An accounting entity is an organization that records and reports business or financial information separately from other businesses. Accounting entities must have economic transactions resulting from arms-length transactions in the business environment; these transactions indicate the entity is a legal business and has important financial information that must be reported to internal or external users. Accounting entities may be an independent business or the subsidiary or individual division of a parent company. A subsidiary or divisional accounting entity must have its financial information reported separately from the parent company’s financial information or statements. Parent companies must follow specific accounting or legal rules when conducting business operations with their subsidiary companies.
In order to be considered an independent business operation, accounting entities should not have more than 50% of their voting stock owned by another company. Generally accepted accounting principles (GAAP) require parent companies to report business information on consolidated financial statements if they own more than 50% of another company’s voting stock. This rule also holds true for the ownership levels parent companies have in subsidiary companies. The percentage of stock ownership between a parent company and an individual accounting entity is a basic guideline for determining how each company reports business information on financial statements.
Companies should proceed with extreme caution when reporting financial information on individual accounting entities or subsidiary businesses. Attempting to transfer major debt or other liabilities owed by the parent company to a separate accounting entity can have serious legal implications. Transferring revenues or business assets from an accounting entity to a parent company can also have serious complications since this will present false information to private investors. Publicly held companies may also be subject to independent investigations by the U.S. Securities and Exchange Commission (SEC) regarding their activities when using a separate accounting entity for conducting business operations. These independent investigations date back to the early 2000s when a few accounting major scandals rocked the accounting industry.
During the major accounting scandals of 2001, Enron attempted to shift significant business losses and debt to special purpose entities in order to keep negative financial information off its publicly released financial statements. This transfer of financial information was later deemed to be illegal by federal regulators; Enron was forced to restate its financial statement earnings for several previous accounting periods, resulting in operating losses rather than profits. Enron is now considered a classic example on the inappropriate use of an individual accounting entity to distort financial information.