Complex VIE guidance offers an escape clause for private companies
Relief from the Financial Accounting Standards Board (FASB) variable interest entity (VIE) guidance came as a special treat on Halloween of this year. Private companies have for years described Accounting Standards Codification (ASC) Topic 810, Consolidation, as one of the most complicated areas of U.S. generally accepted accounting principles (GAAP). Now they have an easier financial reporting option.
Should your business consolidate … or not?
The VIE guidance requires businesses to consolidate (or report on their balance sheets) holdings they have in other entities where they have a controlling financial interest. The intent is to prevent the hiding of liabilities in off-balance-sheet vehicles.
Whether to consolidate has been a decision based primarily on whether a business had majority voting rights in a related legal entity. After the 2003 Enron scandal, the FASB amended the standard to better define when to consolidate, introducing the concept of VIEs.
“Enron figured out a way within the standard to create off-balance-sheet structures with financing that was completely guaranteed by the host company but yet was off the balance sheet — and the VIE guidance was written to fix that,” said Billy Atkinson, chair of the FASB’s Private Company Council (PCC) from 2012 to 2015.
The VIE guidance states that a business has a controlling financial interest when it has both the power to direct the activities that most significantly affect an entity’s economic performance and the right to receive significant benefits from the entity, as well as the obligation to absorb its losses.
Private companies now have alternatives
Most accounting professionals regard the VIE guidance as complicated to follow. Private companies contend that some of their most common business relationships could be considered VIEs under ASC 810, although the relationships were set up for tax or estate planning purposes — not to trick investors or pump up stock prices.
The PCC, which keeps the FASB abreast of private company accounting issues, considered the VIE issue a top priority. “We said, ‘Look guys, we’ve had about ten years-plus of application of this guidance. Let’s see if we can untangle it a bit for the impact on private companies that fall prey to the complicated structural guidance,’” said former PCC Chair Atkinson.
Private companies told the FASB that the VIE model forced them to consolidate multiple affiliated and subsidiary businesses onto a parent’s balance sheet. This frustrated lenders and creditors, who wanted cleaner balance sheets. In addition, in companies where ownership is shared among closely related entities, determining who holds the power may not always be clear.
In 2014, the FASB responded to these concerns with Accounting Standards Update (ASU) No. 2014-07, Consolidation (Topic 810): Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements (a Consensus of the Private Company Council). The updated standard let private companies ignore the VIE guidance for certain leasing transactions. Private companies applauded this update, but problems persisted with the consolidation guidance for transactions that didn’t involve leases.
The latest FASB guidance, ASU No. 2018-17, Consolidation (Topic 810): Targeted Improvements to Related Party Guidance for Variable Interest Entities, allows private companies to skip the VIE guidance. Instead, they can use a new, less complex method defined in the guidance to assess whether common brother-sister transactions must be consolidated.
The updated standard applies to all private company common control transactions that meet certain criteria. It also supersedes the amendments in ASU No. 2014-07. A private company that makes use of the latest amendments to Topic 810 must disclose in its financial statements its involvement with, and exposure to, the legal entity under common control.
“It provides private companies the choice to not apply VIE guidance to their common control arrangements — thereby reducing costs without compromising the relevance of the financial reporting information to financial statement users,” FASB Chairman Russell Golden said in a statement.
Effective for private companies in 2021, but early adoption anticipated
For private companies, the ASU No. 2018-17 amendments are effective for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021. Other organizations must apply the standard for fiscal years beginning after December 15, 2019, and for interim periods within those fiscal years. Early adoption is permitted — and many private companies are expected to opt out of the VIE guidance as soon as possible to simplify financial statement preparation.
Does this still sound complicated? If you have questions, contact Weaver for help with your specific situation.
Sidebar: Public companies, too
The new ASU No. 2018-17 does more than offer relief to private companies in applying consolidation guidance. It also amends rules for assessing how fees paid to “decision makers” (or service providers) affect a consolidation decision. The update requires all businesses to consider indirect interests held through related parties in a common control arrangement to be considered on a proportional basis, rather than as the equivalent of a direct interest in its entirety.
Consider a decision-maker who owns a 20% interest in a related party, and that related party owns a 40% interest in the legal entity being evaluated. The decision maker’s indirect interest in the VIE held through the related party under common control should be considered the equivalent of an 8% direct interest (40% × 20%) for determining whether its fees are variable interests.
The result will be that more decision makers will not have a variable interest through their decision-making arrangements, compared to current guidance. If fewer decision-making fees are considered variable interests, the focus on determining which party within a related party group may have a controlling financial interest will be shifted to the variable interest holders with more significant economic interests. This shift will substantially reduce the risk that decision makers with insignificant direct and indirect interests could be deemed the primary beneficiary of a VIE.
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