It’s a common structure for many closely held private companies: they have one owner (or majority owner) who also owns other brother or sister entities. Oftentimes these entities interact with one another in business or to pursue a common goal. Sometimes they don’t. For many private companies in this situation, the evaluation of the variable interest entity (VIE) guidance to their brother and sister entities has been a confusing and difficult process.
The VIE guidance, originally crafted in response to accounting scandals in the early 2000s, is technically complex. It requires detailed understanding of technical accounting terminology that was developed to assist in the evaluation of how entities are controlled and who controls them. Many private companies not only struggled with understanding the difficult guidance, but they also had to develop interpretations of how to apply the guidance to their situation because the accounting literature didn’t clearly address how to evaluate arrangements between related parties. Arrangements between related parties often made applying the VIE guidance challenging because they may have been (or continue to be) incomplete, nonsubstantive, or simply undocumented.
In 2014, the Financial Accounting Standards Board (FASB), provided an accounting alternative for private companies—entities that do not meet the definition of public business entity, not-for-profit entity or employee benefit plan—that exempted them from applying the VIE guidance to certain entities with leasing arrangements. The FASB issued an Accounting Standards Update (ASU 2018-17) in October 2018 that made improvements to related party guidance for variable interest entities (VIEs) and replaces the existing alternative with a version that is applicable in many more circumstances. Private companies adopting the revised accounting alternative have found several advantages:
- Reduced time and effort in preparing support for the financial statements
- Ability to choose to combine certain entities that were previously consolidated to provide the most useful financial statements to the users of the financial statements
- Elimination of the non-controlling interest presentation in the income statement (which some have found confusing) for formerly consolidated VIEs
- Elimination, or reduction, in qualified audit reports for departures from the VIE guidance for private companies that did not apply the guidance
Even entities that do not have consolidated VIEs or qualifications in their audit reports for VIEs have found adopting the accounting alternative to be helpful because it can reduce the amount of effort put into evaluating related party relationships.
Although the new guidance can save time and energy, there are still some requirements that must be met:
- The reporting entity and the legal entity must be under common control
- The reporting entity and the legal entity must not be under common control of a public business entity
- The legal entity must not be under control of a public business entity
- The reporting entity must not directly or indirectly have a controlling interest in the legal entity
For purposes of evaluating whether the entities are under common control (see criteria 1 above) and whether the legal entity has a controlling interest in the legal entity (see criteria 4 above), the evaluation is done based on the voting model. Many times the evaluation is straight forward. For instance, one person owns 100% of both entities. Other times the evaluation is more challenging. For instance, there may be a complex ownership structure, or the entity is (or similar to) a limited partnership. If an entity is (or similar to) a limited partnership additional analysis may be required. Sometimes an entity that is (or similar to) a limited partnership does not qualify for the new accounting alternative.
In addition to meeting the criteria above, an entity must also make certain disclosures for those relationships that qualify for the scope exception.
Adopting the Accounting Alternative
Private companies could benefit from adopting the accounting alternative by reducing their compliance cost, and it is often a good option for private companies that do not expect to become public business entities. As an aside, a private company that expects to become a public business entity would have to reverse the adoption of any private company accounting alternatives and obtain revised financial statements and audits of those financial statements. This would be required, for instance, when filing with the Securities and Exchange Commission (SEC) for the first time after an initial public offering (IPO).
For this reason many private companies adopted the accounting alternative after it was issued. Others did not. Whether you chose to not adopt initially, or simply were not aware of the possibility of adopting, now is a good time to start considering and planning for adoption.
Keep in mind that when adopting this standard, you can still choose to combine entities under common control in scenarios where combining the separate entities in the financial statements is likely to be more meaningful. The consideration of which entities would be the most relevant to include in the financial statements is a critical step in scoping and evaluating the adoption, as well as in planning for your financial statement preparation and audit in the year of adoption.
The standard is not effective until calendar year-end 2021, but it may be early adopted for your next year-end financial statement(s).
Getting started early with the adoption process can help make sure there is time to evaluate and discuss the impact of the adoption on your financial statements with your advisors, banks or other lenders, owners, and other financial statement users. Any time substantial changes are made that could affect financial statements, it’s an important to notify all your financial statement users to make sure they all are aware of the changes that will be made. For this particular accounting alternative, it may be helpful to consider which entities may need to be combined in the financial statements to meet the needs of all of your financial statement users.
For more information about the VIE accounting alternative, please contact us.
Published on July 30, 2019