4.
What defines a reporting entity?

4.1 Introduction

People are motivated to undertake economic transactions, whether working in isolation or with others, for an enormous range of reasons. They might be motivated by:

• subsistence
• profit
• philanthropy
• compassion
• enthusiasm, whatever the reason
• legal obligation to supply a service.

The law in most countries provides them with only a limited range of legally recognised structures that they may use to undertake their transactions. These are referred to in this unit as potential reporting entities.

4.2 Commonplace legal structures and entities that can be reporting entities

Below is a list of the types of economic structure and legal entity that are available to those undertaking most types of economic activity.

Sole trader

A person is a sole trader when they undertake an economic activity, whether in the course of trade or for some other purpose, in their own name. They accept, therefore, that they are personally liable for all the legal responsibilities arising from doing so, having unlimited liability for all the debts of the firm that they operate.

Partnerships

A partnership can be created in some jurisdictions, including the UK, by verbal agreement, although most professional advisers would suggest that is most unwise. See the Partnership Act 1890.

These occur, whether they are documented or not, when two or more individuals come together to undertake an economic activity in the course of trade or for some other purpose. As such, they accept a joint and several liability for the legal consequences of doing so, meaning that each of them is liable for all of the debts that the partnership incurs whether they made the decision to undertake a particular transaction or not.

Limited liability partnerships

Limited liability partnerships are a fairly recent legal innovation (for example, see the Limited Liability Partnerships Act 2000 in the UK), having only become available in most jurisdictions since the beginning of the 21^st century.¹ They come in a variety of forms, but essentially combine the common ownership arrangements found in partnerships, in which the senior managers and owners of the organisation are the same persons, with the advantages of incorporated status that otherwise usually separates the ownership and management of an organisation.

In 2023, there were about 4,500 such entities in the UK.

A feature of limited liability partnerships in most jurisdictions is that the members of the organisation must share its profits in a ratio that they agree to, whether or not those profits have actually been paid to them. For this purpose, the existence of the separate entity that the limited liability partnership represents is ignored, clearly indicating their hybrid nature. These entities are particularly popular with professional firms, including accountants and lawyers. For example, all the largest firms of accountants, such as Deloitte and EY, are limited liability partnerships in most territories in which they operate.

Unlimited companies

These rarely used entities have many characteristics in common with private limited companies, except that the liability of their members is not limited, meaning that the members are liable to make payment to the creditors of the company in the event of its insolvency. These organisations are occasionally used to register the ownership of land. They sometimes have a use in tax planning. Some multinational corporations also register their subsidiaries in jurisdictions that demand that private limited companies put their financial statements on public record as unlimited companies to avoid this obligation. This does not mean that they actually accept unlimited liability to the creditors of the concerns that they own in those places, because they invariably ensure that the entities used to own these unlimited companies do themselves enjoy the benefits of limited liability. Whether this multi-tiered arrangement was ever intended to exist in law is open to question.

Private limited companies

Most jurisdictions now recognise a distinction between private limited companies, which are those in which the shares of the organisation are not traded on a stock exchange, and most public limited companies, where the shares or debts of the entity are usually traded on such an exchange. Private limited companies are recognised by the suffix Ltd or Limited in the UK, GmbH in Germany, Srl in Italy, and equivalent terms in other countries.

Rules on the incorporation of private limited companies vary between jurisdictions, but the following characteristics are commonplace:

1. The company is recognised to exist because of its registration with an approved government agency or registrar, which usually issues it with a number by which it is legally identified.

For some innovative approaches to ownership that seek to embed nature in corporate decision-making, read the article The firms giving nature a stake in their businesses and this blog on putting nature on the board.

2. The company is owned by its members. Their membership is indicated either by the ownership of shares, which are issued in exchange for the subscription of agreed amount of capital (for example, £1). Alternatively, their membership is indicated by their giving a guarantee to the company that they will meet an agreed liability to settle the debts of the company if it becomes insolvent. These guarantees are usually of modest amount, for example, £1 per member. Companies limited by guarantee are usually associated with not-for-profit organisations as they cannot pay dividends out of their profits earned to their members. As a result, these entities are often called ‘not-for-profit companies’.

3. The members of the company who own shares in it and who have subscribed the full amount of capital demanded from them in exchange for their subscription enjoy limited liability regarding its activities; that is, they cannot be held liable for the debts that it owes to its creditors in the event of its insolvency. Members of the company who offer a guarantee are liable for the debts of the company in the event of its insolvency, but only to the limit of the guarantee that they have offered. Members do, therefore, in both situations enjoy limited liability.

4. A company is managed by its directors, who are usually elected by the members. There is now rarely a requirement that a director should also be a member (or shareholder) of the company, and there is rarely any legal expectation that the directors and members (shareholders) of a company be the same persons.

In 2023, the UK government estimated that there were 5.51 million small businesses (with 0 to 49 employees) in the country, representing 99.2% of the total business population.

5. The directors of a company are its employees. They can, however, be personally liable for its debts if they are reckless. Recklessness apart and presuming that that they have complied with the law, few directors face the risk of personal liability for any of the debts owed by a company – even if they were responsible for the decision to incur them.

6. Most private limited companies are small in scale. They often have only one – or at most a few – shareholders and the directors may quite often be the same as the shareholders. This does not, however, mean that their obligations in each capacity are not distinct, because in law they are. There are, however, exceptions to this generality. There is no legal restriction on the size of a private limited company, and they can be as large as or larger than some public limited companies.

Public limited companies

In principle, public limited companies (or PLCs as they are known in the UK, with the term société anonyme (SA) being used in France, Aktiengesellschaft (AG) in Germany, and Inc. in the USA) are very similar to private limited companies, but there are some obvious notable exceptions.

• Firstly, public limited companies usually include a requirement that they have significantly more than one member, which is the basic requirement for a private limited company in the UK, for example.
• Public limited companies also usually include a requirement that the company has a minimum amount of issued share capital. In the UK, this minimum sum is £50,000.
• There are also usually requirements that the public limited company has more than one director and commonly the company’s own rules will be written to require more than any legally imposed minimum.
• A public limited company is also required in countries such as the UK to have a suitably qualified company secretary who is legally responsible for the company complying with its legal obligations with regard to the documentation required to be placed on public record.
• Finally, a public limited company is also usually required to put its accounts on public record sooner than private limited companies in the same jurisdiction. In the UK, a public limited company’s accounts are required to be published no more than six months after its year-end date, whereas private limited companies have nine months to do so.
• All the above being noted, a public limited company can technically undertake exactly the same activities, and on the same relatively small scale, that private limited companies often do if it so wishes, although that makes little sense given the extra administrative burden that the status involves. When this does happen, it is usually because the company in question wishes to signal it has a status or size that it might not really have.
• Importantly, there is also no requirement that a public limited company have its shares quoted on a stock exchange. Perhaps confusingly, this is not what the name implies. However, all quoted companies must be public limited companies in the UK, for example.

Quoted and unquoted companies

A public limited company that has its shares traded on a stock exchange is commonly referred to as a quoted company.

This means that there will be brokers who are willing to trade in the shares of the company on the stock exchange on which they are registered, or ‘listed’. Those brokers are duty-bound to offer a price to either buy or sell those shares to anyone who is interested. It is this obligation that there must be someone who will always quote a price for the shares of the company so that they can be traded which gives rise to the term ‘quoted’ company. The London Stock Exchange is an example of one such exchange.

The term ‘unquoted company’ simply refers to any company that does not have its shares traded, or listed, on a stock exchange. As previously noted, public limited companies do not need to have their shares listed in this way.

Public-interest entities

The term ‘public-interest entity’, or PIE, is a relatively new one. Its use has developed as result of its adoption by the European Union, which, in broad terms, defines public-interest entities as:²

1. entities governed by the law of a member state, whose shares are traded on a regulated stock exchange
2. credit institutions, such as banks
3. insurance undertakings
4. entities designated by member states as public-interest entities, for instance undertakings that are of significant public relevance because of the nature of their business, their size or the number of their employees.

The purpose of the definition is to specify those organisations that have such significant economic impact because of the activities that they undertake that:

• their failure might have significant economic impact on the country or region where they operate
• the number of people that they employ creates significant risk if they were to fail
• the funds that they manage are significant to a jurisdiction
• the activities that they undertake are of interest to the public.

While it can be argued that most reporting entities are only of microeconomic significance, PIEs tend to have macroeconomic significance.

Civil society organisations

These entities come in several forms, including clubs or societies of a variety of sizes, non-governmental organisations (NGOs) – again of significantly varying sizes and purpose – and civil society organisations (CSOs).

What they tend to have in common is:

1. the absence of a profit motive
2. a focus on the pursuit of a particular goal, which is what motivates their membership
3. a requirement for a significant level of accountability for their actions.

They can be organised as unincorporated organisations, where the members might share unlimited liability for the debts of the organisation, akin to a partnership arrangement. More commonplace is a limited liability organisation, usually organised on a not-for-profit basis. Some jurisdictions now provide for incorporation of special forms of entity for this purpose. What tends to characterise their accounting is a much higher degree of disclosure on their activities than most commercial organisations of similar size provide. They share this characteristic in common with charities.

Charities

The definition of charitable activity varies between jurisdictions, but broadly follows these themes:

• the prevention or relief of poverty
• the advancement of education
• the advancement of religion
• the advancement of health or the saving of lives
• the advancement of the arts, culture, heritage or science
• the advancement of amateur sport
• the advancement of human rights
• the advancement of environmental protection
• the advancement of animal welfare
• others, when regulators agree.

Charities are, by definition, not-for-profit organisations. Many are incorporated as not-for-profit companies for this reason.

Like CSOs, charities are characterised by their purpose, and they usually highlight this work in all that they do, including their reporting. Examples might include the National Trust in the UK, the World Wide Fund for Nature (WWF), the Royal Society for the Protection of Birds (RSPB), and Medicins Sans Frontieres (MSF).

Charities tend to enjoy significant tax advantages in many jurisdictions. As a result, they, their officers and their accounts are usually subject to significant specialist regulation.

Foundations

Charities are commonplace in what are called ‘common law countries’, whose legal systems are usually based on that of England. In ‘Roman law’ countries, where the legal system is derived from continental European practice, foundations are much more commonplace than charities but are otherwise broadly similar in style and regulation. Their legal and governance structures might differ, but the net outcome is similar.

Government and its agencies and organisations

Governments and their agencies are very often the largest organisations in the economy of any jurisdiction, and yet are largely ignored in discussions of accounting issues – even though the accountability of government is at the heart of many theories of government and democracy.

Precisely because the government can set the laws for a jurisdiction, it also sets how it and any governmental agencies will account. This is discussed in more depth in Unit 14. That said, governments tend to be structured as statutory authorities, which are organisations akin to PIEs, but without being structured as companies – except in the case of the trading activities that many governments undertake. These are often managed either through wholly owned companies or in joint venture with others. This is particularly true of arrangements in the extractive industries in many jurisdictions. There, the usual rules of corporate accounting apply. Some governments, such as that of the UK, now try to present consolidated accounts for the government as a whole. These rarely meet the standard expected of private entities, largely due to the complexity of such an exercise.

4.3 The theory of the firm

French economist Jean-Phillipe Robé has created an important distinction when we consider the nature of a business, the reporting entity that operates it, and the obligation to be accountable that it creates.³

In particular, he distinguishes between the activities of what he calls a firm, and the reporting entity, which he usually refers to as a corporation although, as is clear from this unit, the choices of reporting entity available are rather more complex than that.

The firm, as Robé describes it, is the actual economic activity undertaken by a person or a group of people who come together to pursue it. Most commonly, we think of this as a trade, but it could also be investment activity, an NGO or CSO, a charity or all the activities of a part of government.

The concept of accountability suggests that the activities of a firm might, by themselves, and regardless of the nature of the reporting entity that undertakes it, create an obligation to be accountable. Factors that suggest this might be the case include:

• the size of the activity
• the number of people it employs
• the scale of the risk that it creates for its customers
• the nature of the impact of the firm on a community (whether by dominating a local economy, or by undertaking an activity that could be hazardous, or by creating demand on that community, for example, by building infrastructure that might be harmful to the local environment).

It is important to understand that definitions of accountability cannot always be determined by the nature of the entity undertaking an activity. This theory suggests that some firms might need to be accountable whatever type of reporting entity might operate them.

4.4 Moral hazard

A great many of the reporting entities noted in this unit enjoy what is called limited liability. This means that in the event of their insolvency (or inability to pay everyone that they owe money to) the members of these organisations have no duty to make good the losses suffered by their creditors. This creates the risk of what is called ‘moral hazard’ in economic theory. This is defined as the behaviour of a person who is protected from the consequences of their actions. These consequences might be mitigated by insurance, or the benefits of legal limited liability provided to them by company law. Moral hazard can lead to inefficiencies or increased costs for the party bearing the risk.

This risk has been recognised since the time that limited liability companies were first created. Adam Smith wrote in his 1776 book The Wealth of Nations, which is considered the founding text of modern economics, that:⁴

The trade of a joint stock company is always managed by a court of directors. This court, indeed, is frequently subject, in many respects, to the control of a general court of proprietors. But the greater part of those proprietors seldom pretend to understand anything of the business of the company, and […] give themselves no trouble about it, but receive contentedly such half-yearly or yearly dividend as the directors think proper to make to them. This total exemption from trouble and from risk, beyond a limited sum, encourages many people to become adventurers in joint stock companies. […]

The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. […] Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.

More recently, the risk of moral hazard has been reflected in the construction of company law in the UK and elsewhere, almost since the time that the possibility of creating limited liability companies by registration was first made available in the mid-19th century. It can, in fact, be argued that the whole concept of corporate accountability – and thereby accounting in general – is based on fear of the moral hazard implicit in the concept of limited liability.

4.5 The duty of care

This fear of moral hazard is reflected in the requirement imposed on corporations in almost all jurisdictions in the world to prepare accounts for publication either on public record, or at least for submission to local regulatory and tax authorities. The idea is extended to sole traders, partnerships, and unincorporated organisations with any taxable income by the tax laws of most countries that require that these entities prepare accounts in accordance with generally accepted local accounting principles.

The idea that is commonplace to all these requirements is that the business has a duty to others in society.

Section 172 of the Companies Act 2006 suggests that the directors of all UK limited companies have a duty of care, which they summarise as follows:

Duty to promote the success of the company

1. A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to—

   1. the likely consequences of any decision in the long term,
   2. the interests of the company’s employees,
   3. the need to foster the company’s business relationships with suppliers, customers and others,
   4. the impact of the company’s operations on the community and the environment,
   5. the desirability of the company maintaining a reputation for high standards of business conduct, and
   6. the need to act fairly as between members of the company.

2. Where or to the extent that the purposes of the company consist of or include purposes other than the benefit of its members, subsection (1) has effect as if the reference to promoting the success of the company for the benefit of its members were to achieving those purposes.

3. The duty imposed by this section has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company.

Implicit in this legal requirement is the idea that while the company can, of course, make profit or achieve some other goal (defined here, very broadly, as ‘the success of the company’) on behalf of its members, it must do so while taking in to account its obligations to both those it contractually engages with when doing so and with others in the community – even if it does not have contractual relationships with them.

4.6 The concept of accountability

See the FRC Corporate Governance overview which explains the importance of corporate governance and scope of the Code of Corporate Governance in the UK.

In practice, this duty to others that is imposed in UK company law reflects much of what is reflected in ethical standards of behaviour expected of reporting entities in many jurisdictions.

Governance standards suggest that there are two aspects to this concept of accountability. The first is that companies should comply with good governance standards, which broadly reflect the statutory requirement noted above. The second idea is that they should explain if they cannot comply in any way with required standards or have used measures that are not standard in suggesting their compliance. While these standards only really apply to public-interest entities, the ideas permeate throughout accounting and place an emphasis on complying with financial reporting standards, or on explaining departures from them. The assumption is that those standards will meet the needs of all users of financial statements, but that assumption is open to doubt when they are primarily prepared for the benefit of the suppliers of capital to a company.

4.7 The duty to keep records as part of the duty of care

The Companies Act 2006 in the UK interprets this duty of care as requiring that a company must keep proper books and records. All jurisdictions will have similar requirements, although the specific forms of wording will vary from this version, which is current UK law:

Duty to keep accounting records

1. Every company must keep adequate accounting records.

2. Adequate accounting records means records that are sufficient—

   1. to show and explain the company’s transactions,
   2. to disclose with reasonable accuracy, at any time, the financial position of the company at that time, and
   3. to enable the directors to ensure that any accounts required to be prepared comply with the requirements of this Act….

3. Accounting records must, in particular, contain—

   1. entries from day to day of all sums of money received and expended by the company and the matters in respect of which the receipt and expenditure takes place, and
   2. a record of the assets and liabilities of the company.

4. If the company’s business involves dealing in goods, the accounting records must contain—

   1. statements of stock held by the company at the end of each financial year of the company,
   2. all statements of stocktakings from which any statement of stock as is mentioned in paragraph (a) has been or is to be prepared, and
   3. except in the case of goods sold by way of ordinary retail trade, statements of all goods sold and purchased, showing the goods and the buyers and sellers in sufficient detail to enable all these to be identified.

Corporate accounting was built on legal requirements like this, with the aim of protecting those with an interest in a company from the moral hazard that might arise from its operation. That section does, in effect, require that records be maintained to record:

• the income and expenditure of a company (its transactions)
• its cash flows (money received and expended)
• its balance sheet (assets and liabilities).

It can fairly be said that everything else in financial accounting interprets these requirements.

4.8 Summary

• There are differing forms of reporting entity available to those who undertake economic activity in a jurisdiction.
• These varying forms of reporting entity reflect the varying scales of activity, implicit risk and moral hazard implicit in the activities of an entity.
• Limited liability creates the risk that persons independent of a reporting entity who enjoy that advantage might be especially prejudiced by the activity that it undertakes.
• There is a particular duty on limited liability entities to report their affairs on public record.
• This is most especially true in the case of public-interest entities.
• Company law and corporate governance codes reinforce these ideas and lay the foundations for financial reporting but the ideas implicit in those laws and codes also extend into the accounting for other forms of entity.