FASB Issues Important Third Update
The Financial Accounting Standards Board (“FASB”) has issued its third update to Generally Accepted Accounting Principles (“GAAP”), offering an alternative to certain private companies permitting them to elect, in some circumstances, not to consolidate the financial reporting from variable interest entities (“VIEs”) that lease property to them. It may apply in situations where an owner of a private company is also an owner of a second business entity that leases property to the company.
The Private Company Council (“PCC”) was formed in 2012 to improve the process of setting accounting standards for private companies that prepare their financial statements in accordance with GAAP. Among other things, the PCC is tasked with working with FASB to determine whether alternatives to existing GAAP standards can ease the burden on private companies of preparing GAAP-compliant financial statements while better addressing the needs of users of those financial statements. Earlier this year, FASB issued the first two private company GAAP alternatives, addressing goodwill and interest rate swaps.
GAAP Approach to VIEs
Under GAAP, a company must consolidate the financial reporting from an entity in which it has a controlling financial interest. Two models are typically used to determine whether a company has a controlling interest in an entity: the voting interest model or the VIE model.
A VIE is generally 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.
The new guidance specifically applies to leasing arrangements. Private companies commonly lease facilities from separate entities owned by one or more of the company’s owners. This lessor entity is established for tax, estate planning or legal liability purposes. 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.
Due to issues such as off-balance sheet debt arrangements, existing GAAP guidance requires the private company, which is the lessee, to determine whether it holds a variable interest in the lessor entity that owns the rental property(for example, a guarantee of the lessor’s debt). If the private company does hold a variable interest and the lessor is a VIE, the private company lessee must assess whether it holds a controlling financial interest in the lessor under the VIE model. If the entities are under common control, the lessee generally must consolidate the rental property’s operations with their own operations.
The PCC found that most users of private company financial statements, such as banks, consider the information relating to the real estate irrelevant. These users tend to focus on 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. As a result, users who receive consolidated financial statements often request additional information that they use to back out the operations of the real estate entity. In addition, private companies had to pay more in audit and accounting fees in order to obtain a “clean” opinion on their financial statements when they included VIEs. Many private companies elected not to include VIEs in their financial statements, which resulted in an opinion that stated the financial statements were not in accordance with GAAP, and, in many cases, required an explanation for their banks.
New alternative for private companies
Under the new accounting standard, a private company lessee can elect an alternative not to apply the GAAP VIE guidance when all of the following conditions exist:
- The private company lessee and lessor are under common control.
- The private company lessee has a leasing arrangement with the lessor.
- 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 lessee explicitly guarantees or provides collateral for any obligation of the lessor related to the asset leased by the private company, then the principal amount of the obligation at inception does not exceed the value of the asset leased by the private company from the lessor.
If a private company elects to apply this accounting alternative, it should apply the alternative to all current and future leasing arrangements satisfying the above conditions.
Private companies electing this alternative also frees them from providing GAAP-required VIE disclosures about the lessor entity. However, under this alternative, a private company must 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.
These disclosures are required in combination with the other GAAP-required disclosures about the private company’s relationship with the lessor entity, such as those for guarantees, leases and related party transactions.
A private company that elects this accounting alternative must apply it retrospectively to all periods presented on financial statements. The alternative will be effective for annual periods beginning after December 15, 2014, and interim periods within annual periods beginning after December 15, 2015. Early application is permitted for any period for which the company hasn’t yet issued financial statements.