IAS27: SPECIALISED, NOT-FOR-PROFIT AND PUBLIC SECTOR ENTITIES

SPECIALISED, NOT-FOR-PROFIT AND PUBLIC SECTOR ENTITIES

TYPES OF ENTITY

Most of this study text is about the financial statements of profit-making entities, such as limited liability companies.

Other types of entity also prepare and publish financial statements. These entities include:

  • Not-for-profit entities: such as charities, clubs and societies. Each of these organisations is set up for a specific purpose. For example, a charity might be set up to campaign for the protection of the natural environment or to help the poor.
  • Public sector entities: these include central government bodies; local government bodies; and other organisations that operate for the benefit of the general public, such as state schools and hospitals. A public sector entity is owned by the state or by the general public.

Many different types of entity could be described under these headings. These entities are different from limited liability companies, partnerships and sole traders in one vital respect. They do not primarily exist to make a profit.

In practice, the terms ‘specialised entity’, ‘not-for-profit entity’ and ‘public benefit entity’ are often used interchangeably.

OBJECTIVES OF SPECIALISED ENTITIES

The main objective of large listed entities is to maximise their profits in order to provide a return to their owners (investors) in the form of a dividend. This may not be their only objective (for example, they may provide employment to the local community, or aim to operate in a socially responsible way), but it is their main objective.

The objective of owner managed businesses (small privately owned entities) is also to make a profit.

In contrast, the main objective of a specialised entity is to carry out the activities for which it has been created. Again, this may not be the only objective, because all entities need some form of income. Many large charities, for example, carry out trading activities. However, making a profit is not the main aim. In fact, most not-for-profit entities will aim to break even, rather than to generate a surplus of income over expenditure.

In some public sector entities, performance is measured in terms of whether the entity provides value for money from the resources it has available. Assessment of performance will look at how well the resources have been used and it is often done using the 3 E’s – economy, effectiveness and efficiency.

Economy means buying goods and services at a cheap price, so that the entity is not paying too much for its input costs, which could include accommodation, staff and other items.

Efficiency means operating so that inputs are used in the best possible way to provide a maximum output. In the case of a hospital, it may be making sure that the required service is provided at the lowest cost and wastage is kept to a minimum.

Effectiveness means that an organisation has met its goals by using the right resources at the right time.

 

Accounting standards and specialised entities

International accounting standards are designed for profit-making entities.

Whether they are relevant to not-for-profit entities will depend on the way in which they have to report and the information that they have to provide. There is a great deal of variation from organisation to organisation and from country to country.

In some countries, charities and public sector bodies are required to follow accounting standards specifically designed for the purpose (in the UK these are called Statements of Recommended Practice.) Alternatively, the form and content of financial statements and the accounting treatments to be followed may be prescribed by law. IASs and IFRSs are probably largely irrelevant for these entities.

Some not-for-profit entities may be able to draw up accounts in any form that its members or officers wish. Many not-for-profit entities prepare accounts on a cash basis, rather than on an accruals basis. Public sector bodies may also use cash accounting. (This was the case in the UK until fairly recently.) IASs and IFRSs require accruals accounting.

In some countries, public sector bodies and many charities are increasingly expected to apply commercial-style accounting practices. Even for those entities that are not formally required to adopt them, IASs and IFRSs are a useful source of information on current best practice.

THE NOT-FOR-PROFIT SECTOR: REGULATORY FRAMEWORK

The IASB and the FASB are working on a framework for reporting, which includes not-for-profit entities.

The International Public Sector Accounting Standards Board (IPSAB) is developing a set of International Public Sector Accounting Standard based on IFRS.

Regulation of public not-for-profit entities, principally local and national governments and governmental agencies, is by the International Public Sector Accounting Standards Board (IPSAB), which comes under the International Federation of Accountants (IFAC).

Statement of Financial Activities

In addition to a statement of financial position, charities also produce a Statement of Financial Activities (SOFA), an Annual Report to the Charity Commission and sometimes an income and expenditure account. The Statement of Financial Activities is the primary statement showing the results of the charity’s activities for the period.

The SOFA shows Incoming resources, Resources expended, and the resultant Net movement in funds. Under incoming resources, income from all sources of funds are listed. These can include:

Subscription or membership fees

  • Public donations
  • Donations from patrons
  • Government grants
  • Income from sale of goods
  • Investment income
  • Publication sales
  • Royalties

The resources expended will show the amount spent directly in furtherance of the Charity’s objects. It will also show items which form part of any statement of profit or loss and other comprehensive income, such as salaries, depreciation, travelling and entertaining, audit and other professional fees. These items can be very substantial.

Charities, especially the larger charities, now operate very much in the way that profit-making entities do.

They run high-profile campaigns which cost money and they employ professional people who have to be paid. At the same time, their stakeholders will want to see that most of their donation is not going on running the business, rather than achieving the aims for which funds were donated.

One of the problems charities experience is that, even although the accruals basis is being applied, they will still have income and expenditure recognised in different periods, due to the difficulty of correlating them. The extreme example is a campaign to persuade people to leave money to the charity in their will. The costs will have to be recognised, but there is no way to predict when the income will arise.

Exam Approach

In the exam, you may be given a scenario involving a not-for-profit entity or public sector entity and asked to advise on a particular transaction. In many ways your advice should be no different for a not-for-profit entity as for a commercial profit-making entity, but you will need to be aware of the context of the question and the fact that the objectives of a not for profit entity differ from a standard trading entity.

Users of the financial statements of a not-for-profit entity are almost always interested in the way that the entity manages and uses its resources.

For example:

  • A charity may be managed by trustees on behalf of its supporters and those who benefit from its activities.
  • A public sector organisation is managed by elected officials on behalf of the general public.

Performance measurement of non- profit organisation

Additionally, if you have to interpret any information relating to not-for-profit and public sector entities then make sure you are aware who the users of that information are and what they will be interested in.

Typically, users will want to know whether:

  • The entity has enough finance to achieve its objectives
  • The money raised is being spent on the activities for which it was intended
  • The public are receiving value for money (in the case of a public sector entity)
  • Services are being provided economically, efficiently and effectively (in the case of a public sector entity)
  • The level of spending is reasonable in relation to the services provided.

Additionally, standard ratios may not be suitable for these entities so you may have to look at other measures, such as non-financial rations including:

  • The average time that hospital patients wait for treatment
  • The number of schools built in an area
  • Serious crimes per 1,000 of the population
  • Number of complaints by members of the public in a given period  Number of visits made to museums and art galleries in an area.

Entity Reconstructions

  • You need to identify when an entity may no longer be viewed as a going concern and why a reconstruction might be an appropriate alternative to liquidation.
  • You will not need to suggest a scheme of reconstruction, but you will need an outline of the accounting treatment.

Background

Most of a study text on financial accounting is inevitably concerned with profitable, even expanding businesses. It must of course be recognised that some companies fail. From a theoretical discounted cash flow viewpoint, a company should be wound up if the expected return on its value in liquidation is less than that required. In practice (and in law), a company is regarded as insolvent if it is unable to pay its debts. This term needs some qualification. It is not uncommon, for example, to find a company that continues to trade and pays its creditors on time despite the fact that its liabilities exceed its assets. On the other hand, a company may be unable to meet its current liabilities although it has substantial sums locked up in assets which cannot be liquidated sufficiently quickly.

The procedures and options open to a failing company will depend on the degree of financial difficulties it faces. If the outlook is hopeless, liquidation may be the only feasible solution. However, many firms in serious financial positions can be revived to the benefit of creditors, members and society. When considering any scheme of arrangement it is important to remember that the protection of creditors is usually of paramount importance. The position of the shareholders and in particular, the protection of class rights, must be considered but the creditors come first. This section considers some possibilities, but local legislation will govern these situations.

Going concern. The entity is normally viewed as a going concern, that is, as continuing in operation for the foreseeable future. It is assumed that the entity has neither the intention nor the necessity of liquidation or of curtailing materially the scale of its operations. (Framework) It is generally assumed that the entity has no intention to liquidate or curtail major operations. If it did, then the financial statements would be prepared on a different (disclosed) basis. Indications that an entity may no longer be a going concern include the following (from International Standard on Auditing, ISA 570 Going concern):

  • Financial indicators, e.g. recurring operating losses, net liability or net current liability position, negative cash flow from operating activities, adverse key financial ratios, inability to obtain financing for essential new product development or other essential investments, default on loan or similar agreements, arrear as in dividends, denial of usual trade credit from suppliers, restructuring of debt, non-compliance with statutory capital requirements, need to seek new sources or methods of financing or to dispose of substantial assets.
  • Operating matters, e.g. loss of key management without replacement, loss of a major market, key customers, licence, or principal suppliers, labour difficulties, shortages of important supplies or the emergence of a highly successful competitor.
  • Other matters, e.g. pending legal or regulatory proceedings against the entity, changes in law or regulations that may adversely affect the entity; or uninsured or underinsured catastrophe such as a drought, earthquake or flood.

Internal reconstructions

A company may be able to enter into any type of scheme regarding either its creditors or its shareholders as long as the scheme does not conflict with general law or any particular statutory provision.

For a reconstruction of this type to be considered worthwhile in the first place, the business must have some future otherwise it might be better for the creditors if the company went into liquidation. In any scaling down of claims from creditors and loan stock holders, two conditions should be met.

  • A reasonable chance of successful operations
  • Fairness to parties

Transfer of Assets to a New Company

Another form of reconstruction is by means of voluntary liquidation whereby the liquidator transfers the assets of the company to a new company in exchange for shares or other securities in the new company. The old company may be able to retain certain of its assets, usually cash, and make a distribution to the shareholders of the old company who still have an interest in the undertaking through their shareholding in the new company. There may be various rules governing the protection of non-controlling shareholders.

Such a procedure would be applied to the company which is proposed to be or is in course of being wound up voluntarily. A company in liquidation must dispose of its assets (other than cash) by sale in order to pay its debts and distribute any surplus to its members. The special feature of this kind of reconstruction is that the business or property of Company P is transferred to Company Q in exchange for shares of the latter company which are allotted direct or distributed by the liquidator to members of Company P. Obviously the creditors of Company P will have to be paid cash.

Finding the cash to pay creditors and to buy out shareholders who object to the scheme is often the major drawback to a scheme of this kind. It is unlikely to be used much because the same result can be more satisfactorily achieved by a takeover: Company Q simply acquires the share capital of Company P, which becomes its subsidiary, and the assets and liabilities are transferred from the subsidiary to the new holding company. In this situation usually no cash has to be found (although obviously there is no guarantee of success).

The advantage of transferring a business from one company to another (with the same shareholders in the end) is that by this means the business may be moved away from a company with a tangled history to a new company which makes a fresh start. As explained above this procedure can also be used to effect a merger of two companies each with an existing business.

Accounting procedures for a transfer to a new company

The basic procedure when transferring the undertaking to a new company is as follows.

  • To close off the ledger accounts in the books of the old company.
  • To open up the ledger accounts in the books of the new company.

The basic procedure is as follows.

Step 1  Open a realisation account and transfer in all the assets and liabilities to be taken over by the new company at book value.

Step 2  Open a sundry members account with columns for ordinary and preference shareholders.

Transfer in the share capital, reserve balances, assets written off and gains and losses on realisation.

Step 3  With the purchase consideration for the members:

DEBIT                 Sundry members a/c

CREDIT              Realisation a/c

Take any profit or loss on realisation to the sundry members account (ordinary).

Step 4                  In the new company, open a purchase of business account: CREDIT         it with assets taken over

(DEBIT asset accounts)

 

DEBIT                 it with liabilities taken over

(CREDIT liabilities a/cs)

 

DEBIT                 it with the purchase consideration

(CREDIT             shares, loan stock etc)

Any balance is goodwill or a gain on a bargain purchase.

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