Last year, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-07, Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements. This guidance offers private companies a simpler way to account for certain related leasing entities. Construction businesses that adopt the alternative can avoid the potentially costly variable interest entity (VIE) analysis associated with these entities and need not consolidate these entities on their financial statements.
For contractors, excluding leasing entities from their financial statements can be advantageous. Most lenders, sureties and other financial statement users prefer to evaluate a construction company’s cash flow and tangible worth on a stand-alone basis. Indeed, when presented with consolidated financial statements, many lenders and sureties demand supplemental consolidating schedules that essentially undo the effects of consolidation.
Construction company owners often create separate legal entities to acquire real estate, vehicles or equipment. They then lease those assets back to the company. Separate entities offer a variety of tax, estate-planning and liability protection benefits but, in some cases, this strategy implicates FASB’s VIE rules. These rules are complex, and we won’t discuss them in detail, but here’s a brief summary:
Under Generally Accepted Accounting Principles (GAAP), a company’s consolidated financial statements must include any entity in which it has a “controlling financial interest.” Historically, this meant the company owned more than 50% of the entity’s voting interests. But in 2003, FASB adopted a VIE model under which a company may be deemed to have a controlling financial interest in an entity even though it lacks majority voting control. The VIE rules were added in response to a series of high-profile financial scandals involving off-balance-sheet debt arrangements using “special purpose entities.”
Essentially, a VIE is an entity whose value to a company varies with the entity’s financial performance. In other words, the value changes depending on how well the entity performs. A company has a controlling interest in a VIE if it:
- Has the power to direct the VIE’s most significant economic activities, and
- Participates in the VIE’s economics by virtue of an obligation to absorb the VIE’s losses or a right to receive its benefits.
In the construction industry, VIE treatment often arises in connection with separate but commonly controlled leasing entities. Typically, the construction company guarantees or furnishes collateral for the leasing entity’s debt, thereby assuming an obligation to absorb the entity’s losses.
Reasons for the change
ASU 2014-07 permits private companies to opt out of the VIE rules for certain leasing arrangements. FASB determined that these companies generally form separate leasing entities for tax, estate planning and liability purposes — not to structure off-balance-sheet debt arrangements.
In addition, FASB found that most users of private company financial statements say that consolidation isn’t relevant to them, because they focus on the company’s cash flow and tangible worth on a stand-alone basis. In fact, users say, consolidation distorts a company’s financial statements because the leasing entity’s assets are beyond the reach of the company’s creditors.
Before the ASU, construction businesses that prepared GAAP-compliant financial statements often were forced to go through the costly process of applying the VIE rules and, in many cases, to consolidate leasing entities on their financial statements. Companies that wished to present their financial results on a stand-alone basis had to disclose a departure from GAAP or incur additional expense to prepare supplemental schedules for their financial statement users.
FASB concluded that the benefits of applying the VIE rules under these circumstances didn’t justify the additional cost.
ASU 2014-07 permits a private company to opt out of the VIE rules with respect to a leasing entity, provided:
- The company and the leasing entity are under common control,
- The company has a lease arrangement with the leasing entity,
- Substantially all of the activities between the company and leasing entity are leasing-related (including supporting activities, such as providing guarantees or collateral), and
- The amount of any guarantees or collateral the company provides to the leasing entity doesn’t exceed the initial value of the leased assets.
Businesses that opt out must provide certain disclosures about any leasing arrangements in their financial statements.
Should you opt out?
The accounting alternative offered by 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, with early adoption permitted.
If your construction company is considering opting out of the VIE rules, be sure to consult your advisors, lenders and sureties first. Opting out may offer significant benefits, but it’s not right for every contractor. (See below “Proceed with caution when it comes to VIE rules.”)
Proceed with caution when it comes to VIE rules
There are risks to choosing the private company alternative offered by the Financial Accounting Standards Board’s Accounting Standards Update (ASU) No. 2014-07. (See main article.)
Some lenders and sureties, for example, may still want to see consolidated financial statements — even if they’re no longer required by GAAP. And changing your accounting method may alter key financial ratios that lenders and sureties rely on, so it’s important to discuss the potential impact with them first.
It’s also important to consider your future business plans. For instance, if you opt out of the VIE treatment and later take your company public or sell it to a public company, you’ll have to restate your financial statements for prior periods.