FIN 46(R), Consolidation of Variable Interest Entities—An Interpretation of ARB No. 51, was issued in December 2003 in response to accounting scandals in which certain types of variable interest entities (VIE) were used to structure transactions that excluded assets and liabilities from audited consolidated financial statements. The types of VIEs and purposes of such vehicles vary considerably. In practice, owners of private companies frequently establish a lessor entity as a VIE for tax, estate planning, or liability reasons rather than for the purpose of structuring off–balance-sheet arrangements. Under Accounting Standards Codification (ASC) Topic 810, “Consolidation,” VIEs are generally consolidated with other related entities (e.g., a lessee operating company) under common control. Private company financial statement preparers and auditors have suggested, however, that third-party users do not find consolidated financial information of “common control leasing arrangements” to be decision-useful.
In March 2014, FASB issued Accounting Standards Update (ASU) 2014-07, Consolidation (Topic 810): Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements, a consensus of the Private Company Council. ASU 2014-07 gives a private company the option not to consolidate lessor entities under common control if specified criteria are met. FASB and the Private Company Council have concluded that this alternative, if elected, can reduce the cost and complexity of applying the VIE guidance for lessor entities under common control without the loss of decision-useful information. Moreover, financial statement users will be provided with information related to the lessor entities through the extensive disclosures required by ASU 2014-07.
The following is a brief overview of the current accounting requirements for applying VIE guidance and explores the accounting alternative available to private companies under ASU 2014-07. Qualifying criteria and practical considerations are discussed, and illustrations are presented to 1) assist preparers and management of private companies in deciding whether to adopt this accounting alternative and 2) educate other stake-holders as to the consequences.
Overview of Control and VIE Basics
ASC Topic 810 provides two models for determining whether consolidation of one entity by another is necessary based upon the concept of a “controlling financial interest.” These are 1) the voting interest model and 2) the VIE model. Under the voting interest model, consolidation is required when one reporting entity has a controlling financial interest in another by virtue of owning more than 50% of the outstanding voting shares, either directly or indirectly.
The assessment of a controlling financial interest under the VIE model is more complex. The first step is to determine whether a legal entity is a VIE, which is assessed by reference to the provisions of ASC 810-10-15-14. More specifically, a legal entity is a VIE if any of the following conditions exist:
- The total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated support.
- The equity investors in the VIE, as a group, lack any one of the following three characteristics:
- The power, through voting or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance.
- The obligation to absorb expected losses of the entity.
- The right to receive the expected residual returns of the entity.
An entity is deemed to have a controlling financial interest in a VIE when both of the following are present:
- The power to direct the activities that most significantly impact the VIE’s economic performance, and
- The obligation to absorb losses of or receive benefits from the VIE that could potentially be significant to the VIE.
A reporting entity that meets the above criteria is deemed to have a variable interest in an entity and will consolidate the VIE as the primary beneficiary. Under the VIE model, the reporting entity with the controlling financial interest does not necessarily need to be an equity investor. Rather, the reporting entity could be a capital provider by being a debt holder or a guarantor.
An Unintended Consequence of the VIE Model
It is not unusual for a privately owned operating company to lease property or equipment from a related lessor entity that is under common control. The property company/lessor is established to hold the operating company’s facility and is most often formed for tax, estate planning, or legal liability reasons. The property company may issue third-party debt to acquire the facility, with a guarantee provided by the operating company or common owner. The property company’s only source of income is the lease payments from the operating company, which are used to pay down the third-party debt. Note that under the former VIE guidance (ASC 810-10-55-87–89), now superseded by ASU 2014-07, the operating company (lessee) was deemed to have an “implicit” variable interest in the property company (lessor), which required consolidation of the lessor’s financial statements.
Users of private company financial statements have indicated that consolidation is not relevant to them in such situations because they focus on cash flows and tangible net worth of the stand-alone private company lessee rather than on the consolidated cash flows and tangible net worth as presented under U.S. GAAP. These users also contend that consolidated financial statements distort the financial position of both the lessor entity and the lessee entity because the assets held by the lessor or lessee entity would be beyond the reach of its creditors, even in the case of bankruptcy. Private companies have indicated that users often request a consolidating worksheet to enable them to reverse/adjust the effects of the consolidation so they can ascertain the stand-alone assets, liabilities, revenues, and expenses of each entity individually. In some cases, private companies have chosen to depart from GAAP and have not consolidated these lessor entities, thereby accepting qualified opinions on their financial statements to satisfy lenders.
The Accounting Alternative under ASU 2014-07
ASU 2014-07 was issued to provide private companies relief from the costs and complexities of applying the VIE model to common control leasing arrangements. Under the guidance now codified in ASC Topic 810, a legal entity need not be evaluated under the VIE guidance if three criteria are met, with a fourth requirement necessary under certain circumstances:
- The private company lessee (i.e., the reporting entity) and the lessor legal entity are under common control.
- The private company lessee has a lease arrangement with the lessor legal entity.
- Substantially all activities between the private company lessee and the lessor legal entity are related to leasing activities (including supporting leasing activities discussed below) between those two entities.
- The private company lessee explicitly guarantees or provides collateral for any obligation of the lessor legal entity related to the asset leased by the private company. In such cases, the principal amount of the obligation at inception of such guarantee or collateral arrangement does not exceed the value of the asset leased by the private company from the lessor legal entity. This requirement applies only when there are guarantees or collateral provided by the private company lessee.
The first three criteria must be periodically reassessed to ensure that they continue to be satisfied. If any of the criteria subsequently cease to be met, ASC 810-10-15-17C requires the private company to apply the VIE guidance on a prospective basis, as of the date the arrangement no longer qualifies for the accounting alternative. The fourth criterion is only required to be met at the inception of the guarantee or collateral arrangement and limits the obligation amounts to a level not exceeding the value of the leased asset. A subsequent decline in the value of a leased asset below the principal amount of the guaranteed or collateralized debt would not cause a private company to fail this provision. If the lessor subsequently refinances the debt or enters into any new obligation that requires guarantees or collateralization by the private company, however, the new arrangement must be assessed to ensure that this criterion is still met. The decision to apply this accounting alternative is deemed to be an accounting policy election that shall be applied to all legal entities that meet the four criteria specified above.
What Is Common Control?
A majority of comment letters from constituents received in response to the exposure draft that became ASU 2014-07 requested that a definition of common control be included in the final standard because no such definition presently exists in the ASC. Unfortunately, despite these requests, no definition was provided.
Current practice is to refer to the guidance from the Securities Exchange Commission (SEC), which was discussed by the Emerging Issues Task Force (EITF) in EITF Issue 02-5, Definition of “Common Control” in Relation to FASB Statement No. 141. Though no consensus was reached, EITF Issue 02-5 includes SEC staff discussions that suggest common control exists between (or among) separate entities only in the following situations:
- An individual or enterprise holds more than 50% of the voting ownership of each entity.
- Immediate family members (i.e., a married couple and their children, but not grandchildren) hold more than 50% of the voting ownership interest of each entity (with no evidence that those family members will vote their shares in any way other than in concert). Entities might be owned in varying combinations among living siblings and their children, requiring careful consideration regarding the substance of the ownership and voting relationships.
- A group of shareholders holds more than 50% of the voting ownership interest of each entity, and contemporaneous written evidence of an agreement to vote a majority of the entities’ shares in concert exists.
The Private Company Council (PCC) and FASB (ASU 2014-07 para. BC 15) note that the concept of common control is meant to be broader than in the examples provided by EITF Issue 02-5 and argue that common control is not an entirely new concept within U.S. GAAP. They point to the use of the term in ASC Topic 805, “Business Combinations,” and the common control subsections included therein. A review of these subsections, however, does not reveal any substantive definition of common control. Accordingly, it appears that significant judgment will continue to be necessary in the application of this concept.
Further Comments on the Criteria
Leasing activities between the parties.
As noted above, an essential criterion in ASU 2014-07 is that the activities between the lessee and the lessor must be related to leasing activities and include “supporting activities” between the two parties. Though subject to judgment and based on the facts and circumstances, the following are examples of activities that qualify as leasing activities or supporting leasing activities:
- A guarantee or collateral provided by the private company lessee to the lender of a lessor legal entity under common control for indebtedness that is secured by the asset leased by the private company;
- A joint and several liability arrangement for indebtedness of the lessor legal entity, for which the private company lessee is one of the obligors, that is secured by the asset leased by the private company lessee;
- Paying property taxes, negotiating the financing, and maintaining the asset; and
- Paying the income taxes of the lessor legal entity when the only asset owned by the lessor legal entity is being leased either by only the private company or by both the private company lessee and an unrelated party.
The guidance cautions, however, that certain activities are not related to the leasing activity between the private company lessee and the lessor legal entity. These include paying the income taxes of the lessor legal entity on income generated by an asset not being leased by the private company lessee and a purchase commitment entered into between the lessee and lessor to purchase or sell products.
“Substantially all” activities.
The third criterion needed to satisfy the accounting alternative election is that “substantially all” activities between the lessee and the lessor are related to leasing activities. Though the term “substantially all” is not explicitly defined, it has been addressed in two different ways. First, ASU 2014-07 paragraph BC17 indicates that the PCC considered that a greater level of activity by the lessor entity unrelated to the private company lessee would decrease the likelihood of consolidation under the VIE model. In addition, the PCC decided that the accounting alternative should permit the lessor entity to conduct activities other than leasing to the private company lessee, as long as those activities are unrelated to the private company lessee. Second, the implementation guidance provides several examples suggesting activities where the private company may or may not be eligible to elect the accounting alternative treatment, as illustrated in the Exhibit.
Examples of Common Control Leasing Arrangements and the Election in ASU 2014-07
Effective Date and Transition
The accounting alternative in ASU 2014-07 is effective for annual periods beginning after December 15, 2014, and for interim periods within annual periods beginning after December 15, 2015. Early adoption is permitted for any annual or interim period for which an entity’s financial statements have not yet been made available for issuance. In addition, the application of the accounting alternative requires retrospective application to all periods presented in the financial statements.
A private company that elects to apply the accounting alternative in ASU 2014-07 and does not apply the VIE requirements to a lessor entity is subject to the following disclosure requirements:
- The amount and key terms of liabilities of the lessor legal entity that expose the private company lessee to providing financial support to the lessor should be disclosed. The term “liabilities” includes, but is not limited to, debt, environmental liabilities, and asset retirement obligations.
- A qualitative description of any unrecognized commitments or contingencies of the lessor legal entity that expose the private company to providing financial support to the lessor legal entity should be disclosed.
Further disclosure guidance requires a private company to consider exposures through implicit guarantees. The existence of an implicit guarantee is a matter of facts and circumstances, which include but are not limited to:
- There is an economic incentive for the private company lessee to act as a guarantor or to make funds available.
- Such actions have happened in similar situations in the past.
- The private company lessee acting as a guarantor or making funds available would be considered a conflict of interest or illegal.
In practice, an implicit guarantee might include circumstances where there is an expectation that the private company would make funds available to the lessor to prevent the common owner’s guarantee from being called or to provide funds to the common owner to fund a call of the guarantee.
The private company lessee should also disclose any information about the lessor legal entity that is required by other guidance. Related areas include ASC Topic 460, “Guarantees,” ASC Topic 840, “Leases,” and ASC Topic 850, “Related Party Transactions.” These disclosures may be combined in a single note or included by cross-references within the notes to the financial statements.
An entity that is the primary beneficiary of a VIE, or holds a variable interest in a VIE but is not the primary beneficiary, should disclose qualitative and quantitative information about the reporting entity’s involvement with the VIE, both explicit and implicit, including but not limited to the nature, purpose, size, and activities of the VIE, as well as how the VIE is financed.
Consistent with other accounting alternatives available to private companies, management should consider whether it expects to engage in an initial public offering or may be acquired by a public business entity before electing the alternative treatment. Since neither FASB nor the SEC has provided specific transition guidance in these situations, it appears that private companies must retroactively restate their financial statements to apply public company accounting and reporting requirements to all periods presented. Moreover, before making the election, management should also ensure that the financial statements reflecting the accounting alternative will be accepted by key users. Users should also be informed of the expected impact the accounting alternative will have. It would also be prudent to evaluate how the expected results will impact existing loan covenants.
The accounting alternative under ASU 2014-07 gives private companies more latitude in how to recognize VIEs. While this can be beneficial to companies and their stakeholders, the criteria for election are important, and management and their advisors should take them into consideration before electing the alternative.