Another generally accepted accounting principle (GAAP) alternative created by the Private Company Council (PCC) was released by the Financial Accounting Standards Board (FASB) on February 19, 2014, simplifying the accounting for a type of transaction often used by private companies. The new Accounting Standards Update (ASU) exempts many private companies from applying variable interest entity (VIE) guidance to lessor companies under common control. Under this guidance, private companies that meet certain conditions may opt out of the consolidated reporting requirements for VIEs, which are separate legal entities private companies often set up to house their real estate and other assets. The option is available for all entities other than public business entities, not-for-profit entities, and employee benefit plans.
The Private Company Council (PCC) added this issue to its agenda in response to feedback from private company stakeholders indicating that the benefits of applying VIE guidance to assess a lessor entity under common control for consolidation in a leasing arrangement do not justify the related costs. For private companies, the primary purpose of establishing a separate lessor entity is for tax and estate-planning purposes—not to structure off-balance-sheet debt arrangements.
Elliott Davis Observation: Private companies have argued for years that they don’t set up these entities to hide assets or debt, a tactic that was used by Enron. The energy company’s fraudulent accounting for its off-balance-sheet arrangements prompted a major revision to U.S. GAAP related to consolidation.
In instances in which a lessor entity is consolidated by the lessee entity on the basis of VIE guidance, most users of private company financial statements have indicated that consolidation is not relevant to them. Instead, they focus on the cash flows and tangible worth of the standalone reporting lessee entity, as opposed to the consolidated cash flows and tangible worth of the reporting entity as presented under U.S. GAAP. Those users have also indicated that in some cases consolidation of the lessor entity distorts the financial statements of the lessee entity. Consequently, users who receive consolidated financial statements often request a consolidating schedule to enable them to reverse the effects of consolidating the lessor entity.
Elliott Davis Observation: Although sureties have indicated that consolidation of lessor entities under common control provides decision-useful information, they have expressed the most interest in knowing about the terms of the borrowing entered into by the lessor. This is especially true when the performance of a bonded project relies on collateralized equipment or property held by the lessor. Some sureties also have stated that robust disclosures about the terms of the borrowings of the lessor could be sufficient in instances in which the lessor entity is not consolidated. As a result, the disclosures to be provided under the alternative would better align the information that lenders and other users of private company financial statements typically use in assessing the cash flows of an organization preparing financial statements.
Current Accounting for VIEs
Currently, U.S. GAAP requires an entity to consolidate another entity in which it has a controlling financial interest. There are two primary models for assessing whether there is a controlling financial interest: the voting interest model and the VIE model. Under the voting interest model, the principle for a controlling financial interest is contractual or other legal arrangements that provide ownership of a majority voting interest. Under the VIE model, an entity is deemed to have a controlling financial interest when it has both the power to direct the activities of the entity and the obligation to absorb losses or the right to receive benefits of the entity. When a reporting entity has a leasing arrangement with a lessor that is under common control, the reporting entity is often required to consolidate the lessor legal entity under the VIE model, as illustrated below.
Assume ABC Company (lessee) is preparing financial statements and leases a facility from a lessor (XYZ, LLC), which is owned by the lessee’s owners and has the facility as its only asset. The lease, with market terms, is the only contractual relationship between the two companies. Current U.S. GAAP requires the lessee (ABC Company) in such circumstances to consider whether it holds a variable interest, for example, an implicit guarantee of the lessor’s debt. If a lessee holds a variable interest in the lessor and determines that the lessor is a VIE, then the lessee must assess whether it holds a controlling financial interest in the lessor. As a result, ABC Company will probably be required to consolidate XYZ, LLC.
What’s Different with this Alternative?
Under this new alternative, a private company, at its option, would be exempt from applying the VIE model to such arrangements when certain criteria are met. As a result, a private company electing to adopt this alternative would no longer consolidate the lessor legal entity in its financial statements. If a private company lessee elects this alternative, it would be required to disclose additional information about the lessor. Such disclosures would include the key terms of the leasing arrangements, the amount of debt and/or significant liabilities of the lessor under common control, the key terms of existing debt agreements of the lessor under common control, and the key terms of any other explicit interest related to the lessor under common control. In addition, companies within the scope of this option would continue to apply other applicable guidance, such as that related to leases, guarantees, and related party transactions.
What Types of Arrangements Are Eligible for this Option?
Importantly, this new alternative is not available for all VIE arrangements. Instead, when all of the following criteria are met, a private company would have the option to exempt itself from applying the VIE consolidation model to a qualifying arrangement:
- The lessor (which is a separate legal entity) and the private company are under common control;
- The private company has a leasing arrangement with the lessor;
- Substantially all of the activity between the two companies is related to the leasing activity of the lessor to the private company lessee; and
- The leased asset sufficiently collateralizes the debt of the lessor at inception.
“Common control” is not explicitly defined in U.S. GAAP. However, in assessing the first criterion, the PCC has indicated that consideration should be given to whether the parties were acting together or have a common degree of ownership. In determining whether all of the activity between the two companies is substantially related to leasing in the third criterion, the PCC decided that a guarantee by the lessee entity on the lessor entity’s mortgage on a leased asset would qualify as a leasing activity. The PCC concluded that such a guarantee is related to the lease even when the guarantee may be in excess of the lease payments that the lessee entity is required to make under its leasing arrangement with the lessor entity. The objective of the last criterion is to prevent off-balance sheet structuring (i.e., creating off-balance sheet entities which would not be consolidated). However, the criterion will still allow for the private company lessee’s assets to serve as collateral for the lessor entity’s debt, as long as the value of the asset(s) subject to the lease is equal to or greater than the amount of such debt.
What Types of Entities Can Elect this Option?
The following types of entities will not be able to elect the this new alternative (or any other private-company accounting alternatives): (a) public business entities as defined below, (b) not-for-profit entities and (c) employee benefit plans.
Elliott Davis Observation: Under current U.S. GAAP, not-for-profit entities are already substantially excluded from the scope of VIE guidance.
The FASB Accounting Standards Codification (ASC) defines a “public business entity” in its master glossary as an entity that meets any of the following criteria:
- It files or furnishes—or is required to file or furnish—financial statements with the Securities and Exchange Commission (SEC). This includes other entities whose financial statements or financial information are required to be or are included in a filing.
- It is required to file or furnish financial statements with a regulatory agency by the Securities Exchange Act of 1934, as amended, or rules or regulations promulgated under the Act.
- It is required to file or furnish financial statements with a regulatory agency in preparation for the sale of securities or for the purposes of issuing securities.
- It has (or is a conduit bond obligor for) unrestricted securities that are traded or can be traded on an exchange or an over-the-counter (OTC) market.
Elliott Davis Observation: The FASB has stated that an OTC market includes an interdealer quotation or trading system for securities that are not listed on an exchange (for example, OTC Markets Group Inc., including the OTC Pink Markets, or the OTC Bulletin Board).
- It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including footnotes) and make them publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions to meet this criterion.
Elliott Davis Observation: An entity has to provide a full set of U.S. GAAP financial statements (including footnotes) to meet criterion 5. Call reports that are required to be filed by all federally insured depository institutions (which include financial information prepared in accordance with U.S. GAAP, but not a full set of financial statements) would not meet this criterion. However, a bank with over $500 million in assets required to file annual audited financial statements with the FDIC and whose financial statements are available upon request would meet criterion 5. If it has one or more securities not subject to contractual restrictions on transfer. These restrictions may be contained in buy-sell, shareholder, or other agreements.
When is this Option Available?
Although this new alternative is effective for annual periods beginning after December 15, 2014, and interim periods within annual periods beginning after December 15, 2015, early adoption is permitted. This means that an eligible private company could elect the option in its 2013 financial statements, as long as those financial statements have not been made available for issuance prior to the release of the final standards.
A private company will apply the alternative, when elected, using a full retrospective approach in which financial statements for each individual prior period presented and the opening balances of the earliest period presented would be adjusted to reflect the period-specific effects of applying the proposed amendments.
What Should Private Companies Be Doing Now?
A private company should carefully consider whether electing VIE exemption alternative makes sense based on its specific facts and circumstances. The needs and views of current and potential future users of the private company’s financial statements should be considered in this regard. In other words, before deciding to elect an accounting alternative, a private company should determine whether users of its financial statements will accept financial statements in which the accounting alternative has been applied. In addition, if a private company goes public in the future, it will lose the option to elect the accounting alternative(s). There could be challenging accounting consequences when this happens or when a private company discontinues its election to apply one of the accounting alternatives for any other reason. A private company should take those potential challenges into consideration when deciding whether to elect one of the accounting alternatives.
What’s on the Horizon?
At its January meeting, the PCC did not reach any final decisions in its work to create a private company exception for recognizing intangible assets separately from goodwill in a business combination. Instead, the PCC directed the FASB staff to continue its research and analysis of a proposed recognition and measurement alternative, with a focus on intangible assets which are capable of being sold or licensed independently from other assets of the business. It is likely that any final alternative will limit recognition and measurement of intangible assets to only those intangibles which could generate discernible cash flows.
Based on the direction of the PCC’s discussions, certain customer relationship-related intangible assets are not expected to be recognized as intangible assets in the alternative recognition and measurement model. The PCC is expected to resume deliberations on the proposed business combination alternative at its next meeting in April 2014. Any revised alternative that is approved by the PCC, and subsequently endorsed by the FASB, could be re-exposed for public comment.
1See “What Types of Entities Can Elect This Option” for a definition of a public business entity.
2“Common control” is not explicitly defined in U.S. GAAP. However, in assessing the first criterion, the PCC has indicated that consideration should be given to whether the parties were acting together or have a common degree of ownership.
3In determining whether substantially all of the activity between the two companies is related to leasing in the third criterion, the PCC decided that a guarantee by the lessee entity on the lessor entity’s mortgage on a leased asset would qualify as a leasing activity.
4The debt of the separate legal lessor entity is sufficiently collateralized as long as the value of the asset(s) subject to the lease is equal to or greater than the amount of such debt.