In the wake of Enron and other accounting scandals in the early 2000s, FASB developed standards that required companies to consolidate variable interest entities (VIEs) in their financials. The aim was to create a more complete picture of a company’s financial arrangements.
In a similar fashion, owners of private companies frequently create separate entities to operate different parts of their businesses. However, unlike the off-balance-sheet arrangements that got Enron in so much trouble, these separate entities are created for tax or estate planning purposes, or for legal liability reasons.
For example, Chip and Dale own a nut roasting business. The nut roasting business operates in a building owned by an LLC whose member-owners are Chip and Dale. The LLC leases the building to the nut roasting business. The LLC is considered a VIE, so under FASB’s rules for reporting VIEs, Chip and Dale have to consolidate the LLC into the financials for the nut roasting business.
VIE rules don’t serve the stakeholders
Stakeholders for private companies complained to FASB that these consolidated financials mean extra work for them. Since they’re mainly concerned with the cash flows and performance of the operating companies, they need additional information so that they can de-consolidate the VIEs from the reporting entities. The VIE reporting rules force private companies to do extra work that their stakeholders have to undo.
Stakeholders also complained that because these VIEs are separate legal entities, their assets on the balance sheets distort the true financial health of the reporting entities. In case of a bankruptcy of the reporting company, the assets of the VIE are out of reach of creditors.
In response to feedback from stakeholders of private companies about VIEs and other parts of U.S. GAAP that are overly complex and irrelevant, FASB created the Private Company Council (PCC) in 2012 to suggest alternatives to GAAP for private companies.
In 2014, following suggestions from the PCC, FASB released four updates that simplify accounting for private companies in goodwill, hedge accounting, leasing arrangements with variable interest entities and intangibles resulting from business combinations. These simplifications can be adopted by any companies, except for public business entities, not-for-profit organizations and employee benefit plans.
Simplification for leases with VIEs
The 2014 update for VIEs, Accounting Standards Update (ASU) 2014-07, Consolidation (Topic 810): Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements, allowed private companies who have leasing arrangements like Chip and Dale’s to elect not to consolidate lessor VIEs into lessee reporting entities.
Simplification for all VIEs
In late 2018, that guidance was superseded and broadened by a new update: Accounting Standards Update (ASU) 2018-17, Consolidation (Topic 810): Targeted Improvements to Related Party Guidance for Variable Interest Entities.
Thanks to this expanded guidance, reporting entities with related VIE entities are no longer required to consolidate the VIE into their financials if they meet the following four conditions:
- The reporting entity and the VIE are under common control.
- The reporting entity and the VIE are not under common control of a public company.
- The VIE under common control is not a public company.
- The reporting entity does not directly or indirectly own more than 50 percent of the outstanding voting shares of the VIE.
Companies that adopt this must apply this to all current and future VIEs that meet these criteria. They will also be required to make additional disclosures in their financials regarding the business relationships, financial impacts and the likelihood of future losses for all qualifying VIEs. This update will be effective for periods beginning after Dec. 15, 2020. Early adoption is allowed.
What is common control?
Common control is not defined in this update because FASB did not want to adversely impact other standards that mention common control. The background information for ASU 2014-07 cites the SEC definition, but says that for financial reporting purposes, the definition of common control should be based on the facts and circumstances, and may result in definitions that are broader than that of the SEC.
According to the SEC definition, common control occurs when the same individual or several closely related individuals own 51 percent or more of separate entities, or when the same group of shareholders own 51 percent or more of separate entities.
It’s not often that FASB makes such broad simplifications. With this update, the end result is a win-win all around: financials that are more meaningful for stakeholders and easier reporting for your clients.