As part of continuing efforts to ease the burden on private companies that prepare their financial statements in accordance with Generally Accepted Accounting Principles (GAAP), the Financial Accounting Standards Board (FASB) has established another alternative to GAAP reporting requirements. The alternative, described in Accounting Standards Update (ASU) 2014-07, Consolidation (Topic 810): Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements, may provide relief for private companies that lease property from a business entity owned by an owner of the private company.
The ASU, which originated with the Private Company Council (PCC), allows GAAP-compliant private companies to elect not to consolidate the financial reporting from variable interest entities (VIEs) that lease property to the companies under certain circumstances.
GAAP’s consolidated reporting requirement
GAAP requires companies to consolidate their financial reporting with the reporting of any entities in which they hold a controlling financial interest. Two models are typically applied to determine whether a company has a controlling interest in an entity: the voting interest model or the VIE model. The VIE model applies if the company has an explicit or implicit variable interest in the entity and that entity is a VIE.
An explicit variable interest exists if the company has contractual, ownership, or other financial interests in the entity that directly absorb or receive the variability of the entity. An implicit variable interest involves the absorbing or receipt of variability from the entity indirectly. The identification of implicit interests is a matter of judgment based on the relevant facts and circumstances.
A VIE is generally defined as a corporation, partnership, or any other legal structure that is used for business purposes and either doesn’t have equity investors with voting rights or has equity investors that don’t provide sufficient financial resources for the entity to support its activities.
If the VIE model applies, a company will be deemed to have a controlling financial interest in an entity when it has 1) the power to direct the activities that most significantly affect the entity’s economic performance, and 2) the obligation to absorb losses, or the right to receive benefits, of the entity that could potentially be significant to the entity.
GAAP applied to leases
The alternative described in ASU 2014-07 specifically applies to private company leasing arrangements. Private companies often lease facilities from separate lessor entities owned by one of the private company’s owners. Typically, the lessor entity’s only asset is the leased facility, and the lease is the only contractual relationship between the lessee company and the lessor entity. The lessor entity may have been established for tax, estate planning, or legal liability purposes — not to structure off-balance sheet debt arrangements that might trigger alarm among financial statement users.
Under current GAAP guidance, the lessee company must go through the costly and complex process of determining whether it holds a variable interest in the lessor entity. If it does, and the lessor is a VIE, the lessee company must apply the VIE model to determine whether it holds a controlling financial interest in the lessor. If the entities are under common control, the lessee generally must consolidate the financial reporting from the lessor.
According to the PCC, most users of private company financial statements find the consolidation of lessors under common control irrelevant. These users are interested in the cash flows and tangible worth of the stand-alone lessee entity, not the cash flows and tangible worth of the consolidated group presented under GAAP.
In addition, consolidation of the lessor distorts the lessee’s financial statements. To remedy the situation, users who receive consolidated financial statements often request a consolidating schedule that they can use to reverse the effects of consolidation.
The private company alternative
ASU 2014-07 allows a private company lessee to elect an alternative not to apply the GAAP VIE guidance to a lessor as long as:
- The private company lessee and the lessor entity are under common control,
- The private company has a leasing arrangement with the lessor, and
- Substantially all of the activity between the private company and the lessor is related to the leasing activities (including supporting leasing activities, such as issuance of a guarantee or providing collateral on the obligations related to the leased asset) between those two companies.
If the private company explicitly guarantees or provides collateral for any obligation of the lessor related to the asset leased by the private company, the principal amount of the obligation at inception can’t exceed the value of the asset leased by the private company from the lessor.
A private company that elects to apply the accounting alternative must apply it to all current and future leasing arrangements meeting the above conditions.
Private companies that elect the alternative will also avoid the GAAP VIE disclosure requirements. They must, however, disclose the following information:
- The amount and key terms of liabilities (for example, debt, environmental liabilities, and asset retirement obligations) recognized by the lessor entity that expose the private company to providing financial support to the entity, and
- A qualitative description of circumstances not recognized in the lessor entity’s financial statements (for example, certain commitments or contingencies) that expose the private company to providing financial support to the entity.
The alternative disclosures must be made in combination with the other GAAP-required disclosures about the private company’s relationship with the lessor entity, including those for guarantees, leases, and related party transactions. Be aware, too, that the private company should continue to apply GAAP consolidation guidance other than that on VIEs.
If elected, the accounting alternative must be applied retrospectively to all periods presented on financial statements. The alternative becomes effective for annual periods beginning after Dec. 15, 2014, and interim periods within annual periods beginning after Dec. 15, 2015. Early application is permitted for any period for which the company hasn’t yet issued financial statements.
On the horizon
ASU 2014-07 represents the third private company alternative that FASB has developed in conjunction with the PCC. ASU 2014-02 and ASU 2014-03, released earlier this year, address goodwill and interest rate swaps, respectively. The two bodies are now considering alternatives related to the reporting of identifiable intangible assets in a business combination such as a merger or acquisition.
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