In reporting on its performance, an organisation faces a number of questions about who contributes to its overall performance. Financial reporting has developed a set of explicit rules regarding the consolidation of accounts in order to create comparability in reporting, and to assure complete disclosure of economic interest. In the context of sustainability, defining boundaries for performance is not a straightforward process. An organisation's economic, environmental, and social impacts occur as a result of and are linked to activities involving a complex network of entities, from those wholly or partially owned by the organisation, to business partners such as suppliers, distributors, or consumers. The
organisation's level of control or influence over the entities involved in these activities and their resulting impacts also ranges from little to full. Thus, reporting strictly on entities within the boundaries used for financial reporting may fail to tell a balanced and reasonable story of the organisation's sustainability performance.
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In order to achieve the goal of effectively communicating sustainability performance and creating a fair basis for comparing reports, a common approach to setting boundaries is needed.
Economic or political importance/influence refers to the ability of an entity to make a significant impact on the welfare of external parties. The greater the economic or political importance of an entity, the more likely it is that there will exist users dependent on general purpose financial reports as a basis for making and evaluating resource allocation decisions. Reporting entities identified on the basis of this factor are likely to include organisations which enjoy dominant positions in markets and those which are concerned with balancing the interests of significant groups, for example, employer/employee associations and public sector entities which have regulatory powers.
B. Other Extensions of Reporting Boundary
A number of alternative concepts of the reporting entity are implicit in existing legislation and regulations which specify the entities which should prepare general purpose financial reports. These concepts include the legal entity concept, which has been employed in legislation in the private sector, and a broad concept based on accountability of elected representatives and appointed officials, which has been employed in the public sector. In the private sector it has been common for entities to be required to report whenever they have had legal status (for example, companies have been so obliged). In the public sector the accent on accountability has seen widespread application of the fund concept of reporting, which implies a concern with reporting the results of individual funds. In other cases, the concept based on accountability of elected representatives and appointed officials has led to entities which haven such representatives and/or officials preparing general purpose financial reports.
The concept requires that individual reporting entities be identified by reference to the existence of users who are dependent on general purpose financial reports for information for making and evaluating resource allocation decisions. This means that a class of entity defined under another concept, such as the legal or fund concepts (for example, proprietary companies or special and general purpose funds), may include some entities which should be identified as reporting entities, by virtue of the existence of users dependent on general purpose financial reports prepared by the entity, and other entities which should not be so identified.
It should therefore be noted that the concept of the reporting entity adopted by is not dependent on the sector - public or private - within which the entity operates, the purpose for which the entity was created - business or non-business/profit or not-for-profit - or the manner in which the entity is constituted - legal or other. It is a concept which is tied to the objective of general purpose financial reporting and is a concept which requires all entities with users dependent on general purpose financial reports for information to prepare such reports.
An implication of applying the reporting entity concept in the public sector is that a government as a whole, whether at the Federal, State, Territorial or local government level, would be identified as a reporting entity because it is reasonable to expect that users will require general purpose financial reports to facilitate their decision making in relation to the resource allocations made by, and the accountability of, those governments. At a lower level of reporting, a number of individual statutory authorities and departments (and the entities they control) may also be defined as individual reporting entities because of their economic or political significance and/or their financial characteristics (for example, resources controlled and level of indebtedness). In some cases, these factors may also identify a ministerial portfolio as a reporting entity.
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C. External Factors in Motivating the Split of the Mayne Group
The concept of the reporting entity and the identification of the boundaries of a reporting entity are related. For example: (a) if the concept of the reporting entity adopted was based on a class of legal entity (such as Mayne Group), this would imply identification of the boundaries of the entity by reference to legal considerations, which would mean that only entities of that legal class could be aggregated to form a reporting entity; and (b) if the fund concept of the reporting entity was adopted, this would imply identification of the boundaries of the reporting entity by reference to the functional uses for which resources were designated and deployed. This would (unless more than one concept of the reporting entity was adopted) render illogical and inoperative the concept of aggregating separate funds to recognise the existence of a reporting entity.
However, the concept of the reporting entity established is one linked to the information needs of users of general purpose financial reports in making and evaluating resource allocation decisions. The provision of information for these purposes is the criterion used to determine the boundaries of a particular reporting entity.
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.
Accordingly, while in some instances a reporting entity will comprise an individual entity; in other instances a reporting entity will comprise a group of entities, some of which individually may be reporting entities. One of the entities within the group will control the other entities so that they operate together to achieve objectives consistent with those of the controlling entity. The group, which may be termed an economic entity, will be a reporting entity where there exist users dependent on general purpose financial reports for making and evaluating resource allocation decisions regarding the collective operation of the group of entities. Whether one entity has the capacity to control other entities, and therefore whether an economic entity exists, will depend on an evaluation of the circumstances of the particular entities. In determining whether control exists, the factors to be considered include the following: extent and implications of financial dependence, capacity to appoint or remove managements or governing bodies, and power to direct operations.
D. The Concept of Conglomerate Discount
Conglomerate discounts have been attributed to diversity in divisional investment opportunities on the theory that such diversity exacerbates agency problems, distorting investment allocation, and causing a loss in firm value. The diversity cost hypothesis is difficult to test directly, however, because of the absence of stock market and other financial information at the divisional level (Burch and Nanda 2003). A recent stream of literature suggests that conglomerate discounts do not represent losses in firm value after all. They may be the result of a selection bias, reflecting characteristics of divisions constituting the conglomerate, rather than inefficiencies stemming from the diversified structure itself. Alternatively, they could result from methodological flaws.
Lamont and Polk (2001) argue in a contemporaneous paper that when trying to explain determinants of the conglomerate discount, one should not only look at cash flow effects (e. g. inefficient investment) but also on return effects. In an empirical study, they show that discounted conglomerates have also higher subsequent returns than premium conglomerates, again explaining the lower overall values.
In recent contributions, two criticisms challenge the traditional view that the observed conglomerate discount is attributable to a prior decision to diversify the firm. The first criticism is more of a technical nature and refers to measurement error. It arises when studying the relation between measures of diversification and conglomerate discount where both measures rely on the same underlying data. As a result, a mechanical correlation between the two measures is likely to evolve, making inferences drawn on such a spurious correlation misleading. Whited (2001) examines this criticism and finds cross-subsidization symptoms to disappear when controlling for measurement error.
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The second criticism refers to the causality of diversification and destruction in value which is suggested by the conglomerate discount. It is more subtle to encounter as it builds on both, theoretical and empirical arguments. A missing causality of diversification may be theoretically explained by an endogeneity of the decision to diversify: if the decision to diversify is not exogenous but itself dependent on some other variables e. g. like prior underperformance, then the observed conglomerate discount is not entirely attributable to the decision to diversify.
Empirically, there is substantial evidence that corporate diversification destroys shareholder value. Berger & Ofek (1995) estimate a 13% to 15% conglomerate discount for US companies in the period from 1986 to 1991. Tobin's q and firm diversification are negatively related during the 1980s and diversified firms underperform undiversified companies according to Lang & Stulz (1994). Comment & Jarrel (1995) find a positive relation between stock returns and focus. For the 1960s and early 1970s Servaes (1996) finds a diversification discount during the 1960s which declines to zero in the 1970s. Lins & Servaes (1999) estimate for the years 1992-1994 no diversification discount in Germany, but a 10% discount in Japan and a 15% discount in the U.K. According to Morck, Shleifer & Vishny (1990), financial markets react negatively to diversifying takeovers. In contrast, spin-offs generate value for the parent company, as observed by Daley, Mehrotra & Sivakumar (1997). According to Hyland & Diltz (2002), however, it is still doubtful whether there is causality between diversification and value destruction or whether both observations depend on a third common factor.
E. Significant Variance
The concept of control as the basis for identifying an economic entity has important implications. In the private sector, it has been common practice for groups of entities to be recognised as an economic entity only where the entities making up the group are established in the same legal form (for example, all are companies). An implication of the concept of control is that an economic entity may comprise entities which are established in a form different from that of the controlling entity, and such entities may be parts of, or a combination of, entities recognised for other purposes.
Because an economic entity, comprises only the controlling entity and controlled entities, those entities which are significantly influenced, but not controlled, by a member of the economic entity do not form part of the economic entity. (Entities which are significantly influenced are termed associated entities.) This means that in preparing the general purpose financial report for the economic entity, additional information about an investment in an associated entity may be reported, possibly in a supplementary form, but it would not be reported on the basis of the associated entity forming part of the economic entity.
As the concept of the reporting entity reflected in is related to the information needs of users, it is evident that the creation of a company, statutory authority or other organizational structure does not of itself mean that the entity or organisation will qualify as a reporting entity. Judgment will be required in determining whether an entity satisfies the criterion for being so classified.
In the private sector the factors will identify as reporting entities all entities in which there is significant separation of ownership/membership and management, for example public companies and listed trusts. In contrast, entities in which the case for most sole traders, partnerships and exempt proprietary companies, would usually not be identified as reporting entities on the basis of this factor. However, there will be circumstances in which entities such as these ought to be regarded as reporting entities. For example, an entity which undertakes the raising of debt or equity funds from the public will become a reporting entity because there will exist potential resource providers who require general purpose financial reports as a basis for making resource allocation decisions. For similar reasons, undertaking to sell an entity may result in the identification of the entity as a reporting entity. Also, the size and/or economic significance of some entities to their suppliers, clients or employees or to the public may dictate that those entities are reporting entities even though the members manage the entity. Examples of this would be professional partnerships which service a very large number of customers or clients and which enjoy a special status in the community, and exempt proprietary companies which attract a special public interest because of their financial characteristics.
There will be some entities which will not be regarded as reporting entities, but which form part of an economic entity which is a reporting entity. This would be the case, for example, where a company is a wholly-owned subsidiary of another entity in the economic entity, and the size and other economic characteristics of the company are such that there do not exist users dependent on general purpose financial reports as a source of information for making and evaluating resource allocation decisions about the wholly-owned company. Instead, users are interested in information about the collective operation of the company and the other entities comprising the economic entity. Similarly, 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.
Classification as a reporting entity may not be constant from one reporting period to the next. For example, a partnership or company established for the conduct of a family business may not, under normal circumstances, qualify as a reporting entity. However, where one or more partners or owners become distanced from the business or are in dispute with other participants, or where new nonfamily shareholders are admitted to the company, users dependent on general purpose financial reports may exist in respect of the financial reports for the periods during which disputations or nonfamily shareholdings occur. As such, the partnership or company would meet the conditions for classification as a reporting entity in respect of one or more reporting periods.
It is likely that application of this Statement will result in substantial changes to current practice. For example, it will result in some partnerships, trusts, government departments, statutory authorities and other organisations that currently do not prepare general purpose financial reports being identified as reporting entities which therefore ought to prepare such reports in accordance with Statements of Accounting Concepts and Accounting Standards.
Similarly, it will result in a government as a whole being identified as a reporting entity which therefore ought to prepare general purpose financial reports. Other entities, for example some private companies, which currently prepare general purpose financial reports may not meet the criterion for identification as reporting entities. This Statement would not, therefore, require such entities to prepare general purpose financial reports. In this regard however, it should be noted that the fact that this Statement may not require a particular entity to prepare general purpose financial reports does not preclude other parties, for example, regulatory authorities and financial institutions, from imposing a requirement on that entity to prepare general purpose financial reports.
Statements of Accounting Concepts and Accounting Standards are applicable to all entities which prepare general purpose financial reports. It is sometimes proposed that certain entities should be permitted to depart from all or certain of these Statements and Standards in the preparation of their financial reports. This notion is referred to as differential applicability of Statements of Accounting Concepts and Accounting Standards, or differential reporting.
Bases that have been proposed for identifying the entities which should be permitted to depart from these Statements and Standards are: (a) the size of the entity - that is, entities classed as small in relation to certain size benchmarks, based on any combination of turnover, assets and number of employees, would be permitted to depart; (b) ownership characteristics - for example, privately-owned entities would be permitted to depart, whereas publicly owned entities would not be permitted to depart; and (c) a combination of size and ownership characteristics - for example, privately-owned entities which are classed as small would be permitted to depart from the Statements and Standards.
Accordingly, in most instances the following private sector entities are unlikely to be required by this Statement to prepare general purpose financial reports: sole traders, partnerships, privately-owned companies and trusts other than those where funds are subscribed by the public. There may be some instances when it is considered necessary or desirable that a general purpose financial report about an entity in these categories is prepared, for example when a privately-owned company intends to raise funds from the public. In these circumstances the report is required to comply with all Statements of Accounting Concepts and Accounting Standards.
In the public sector, although most government departments and statutory authorities are likely to be required to prepare general purpose financial reports, the financial characteristics of some authorities and government agencies will mean that they will not be required by this Statement to prepare such reports. Types of entities which always would be identified as reporting entities and types of entities those are or are not likely to be identified as reporting entities.