Accounting Standards
Classification of an Entity | Standard Setting Bodies | GAAP | AICPA | Reporting Requirements | Reporting Entity | Financial Statement Comparison
A trite expression is that “accounting is the language of business.” That expression is usually directed at accounting for entities that are operating with the objective of making a profit. These entities are thus known as being “for-profit.” The expression is intended to convey the idea that proper accounting is a means of communicating financial results to stakeholders including owners and lenders.
Not all organizations, however, operate with profit as the main objective. One broad way of referring to these entities is to call them “not-for-profit.” The government of your local town or city may be a great example of such an organization. The goal of that organization is to provide essential services such as police and fire protection. Generating profit, in other words, is not the purpose of that organization.
Accounting is nonetheless essential for these entities. In fact, many arguments can be made that the accounting is even more essential for the not-for-profit sector. For instance, although a not-for-profit entity should not have owners, it will have any number of other stakeholders. Consider again your local town or city. Some examples of stakeholders include the residents of that municipality, people and businesses who own property within the boundaries of the town or city, and individuals and organizations who pay taxes there.
Each of these stakeholders may be interested in being informed of the financial results of the municipality and its effectiveness in providing services with the resources provided. Accounting and financial reporting is thus indispensable. However, since there is not a profit motive, and because the financial reporting is intended to cover some other operational aspects, that municipality and all other organizations in the not-for-profit sector must report results in a manner different from the business sector.
This week, we will address the role of standard setting bodies in establishing the proper rules for the accounting and financial reporting. Before doing so, some basic ideas concerning determining if an entity is a for-profit or not-for-profit entity is essential. Then, we will address how not-for-profit entities can be further classified as either governmental or nonprofit.
| Classification of an Entity |  |
Classifying an entity is imperative for a number of reasons. The determination of the applicable accounting standards is the reason most pertinent to our discussions. The classification can be seen as a two-step process. First, it must be determined if the entity is “for-profit” or “not-for-profit.” Second, if the entity is a “not-for-profit,” it must be determined if it is a “governmental” entity or a non-governmental “nonprofit organization.”
The first step is arguably easier than the second. Simply stated, there are three criteria that result in an entity being a not-for-profit. Those three criteria are: (1) significant receipts in nonexchange transactions, (2) operating purposes other than with a profit motive, and (3) an absence of ownership interests. That is, if these criteria are met, the entity is a not-for-profit. Granted, the “nonexchange” criteria may sound cryptic at first, but all that is saying is that the revenues may come from sources such as taxes or contributions rather than sales.
What is more difficult in many instances is that after you have determined that an entity is not a for-profit business, then you have to decide if it is a governmental entity or a nonprofit organization. Taxation as a major source of revenue can be a major determinant in this regard. That is, if the entity can assess taxes, more than likely it is a governmental entity. Another factor to consider is if the power over the entity “ultimately rests in the hands of the people”; if it does, that is an indication that the entity is governmental.
What you can’t do, though, is try to classify by function. For example, a hospital could fall into any of the three categories. It could be governmental with examples being Cook County Hospital in the Chicago area, or Denver General Hospital in Denver, Colorado. Or it could be a private hospital owned by a religious order (and thus a nonprofit). Or it could be a hospital owned by a for-profit business.
| Standard Setting Bodies | |
Because the structure of the various for-profit and not-for-profit organizations vary so drastically in the United States of America, with resulting variations on the reporting needs, a number of standard setting bodies have evolved. The goal of each such body, by the way, is to set forth the rules and other guidance on how the financial position and results of operation should be reported by the entities under its purview. This is to assist readers with the readability, for consistency within an entity, and for comparability between similar entities. See the discussion of “Generally Accepted Accounting Principles” (GAAP) below.
At the federal level, the applicable standard settings body is the Federal Accounting Standards Advisory Board (FASAB). It has a challenging role considering the fact that there are many diverse users of federal financial information. For instance, there are congressional oversight groups that need the financial and budgetary information. The executive agencies and departments also need such information. So the mission of the FASAB is to recommend accounting standards for the federal government with the informational needs of these various users in mind.
The FASAB is a federal advisory commission. An entity with a very similar acronym is the FASB. FASB is an acronym for Financial Accounting Standards Board. The FASB sets the accounting and reporting standards for for-profit entities and for non-governmental nonprofit organizations. The FASB does not, however, set standards for state and local governments. Those rules are set by the Governmental Accounting Standards Board (GASB).
| Standard Setting Bodies | |
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In the coming weeks, we will mainly be addressing the standards set by the GASB. In fact, many of our discussions will center on just one standard (called a “statement”) of the GASB. Specifically, we will be addressing in detail GASB Statement 34. The title of that statement is “Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments.” We will, though, also touch on the role of, and standards set by, the FASAB and the FASB.
Next, let’s address the concept of Generally Accepted Accounting Principles (GAAP).
| GAAP | |
The overall goal of each of these standards setting bodies is to establish Generally Accepted Accounting Principles, also known as GAAP. In other words, the goal of each such body is to establish GAAP for the entities within its purview. Then the entities should follow the GAAP rules.
What is potentially confusing though, is that at first glance, it sounds as if GAAP mandates only one method of accounting and reporting for any given entity. However, there is actually some flexibility within GAAP. The key is for an entity to choose a method, disclose the particulars in its financial reporting, and usually stay on that method from year-to-year.
Let’s briefly discuss a for-profit business as an example. If a business buys property to be used in the business and that asset is expected to last beyond the current year, the full cost cannot be written off the first year. Rather, the cost must be depreciated over the useful life of the asset. The resulting depreciation can be a major expense for many such businesses. There are many different methods, however, for a business to compute depreciation. For instance, a business may decide to use straight-line depreciation, which merely means that the cost of the asset will be written off ratably throughout its life. Alternatively, the business may decide to use an accelerated method to claim additional expense in the first few years the asset is owned.
Keep in mind that the overall goal of reporting for a business is to indicate if it has made a profit or loss for the year. Depreciation is one necessary step to try to match the expenses with the revenues for the year to see if there is a profit or loss. For a government, however, remember that profit or loss is not necessarily a key factor. Hence, the reporting of capital assets and depreciation may be far different. In fact, for many years, state and local governments did not have to capitalize certain infrastructure costs such as roads and bridges. Even today, there are ways in which such a government might not have to depreciate eligible infrastructure costs.
A particular interesting aspect of GAAP is that it is constantly evolving. Specifically, as new financial issues arise, the applicable standard setting body should go through a process of formulating new rules and standards. After an appropriate approval process, the standard setting body should publish those rules as an accounting statement or perhaps as an interpretation of an existing statement. Within governmental reporting, for example, the issue of governments promising certain benefits to long-time employees for life after retirement may be seen as an evolving issue.
This ongoing matter of capitalizing assets and this emerging issue of post-retirement benefits have each been presented here to illustrate nuances of the financial reporting that should be addressed in the GAAP rules. Next, we should address the role of the American Institute of Certified Public Accountants (AICPA) in this regard.
| AICPA | |
A Certified Public Accountant (CPA) is an individual who has passed a qualifying examination (the Uniform Certified Public Accounting Examination) and has met other qualifications to become licensed by his or her state, territory, or the District of Columbia. The American Institute of Certified Public Accountants (AICPA) is a voluntary organization of CPAs.
For many years, the accounting and auditing professions were self-regulated with the AICPA establishing the rules. Self-regulation has changed in some ways over the past few years with respect to publicly-traded companies. There is now more government involvement. Regardless of that change, the AICPA generally is the controlling body to determine who can establish the GAAP rules.
This power of the AICPA may be seen as partly a result of a circular equation. In effect, the AICPA promulgates auditing standards. If those standards are followed, a CPA may issue an audit report. The goal of such a report is for the auditor to be able to state if the entity’s financial statements were presented fairly in accordance with Generally Accepted Accounting Principles. Hence, the AICPA can determine what is GAAP.
Perhaps a brief discussion of the FASAB may highlight this role of the AICPA. As mentioned earlier, the FASAB does establish GAAP for federal entities. The FASAB was formed in 1990 as an advisory board by certain federal officials, including the Secretary of the Treasury, the Director of the Office of Management and Budget, and the Comptroller General of the United States. Each of those officials ceded power to establish GAAP to the FASAB.
A CPA or a CPA firm may, upon occasion, be asked to audit or otherwise opine on financial statements for federal entities. In order to recognize the pivotal role of the FASAB, the AICPA has recognized advisory board statements as the highest level of GAAP for such entities. In other words, AICPA has stated that if the FASAB has issued guidance on an issue, that guidance should be followed to determine GAAP for audit purposes. However, if there is not FASAB guidance or it is not clear, the AICPA member can look to other sources such as the FASB and AICPA auditing rules. These secondary sources do not carry as much weight as the FASAB rules. This is an example of the hierarchy of the GAAP rules and the interplay between the FASAB and the American Institute of Certified Public Accountants.
| Reporting Requirements | |
The Governmental Accounting Standards Board (GASB) does set forth some minimum requirements for the financial reporting by state and local governments. Those requirements can be seen as falling into three areas. First, the reporting must include a Management Discussion and Analysis (MD&A). Second, Basic Financial Statements must be presented. Third, Required Supplementary Information (RSI) other than the MD&A must be included. Note that MD&A is considered to be RSI but should be presented separately.
| Required Contents of a State or Local Government Financial Report | |
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The Basic Financial Statements consist of Government-wide Financial Statement and Fund-basis Financial Statements. The Government-wide (also called Governmental-activities Government-wide or GAGW) is introduced this week and we will focus on the topic again later in the session. You should thus get familiar with some basics of the Government-wide statements including the Statement of Activities. But we will mainly be concentrating for now on the Fund-basis Financial Statements (which we may refer to at times as the fund statements).
The GASB does not require that a reporting government bundle these items and more into a report known as a Comprehensive Annual Financial Report (CAFR) but there is encouragement to do so.
If a CAFR is produced by a reporting government, the required elements of the financial reporting will be included in a Financial Section of the CAFR. In addition, that Financial Section may include yet other items such as an Auditor’s Report and perhaps supplementary information even beyond the required information. The Financial Section of the CAFR should be preceded by an Introductory Section and followed by a Statistical Section.
| Contents of a Comprehensive Annual Financial Report (CAFR) | |
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The Introductory Section of a CAFR may include items such as a transmittal letter from an appropriate government official, an organization chart, and a list of principal officers. Also, if the reporting entity received a Certificate of Achievement for Excellence in Financial Reporting for the preceding year, a reproduction of that certificate might be included in this introductory section.
The Statistical Section may include a number of tables that are intended to reflect historical data and trends for both the reporting entity and its environment. Generally, 10 years of information is presented in any given statistical analysis. The goal of presenting this statistical information is to allow the reader to understand better the information presented for the current year. For instance, financial trend information may allow the reader to see how the government’s financial position has changed over the time period presented. Similarly, demographic and economic information may allow the reader to assess how the conditions in the government’s community have changed over time and how that has affected that entity or entities.
We should next examine the difficulties in determining what entities should be included in the financial reporting by a government whether via the minimum statements or in a CAFR.
| Reporting Entity | |
Governmental entities can be far more complicated than for-profit entities because funds should be created for different types of activities and because various structures can be created in order to segregate some operations and/or delegate some responsibility. Issues can thus arise as to which entities or units should be part of a government’s financial report.
One critical piece of terminology in this regard is “financial reporting entity.” Generally, this refers to a primary government and additional governments for which that government is financially responsible or for which the omission from the statements would be misleading. For instance, a city might be the primary government but it may also need to include an airport authority. Inclusion would be needed in this example if the city is ultimately responsible for the financial obligations of that airport authority or if there is some other overriding reason arguing for inclusion. There can also be instances where other than a primary government issues its own financial statements. In that instance, it could be a financial reporting entity. Most of the discussions in this course, though, will use the more common example of a city and component units being a financial reporting entity.
Two other critical terms are part of this concept of a financial reporting entity: primary government and component units.
A primary government usually is a state government or a general-purpose local government such as a town or city. A special-purpose government, however, can also be a primary government if certain conditions are met. For purposes of this course, we will almost always use the term “primary government” in the general sense of it being a state or a general-purpose local government.
A component unit usually is a legally separate entity but one for which the elected officials of the primary government are financially responsible. A component unit can also be an organization that has such a significant relationship with the primary government that excluding its financial information would make the financial statements of the primary government misleading
This concept of a primary government and component units is but one example of the major theme of this week – the economic and reporting differences of governmental entities as compared to for-profit businesses. Accordingly, as the last part of this lecture, let’s look at some differences in the financial statements between those two broad categories of entities. As you will see from the tutorial in the next section, we can further limit the comparison to just a General Fund to try to fully highlight select differences.
Financial Statements Comaprison Tutorial
