Are Charter Schools Component Units?

The annual audited financial statements of state and local governments will, under certain circumstances, report the finances of not just the government itself but also one or more legally separate entities related to the government—referred to as component units. School districts may be less likely than other types of governments to have component units in general, but there is one particular kind of entity that school districts increasingly have to evaluate as potential component units—charter schools. Because determining whether a charter school should be incorporated into a school district’s financial statements as a component unit can be complex, we’ve provided a resource that illustrates the process described below.

The Financial Reporting Entity

Let’s begin with the relevant accounting lingo. Under the guidance of the Governmental Accounting Standards Board (GASB), the school district itself is called the primary government to distinguish it from the component units included in the district’s financial statements. The primary government and its component units together are referred to as the financial reporting entity, which represents the boundaries of the financial activity reported in the financial statements.

Most legally separate entities determined to be component units are those for which a school district is financially accountable. Others are reported as component units because of their close relationship to the government—because either (1) they essentially exist solely to support a school district or its constituents or (2) it would be misleading to exclude them from a district’s financial statements (i.e., the reader would not get the complete picture of a district’s finances if they were left out).

Financial Accountability

Charter schools for which a school district is financially accountable should be included in the district’s financial statements as component units. To determine financial accountability, consider the following questions.

Question 1: Does the school district appoint a voting majority of the charter school’s governing board?

Appointing a voting majority also includes circumstances in which a law requires district board members or staff to serve on the charter school’s governing board, and they represent a voting majority.

Question 2: Can the school district impose its will on the charter school, or is there a potential for it to provide financial benefits to or impose financial burdens on the district?

In the accounting standards, a district is considered to be able to impose its will if it can “significantly influence the programs, projects, activities, or level of services performed or provided by” the charter school. That definition includes (but is not limited to) the district being able to do any of the following:

• Remove members of the charter school’s governing board at will
• Veto, overrule, or modify decisions of the charter school’s governing board
• Modify or approve the charter school’s budget, and/or
• Appoint, hire, reassign, or fire the charter school’s management.

A district only needs to have the ability to impose its will for a charter school to be a component unit; it doesn’t have to actually do so.

The potential for a charter school to provide financial benefits to or impose financial burdens on a district—in short, to have a financial benefit-burden relationship—most commonly means one or more of the following:

• The district is legally entitled to or can access the charter school’s resources
• The district is legally obligated or has assumed the obligation to finance the charter school’s deficits or provide it with financial support, and/or
• The district is obligated for the charter school’s debt.

Criterion (a) means that the district has the ability to obtain resources from the charter school as it operates (even if the district never does so). It doesn’t include being entitled to the charter school’s remaining resources in the event it shuts down.

If the answers to both questions 1 and 2 are yes, the charter school is a component unit of the school district.

If the answer to one or both of the questions is no, there are two other paths to determining a school district is financially accountable for a charter school—fiscal dependency and majority equity interest.

Question 3: Is the charter school fiscally dependent on the school district?

A charter school is considered fiscally dependent if it needs the school district’s approval for any of the following:

• To approve or modify its budget
• To set rates or charges for services, and/or
• To issue debt.

Question 4: Is there a financial benefit-burden relationship between the charter school and the district?

If the answers to both questions 3 and 4 are yes, the charter school is a component unit of the school district.

If the answer to either question 3 or 4 is no, answer question 5 about majority equity interest.

Question 5: Does the school district hold a majority equity interest in the charter school that does not meet the definition of an investment?

An investment is an asset that is owned primarily for the purpose of income or profit. Its usefulness is based solely on its ability to generate cash or to be sold to generate cash. If a school district owns a majority of a charter school, and that ownership does not meet the definition of an investment, the charter school is a component unit. Considering that school districts provide charter schools with operating resources rather than vice versa, it is unlikely (though not impossible) that a charter school in which a district is the majority owner would meet the definition of an investment.

If the answer to question 5 is yes, the charter school is a component unit of the school district.

Existing for the Benefit of the School District

If it is determined that a school district is not financially accountable for a charter school, the charter school still could be a component if it is a legally separate, tax-exempt organization that meets all three criteria in questions 6–8.

Question 6: Are the charter school’s resources entirely or almost entirely for the direct benefit of the school district, its component units, or its constituents?

This means that the charter school exists solely to provide benefits directly to the district, other component units of the district, and/or the students or other constituents of the district.

Question 7: Is the school district or its component units entitled to or able to access a majority of the charter school’s resources?

This criterion can be difficult to apply. It means a school district has the ability to access to the charter school’s resources while it is in operation, regardless of whether the district ever has done so. However, a district’s history of receiving significant resources from a charter school may be evidence of having the ability to access resources. This criterion does not refer to circumstances in which a district gets a charter school’s remaining resources in the event it shuts down.

Question 8: Are those charter school resources significant to the school district?

Stated differently, are the resources enough to matter to the district and its finances?

If the answers to questions 6, 7, and 8 are all yes, the charter school is a component unit of the school district.

Misleading to Exclude

If a charter school fails to meet the preceding criteria for either financial accountability or existing primarily for the benefit of a school district, it’s not a component unit, right? Most of the time, that would be correct. However, if a school district believes that it would be misleading to exclude the charter school from the district’s financial statements, then the district should include the charter school as a component unit.

Misleading to exclude essentially means that the financial statement users would not be getting the full picture of the school district’s finances without the charter school’s financial information being included. Stated differently, if the charter school’s financial information is left out, the users may draw incorrect conclusions about the district’s financial status—they could be misled.

What constitutes misleading to exclude may differ depending upon whom you ask, but ultimately, it comes down to the professional judgment of the district. It is not an easy determination to make. The accounting standards say that “misleading to exclude” may apply to organizations that are closely related to or financially integrated with the district but otherwise don’t offer additional guidance.

How Should Charter Schools That Are Component Units Be Reported?

If it is determined that a charter school is a component unit of a school district, it will be included in the district’s financial statements either discretely in a separate column from the primary government or blended within the primary government. Determining which approach is required is the subject of a second article on charter schools.

Need Help with Component Units?

The partners in CRI’s government and public sector practice know the financial reporting entity standards backward and forward. If you need help evaluating potential component units or with other reporting entity issues or any governmental accounting and financial reporting problem, contact CRI for swift and expert assistance.