Governments often hold equity interests in legally separate entities that are utilized to deliver government services, sometimes through cooperative ventures, or for investment purposes. Governments need to determine which of these entities are part of their financial reporting entities. GASB Statement 90 resolves this reporting entity issue. Many governments will find that implementing the standard requires little change to their financial statements, but other entities will need to incorporate newly identified component units, leading to a significant impact.
Many governments hold equity interests in other legally separate governmental entities, not-for-profit corporations, and for-profit entities. The types of separate legal entities are various, including libraries, airports, jails, healthcare entities, and real estate development entities. Some of these equity interests are held to give a government varying levels of influence or control over a legally separate entity, in order to facilitate delivery of government services. Others are held for investment purposes—either by the governmental activities or business-type activities of a government or as part of its fiduciary activities. Some are cooperative ventures between multiple units of government. In some cases, a government may hold a 100% equity interest in a legally separate entity. Just as a business must determine which entities to consolidate in its financial statements, a government must determine which legally separate entities to include as part of the reporting entity covered by its financial statements and how to incorporate those entities in the financial statements.
In 1991, GASB issued Statement 14, The Financial Reporting Entity, to provide primary guidance on defining the government reporting entity. The guidance addressed most of the issues governments face in making reporting entity determinations. Statement 14’s guidance centers on the concept of financial accountability and requires a government to include legally separate entities for which it is financially accountable (as well as limited other entities) as component units of its reporting entity. Two particular areas that Statement 14 did not cover adequately were foundations (and similar entities) and majority equity interests in organizations other than businesses. Statement 14 specifically acknowledged that GASB intended to provide future guidance on foundations and similar entities. In 2002, GASB provided this additional guidance in Statement 39, Determining Whether Certain Organizations Are Component Units—an amendment of GASB Statement No. 14.
GASB Statement 14 only addressed when a majority equity interest in a business enterprise is a component unit, even as the standard acknowledged that governments hold equity interests in many other types of entities. Paragraph 55 required a government to include a business in which it held a majority of the common stock as a component unit if it purchased the interest in order to “directly enhance its ability to deliver governmental services,” but not if the interest was acquired for investment purposes. GASB Statement 14 did not specifically require majority equity interests in nonbusiness entities to be reported as component units. However, a majority equity interest could potentially meet the financial accountability criteria and result in a nonbusiness entity being reported as a component unit. (Exhibit 1 provides the current definition of an equity interest from GASB Statement 90, Majority Equity Interests.)
GASB Statement 90—Definition of an Equity Interest
GASB Statement 90, paragraph 3, defines an equity interest as:
A financial interest in a legally separate organization evidenced by the ownership of shares of the organization’s stock or by otherwise having an explicit, measurable right to the net resources of the organization that is usually based on an investment of financial or capital resources by a government. An equity interest is explicit and measurable if the government has a present or future claim to the net resources of the entity and the method for measuring the government’s share of the entity’s net resources is determinable.
A footnote to the definition states that the definition “is not intended to include a government’s residual interest in assets that may (on dissolution) revert to the government for lack of another equitable claimant,” which “is, in substance the same as escheatage.”
The primary changes that GASB Statement 90 made from the prior definition were (1) changing from interests in joint ventures to interests in any legally separate organization, and (2) the addition of the second sentence regarding the meaning of explicit and measurable. Similar guidance for what “explicit and measurable” meant was provided for joint ventures in the prior literature but was not included in the equity interest definition.
Some discussion of an equity interest is provided in the GASB’s Comprehensive Implementation Guide (Question 4.48.1), which states, “For example, if an agreement specifically spells out the participant’s rights to the organization’s net resources based on the original contributions, this would represent an equity interest.” Where stock ownership is not the basis for an equity interest, one must carefully review the agreements establishing separate legal entities to determine if a government’s relationship with the entity involves an equity interest.
In 2010, guidance included in GASB Statement 61, The Financial Reporting Entity: Omnibus—an amendment of GASB Statements No. 14 and No. 34, resolved the question of when a government’s majority equity interest in a government or not-for-profit entity requires the government to include that legally separate entity, such as an airport or a healthcare entity, as a component unit in its reporting entity. This resolution was short lived, however, as a result of the provisions in two subsequent standards—GASB Statement 72, Fair Value Measurement and Application, and GASB Statement 69, Government Combinations and Disposals of Operations. GASB Statement 90 revises the guidance for classifying and reporting majority equity interests to resolve the issues that arose from these standards related to the provisions of GASB Statement 61.
Given this litany of guidance, majority equity interest issues arose from the following factors:
- The definition of investments in GASB Statement 72, which raised questions about both the classification and reporting provisions for majority equity interests in Statement 61
- The accounting guidance for government acquisitions provided in GASB Statement 69, which raised questions about the reporting provisions of Statement 61.
This article discusses the above issues and then illustrates both how GASB 90 resolves these issues and how it provides for classifying and reporting majority equity interests in legally separate entities. The steps that a government should take to ensure that it applies the standard correctly are also illustrated below. GASB Statement 90’s effective date was delayed due to the effects of the coronavirus (COVID-19) pandemic and now must be applied for reporting periods beginning after December 15, 2019. Accordingly, it applies to fiscal years ending on or after December 15, 2020.
GASB Statement 72 Related Issues
In 2010, GASB Statement 61 amended Statement 14 by establishing that a government’s intent for acquiring a majority equity interest in another legally separate entity (whether a business, government, or not-for-profit organization) determines whether it is an investment or results in reporting the investee entity as a component unit. If the majority equity interest was acquired to “directly enhance its ability to deliver governmental services,” that legally separate entity is a component unit. If, instead, the government holds an equity interest (whether or not a majority interest) for the purpose of obtaining income or profit, Statement 61 required the equity interest to be reported as an investment.
However, GASB Statement 72’s definition of an investment includes two criteria that must be met to report an asset as an investment. Paragraph 64 defines an investment as “a security or other asset that (a) a government holds primarily for the purpose of income or profit and (b) has a present service capacity based solely on its ability to generate cash or to be sold to generate cash” (emphasis added).
The second requirement, that an investment’s present service capacity be based solely on its ability to generate cash or to be sold to generate cash, raises the possibility that a majority equity interest that was not acquired for the purpose of directly enhancing a government’s ability to deliver governmental services also might not meet the definition of an investment. The definition of an investment thus involved more than purpose or intent. The only alternatives for reporting majority equity interests under GASB Statement 61, however, are reporting the interest as an investment or reporting the entity in which the interest is held as a component unit. In addition, GASB acknowledged in the basis for conclusions of Statement 90 that some majority equity interests might meet both the component unit criteria of Statement 61 and the revised investment criteria from Statement 72 (which amended the investment classification guidance in Statement 61).
If a majority equity interest meets the two GASB Statement 72 criteria for an investment, it must be reported as an investment, and the investee entity may not be reported as a component unit.
This change from intent alone as the determining factor for whether a majority equity interest is treated as an investment or results in a component unit created the need to know which reporting alternative has precedence. Some might interpret the fact that Statement 14, paragraph 55 (as amended by GASB Statements 61 and 72) first discussed the issue of when to classify a majority equity interest as a component unit to indicate that the component unit question should take priority. However, this could lead to a determination to report a majority equity interest as an investment even though it does not meet the GASB Statement 72 investment criteria. In some cases, if the component unit criteria were to take priority, governments could acquire such interests for investment purposes but have to report them as component units. Others argued that a government should first determine whether the majority equity interest qualifies as an investment under Statement 72 and, if it does not, report it as a component unit. GASB Statement 90 resolves this question, as well as others.
Classifying Majority Equity Interests: Identifying Investments
Consistent with the accounting for any other asset or security, GASB Statement 90 requires a government to determine first if a majority equity interest it holds in a separate legal entity is an investment. If a majority equity interest meets the two GASB Statement 72 criteria for an investment, it must be reported as an investment, and the investee entity may not be reported as a component unit.
Note that the investment definition is applied when an asset or security is acquired. This determination is not to be changed subsequently according to Statement 72, paragraph 68, which states, in part:
The determination of whether an asset is held primarily for the purpose of income or profit or whether its present service capacity is based solely on its ability to generate cash or to be sold to generate cash is based on actions by a government’s management at acquisition. Once the government determines whether the asset is an investment or another type of asset, the classification should be retained for financial reporting purposes, even if the government’s usage of the asset changes over time.
This provision prevents a government from reconsidering the classification of a majority equity interest on a yearly basis. Applying the investment definition to majority equity interests also is simplified somewhat by identifying which, if any, of these interests are held as part of a fiduciary activity.
Majority Equity Interests Held by Fiduciary Activities
While not stated explicitly in the standards portion of GASB Statement 90, a majority equity interest held by a fiduciary activity will virtually always (and likely always) meet the definition of an investment, whether held by a special-purpose government engaged only in fiduciary activities or reported through a fiduciary fund of another government. Therefore, majority equity interests held by fiduciary activities will rarely (and likely never) result in reporting an organization as a component unit. This point is highlighted in the Exhibit 2 flowchart, which diagrams the primary decisions that determine the classification of majority equity interests and the related reporting requirements.
Two sources, one from GASB Statement 72 and one from the basis for conclusions of GASB 90, support the position that every majority equity interest held by a fiduciary activity likely must be reported as an investment. GASB Statement 72, paragraph 66, states, in part:
Evidence that a government holds an asset for income or profit also may be found in the fund that reports the asset. For example, income producing real property in a pension plan suggests that the asset is held primarily for income or profit. [Emphasis added.]
This Statement 72 provision conveys that an equity interest held in a fiduciary activity will be considered as acquired primarily for income or profit. Furthermore, fiduciary activity assets cannot be held for the benefit of the reporting government’s own programs, which limits an equity interest’s service capacity (to the government) to “its ability to generate cash or to be sold to generate cash.”
While the wording of Statement 90, paragraph 6, may suggest to some that a majority equity interest held in a fiduciary capacity could potentially not meet the definition of an investment, paragraph B6 of the GASB Statement 90 basis for conclusions appears to preclude that possibility, stating:
The Board believes that the definition of an investment is met, for example, when the majority equity interest in a legally separate organization is held by a special-purpose government engaged only in fiduciary activities or as part of the fiduciary activities of a government, such as those reported in private-purpose trust funds or pension (and other employee benefit) trust funds. In those circumstances, the majority equity interest has a present service capacity based solely on its ability to generate cash or to be sold to generate cash because of the government’s fiduciary duty to put the interests of the beneficiaries ahead of its own. [Emphasis added.]
Although the basis for conclusions is not authoritative, an unequivocal expression of the board’s thinking such as this is of major significance. First, the board clearly would not have made such an absolute statement if it were aware of even a single situation in which a fiduciary activity’s holding of a majority equity interest would not qualify as an investment. Second, when GASB provides implementation guidance for a standard, the most convincing source of evidence of the board’s intent, and thus of the appropriate implementation, is the basis for conclusions. It would be more than surprising if any future implementation guidance, needed because of varying interpretations of the standard, were inconsistent with this strong position in the basis for conclusions.
Classifying Majority Equity Interests Not Held by Fiduciary Activities
Majority equity interests not held by fiduciary activities must be evaluated using the GASB Statement 72 guidance to determine if they are investments. As noted earlier, if the two investment criteria are met, they will be reported as investments, and the entity in which the interest is held will not be a component unit. On the other hand, if the majority equity interest is not an investment, the entity in which the interest is held will be considered a component unit of the reporting government, as shown in Exhibit 2.
Reporting Majority Equity Interests that Are Investments
Statement 90 specifies that a majority equity interest that is an investment must be reported using the equity method unless held by a—
- special-purpose government engaged only in fiduciary activities,
- fiduciary fund,
- term endowment or permanent endowment, or
- permanent fund.
In these latter cases, the majority equity interest is reported at fair value, and changes in fair value also are reported in the financial statements. Remember that all majority equity interests that are not investments make the investee entity a component unit. GASB Statement 90 provides specific guidance for reporting these other majority equity interests and the related component units.
Component Unit Reporting Issues Raised by GASB Statement 69
In 2013, GASB issued Statement 69 to provide guidance on government combinations and transfers of operations, including government acquisitions of other entities. In a government acquisition, a government acquires another entity, or its operations, in exchange for significant consideration. The acquired entity is no longer a separate legal entity. Indeed, Statement 69, paragraph 7, specifically excludes combinations involving acquiring an organization that continues to exist and equity interests in legally separate entities from its scope. Statement 69 requires that the assets acquired and liabilities assumed in an acquisition are recorded generally at their acquisition values on the acquisition date. With respect to majority equity interests, this guidance raised the question of whether the accounting and reporting for acquisition of a 100% equity interest in another entity, which might or might not have been reported as a component unit in the past, should be comparable to that for a combination involving the acquisition of a legally separate entity. In essence, when a government attains a 100% majority equity interest that is not an investment, should the key provisions of GASB Statement 69’s acquisition accounting guidance apply? GASB’s determination that this is the case results in some differences in accounting for a majority equity interest in a component unit (and reporting of the component unit in separate financial statements) once the 100% equity interest is acquired.
In essence, when a government attains a 100% majority equity interest that is not an investment, should the key provisions of GASB Statement 69’s acquisition accounting guidance apply?
Reporting Component Units Arising from Majority Equity Interests
Under GASB Statement 90, reporting majority equity interests in component units and reporting for the resulting component unit depend upon whether the component unit is blended or discretely presented, and whether the majority equity interest is less than a 100% interest or is a 100% interest.
The determination of whether the component unit is blended or discretely presented is based upon the pre-existing criteria in GASB Statement 14, as amended. (Discrete presentation will be the norm, especially when the government’s equity interest is less than 100%.) In addition, while the classification provisions and investment reporting provisions of GASB 90 must be applied retroactively, the guidance on reporting majority equity interests in component units and on reporting the component units must be applied prospectively.
Reporting Majority Equity Interests of Less than 100%
If a majority equity interest of less than 100% is held in a discretely presented component unit, the government’s majority equity interest in the component unit is reported in the appropriate fund of the primary government using the equity method. If the interest is held through a governmental fund, the equity interest reported in the governmental fund should only include amounts consistent with the flow of current financial resources measurement focus. (For example, any discretely presented component unit capital assets and long-term liabilities would be excluded from the determination of the equity interest held by a governmental fund.) The equity interest is also reported in the government-wide financial statements. In addition, the government must discretely present the component unit itself. Component unit assets, deferred outflows of resources, liabilities, and deferred inflows of resources are not remeasured when the government holds less than a 100% equity interest.
For blended component units (which should be uncommon when the equity interest is less than 100%), the government’s equity interest and any related net position should be eliminated in the blending process. No remeasurement of the component unit assets, liabilities, and so on is required when the government’s equity interest is less than 100%.
Reporting Majority Equity Interests of 100%
If a government acquires a 100% equity interest in a legally separate entity that is not an investment, GASB Statement 90 requires that it be accounted for as if it were a new entity on the date that the 100% equity interest is achieved. GASB’s goal is for the reporting to be consistent with that of the acquisition of a legally separate entity that becomes part of a government’s legal entity when acquired by a government, which is reported as an acquisition per GASB Statement 69.
In the government’s financial statements, the initial amount reported for the equity interest at the time of achieving a 100% equity interest, and the amounts reported in subsequent years, will be the same whether 1) the government’s interest was established in a single transaction or 2) the government held a lesser equity interest for a period of time before ultimately acquiring a 100% equity interest.
The pertinent provisions in GASB Statement 69 regarding the combination of an external entity in an acquisition must be applied to remeasure the component unit’s assets, deferred outflows of resources, liabilities, and deferred inflows of resources as of the date the 100% equity interest was acquired. GASB Statement 90 specifies that the measurement of the consideration provided in the transaction and the net position acquired should be as follows:
- The consideration provided by the government equals 1) the net resources provided to complete the transaction plus 2) the balances of any equity interest asset and deferred outflow of resources recognized by the government prior to the transaction that completes the acquisition of the 100% interest.
- The net position (of the component unit) acquired is the net position after remeasuring the component unit’s assets, liabilities, deferred outflows of resources, and deferred inflows of resources to the acquisition values (with some limited GASB 69 exceptions) per the guidance in GASB Statement 69. Note that assets and liabilities not previously reported in the component unit financial statements may also be included per GASB Statement 69.
While most governments will not find equity interests that were not already known, in the authors’ experience at least some governments are likely to have one or more unreported equity interests.
The differences between the consideration provided and the net position acquired are handled in accordance with GASB Statement 69. For example, if the consideration provided exceeds the net position acquired, GASB Statement 69 requires reporting a deferred outflow of resources in the amount of the difference (to be amortized over future years). In such a case, a government that has acquired a 100% interest would have an equity interest equal to the net position acquired and a deferred out-flow of resources for the balance of the consideration provided.
The subsequent flows statements of the component unit must report only transactions that occur after the acquisition of the 100% interest. Again, this “fresh start” approach parallels the amounts that would have been reported had the component unit become part of the government’s legal entity through an acquisition.
As with discretely presented component units in which the government has a majority equity interest of less than 100%, the government’s 100% equity interest in the component unit is reported in the primary government financial statements using the equity method (but based on remeasured amounts). Likewise, the government also would discretely present the component unit using the remeasured amounts. If the component unit is blended, the government’s equity interest and the related net position are eliminated in the blending process. Separate financial statements issued by the component unit after the government attains a 100% equity interest must also be based on this “fresh start” accounting using the remeasured amounts.
To implement GASB Statement 90 effectively, the first step a government should take is to evaluate its relationships with legally separate entities based on provisions in the documents related to formation of the entity (as well as subsequent agreements) to ensure that all equity interests acquired, including majority equity interests, have been identified. While most governments will not find equity interests that were not already known, in the authors’ experience at least some governments are likely to have one or more unreported equity interests, which in some cases would result in reporting a major component unit.
The next step is to evaluate any majority equity interests using the guidance in GASB Statement 90. For most governments, interests reported as investments in the past will typically still be investments and not result in the reporting of a component unit. Similarly, if a majority equity interest resulted in reporting a component unit under Statement 61, it is likely to be a component unit under Statement 90. Exceptions may be found because of different interpretations used in applying Statements 61, 69, and 72, or as a result of past oversights.
The most involved efforts in the initial implementation will likely occur from including component units not reported in past years and the remeasurements required for 100% equity interests that are acquired or attained in the year of implementation. Many governments will find that the provisions of the standard require little, or no, changes to their financial statements and reporting entity definition. But other entities will need to incorporate newly identified component units, which is likely to significantly impact their financial reports.