemented in some way or be a component of a higher level concept?
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