Leases – Part Five

Five Areas Where It’s Easy to Stump Your Toe

ASC 842 is in full swing now. Most private companies and CPA firms have been in the weeds for some time. It would be an understatement to say the standard is massive and not entirely transparent. Because ASC 842 is principle-based and yet very specific in certain areas, it’s far too easy to make implementation errors. In no particular order, here are my top five areas prone to mistakes.

  1. Misunderstanding the Effective Date for Interim Financial Statements. The effective date for private companies and private not-for-profit entities is fiscal years beginning after December 15, 2021. This includes all annual financial statements with dates that begin in 2022. However, it does not include interim periods that begin in 2022. For example, a company that prepares interim financial statements for May 1, 2022, through October 31, 2022, would account for leases under ASC 840 unless the company implements ASC 842 early. This is because the FASB set the effective date for interim financial statements for a year later, i.e., interim periods beginning after December 15, 2022.

  2. Not Giving Sufficient Thought to Elections. The standard is replete with various elections that can significantly affect the complexity and results of lease accounting. These elections include:
    • Short-term lease. This is a very beneficial election made at the class level to not apply the lease standard to leases of twelve months or less.
    • Nonlease components. This is an election, made at the class level, to combine lease and non-lease components as a single lease component. This election can significantly reduce the complexity of accounting but may increase the lease liability.
    • Discount rate. This is an election, made at the class level, to use the risk-free rate to measure the lease liability. This election reduces complexity but will generally increase the lease liability.
    • Classification Criteria. One classification criterion is determining if the lease term is a major part of the underlying asset’s economic life. A policy election may be made to define major part as 75%. Another classification criterion is determining if the lease payments’ present value is substantially all of the fair value of the underlying asset. An election can be made to define substantially all as 90%.

      These elections bring back the bright-line rules under ASC 840. The good thing about these elections is that they provide a bright line. But the bad thing about these elections is that the decision is made using bright lines instead of professional judgment.

    • Transition Package Election. Transition relief must be elected as a package that streamlines and simplifies the transition of leases under the old standard to ASC 842.

  3. Embedded Leases. Are you familiar with the Shakespearian expression “beware the Ides of March”? Well, beware of embedded leases. They can hide in service contracts, subcontracts, and who knows where? Even though not described as such, they are leases in sheep’s clothing that must be carved out and accounted for as leases under ASC 842. Think in terms of significant underlying assets, like cranes and scaffolding.

  4. Reasonably Certain. What is reasonably certain? This one is hard to tie up into a nice pretty bow. Even though the concept of reasonably certain is critical under the standard, it is not defined in ASC 842.

    In which areas does the concept of reasonably certain become important?

    • Options to extend the lease term
    • Options to purchase the underlying asset
    • Options to terminate the lease
    • Lease classification (finance or operating)
    • Short-term lease election
    • Lease liabilities measurement
    • Lease ROU asset measurement

    As can be seen, the concept impacts several essential areas. Even though important, there are no bright lines. Some commentators have suggested that reasonably certain is 75% or better certainty. Others have suggested that it is “almost certain.” One thing is certain, though. The certainty rests in the minds of the company’s decision-makers. It will take sound professional judgment to ascertain the degree of reasonableness.

  5. ROU Asset Life. It’s far too easy to stump your toe in this area and, therefore, really mess up the ROU amortization. The ROU asset life is usually the same as the lease term. “ROU asset life equals the lease term” can become automatic to us. After all, this is lease accounting. However, suppose you have a finance lease that transfers ownership or is almost certain to transfer ownership of the underlying asset to the lessee. In that case, the ROU asset’s life is the useful life of the underlying asset (not the lease term.)

    ASC 842-20-35-8 states the following:

    A lessee shall amortize the right-of-use asset from the commencement date to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term. However, if the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, the lessee shall amortize the right-of-use asset to the end of the useful life of the underlying asset.

Leases – Part Four

Common Control Lease Arrangements – Give Me a Break?

On November 30, 2022, the FASB issued, for public comment, Exposure Draft 2022-ED500 Leases (Topic 842)-Common Control Arrangements (Update). The Update proposes significant changes to common control arrangements (leases between related party entities) in two areas:

Issue 1. Determining if a related party lease between entities under common control exists and, if so, the classification and accounting for that lease, and

Issue 2. Lessee accounting for leasehold improvements associated with leases between parties under common control.

The proposed amendment to Issue 1 above would be available as a practical expedient for private companies and most not-for-profit entities. The proposed changes to Issue 2 above would be open to all entities (public, private, and not-for-profit.)

Comments are due January 16, 2023. Based on the AICPA’s discussions with the FASB staff, the Board will attempt to promptly issue a final ASU after considering public comment.

Will it be effective for private companies implementing ASC 842 in 2022? Maybe. However, in the exposure draft, the Board decided it would establish the effective date of the final amendment after receiving comments. If the exposure draft is issued as written, it will provide improved clarity and simplification to the determination, classification, and accounting for related party entity leases. Additionally, it will more faithfully represent the economic realities of leasehold improvement for related party leases between entities under common control.

Related Party Arrangements. Under ASC 842, companies are to determine if a related party arrangement is a lease and, if so, classify and account for the lease based on legally enforceable terms and conditions. However, what is legally enforceable between related parties under common control can be complex. Often, related party entities are owned by the same individual or group of individuals; thus, determining legally enforceable terms is ambiguous at best. In addition, there are often roadblocks in obtaining a meaningful legal opinion on a hypothetical with such a potentially fluid fact pattern.

This determination is often complicated by the existence of substantial leasehold improvements to the underlying lease asset made and owned by the related party lessee. ASC 842 generally requires leasehold improvements to be amortized over the shorter of the remaining lease term or the useful life of the leasehold improvements. This approach often does not recognize the economic realities between related parties under common control and may distort the presentation of operations.

But the Update appears to provide some much-needed relief. Here’s what it proposes.

Issue 1: Terms and Conditions to be Considered. A practical expedient is provided whereby the written terms and conditions of a common control arrangement (in contrast to the legally enforceable terms and conditions provision found in ASC 842) are used to determine the following:

  1. Whether a lease exists and, if so,
  2. The classification of and accounting for that lease.

Under the practical expediency, the Company would not be required to determine if the written terms are legally enforceable. Additionally, the practical expediency may be applied on an arrangement-by-arrangement basis. However, the practical expedient is not available if there are no written terms and conditions (i.e., no written contract). In such a case, the Company must continue using legally enforceable terms and conditions to apply the provisions in ASC 842.

Importantly, the Update permits the Company to document any existing unwritten terms and conditions of an arrangement between entities under common control before the date on which the Company’s first interim or annual financial statements are available to be issued in accordance with the amendments of the proposed Update.

Issue 2: Accounting for Leasehold Improvements. The Update would require the following for leasehold improvements associated with related party leases between entities under common control:

  1. Leasehold improvements should be amortized by the lessee over the economic life of the leasehold improvements (regardless of the lease term) as long as the lessee controls the underlying asset under a lease agreement.

    However, if the lessor obtained the right to control the underlying asset through a lease with an entity not part of the same controlled group, the amortization period may not exceed the lease term of the lessor’s unrelated party lease.

  2. Leasehold improvements should be accounted for as a transfer between related parties via an adjustment to equity when the lessee no longer controls the use of the underlying asset.

This is a significant change. As stated above, ASC 842 generally requires that leasehold improvements be amortized over the shorter of the remaining lease term or the useful life of the improvements. If the related party lease is classified as a short-term lease, the lessee’s operations could be punished because of misleading rapid amortization. Under the Update, generally, the amortization period would be the economic life of the leasehold improvements with respect to the related party group. This would be a significant and much-needed amendment to ASC 842.

Stay tuned. We’ll see what the FASB decides to do. And if the Board acts quickly enough, whether it will be applicable to unissued 2022 financial statements.

Leases – Part Three

Lease Accounting is No Cake-Walk

I remember when the Financial Accounting Standards Board issued FAS No. 13, Accounting for Leases, in November 1976. I was tasked with outlining the standard for the firm where I worked. Now, here it is in November, some 46 years later, and I’m looking at the latest rendition of the lease standard—ASC 842. When comparing the two, FAS 13 was much kinder and gentler than ASC 842, even though FAS 13 did not seem that way at the time. Under FAS 13, there were bright lines, and the accounting was more straightforward. For example, operating leases were not capitalized nor depreciated. On the other hand, capital leases, as the name implies, were capitalized and depreciated; thus, you could account for them in much the same way as you did with property, plant, and equipment.

However, ASC 842 requires capitalization of all leases on the balance sheet, both operating and finance leases. That is, unless you choose to make the short-term lease election not to capitalize a lease with a term of twelve months or less. Additionally, after the initial recording of the right-to-use asset and lease liability, ASC 842 requires different accounting for operating and finance leases on the income statement. This is because the FASB conceptually views finance leases more akin to property, plant, and equipment. But it considers operating leases conceptually more like the old FAS 13 operating leases and, therefore, affords them treatment on the income statement similar to that found in FAS 13.

This article will describe a few complex areas of ASC 842 for the lessee as a heads-up to those who have not yet made the deep dive into the (semi) new accounting standard. And by the way, if you are not up to speed on ASC 842 yet, it might be wise to set aside some time over the holidays to become more familiar with its oddities. It isn’t easy to wrap your head around it because leases are structured in countless ways. While the standard is principle-based to accommodate the many variations in lease agreements, it is also very specific in numerous areas to facilitate consistency in practice. And some of it may seem counter-intuitive.

The Components of a Lease Contract. A lease contract may specify payments for more types of components than just a lease component. Identifying each component of a lease contract is essential because each component type is to receive an allocation of the contract consideration, which is accounted for under different sections of the ASC.

A lease contract can have three broad components:

  1. Lease component
  2. Non-lease component
  3. Non-components

A good or service must be transferred to the lessee or customer to be considered a contract component. This is important because consideration in the contract is only allocated to components that transfer a good or service. Contract components are the first two identified above (i.e., lease component and non-lease component).

If the transfer of goods or services relates to an asset used in a leasing arrangement, it is considered a lease component subject to the rules of ASC 842. This includes leases for:

  • Real property (building and land)
  • Vehicles
  • Construction equipment
  • Copiers, etc.

All other payments for goods and services transferred in the contract are non-lease components accounted for under other GAAP (e.g., ASC 606 Revenue Recognition). This would include payments for:

  • Common area maintenance services
  • Management fees
  • Security services
  • Repairs and maintenance of the leased asset

Payments in the contract that are not for the transfer of goods and services are considered non-components. This would include the following:

  • Reimbursements of insurance and property taxes to the lessor or third party for the benefit of the lessor.
  • Administrative tasks to initiate the lease.

As stated above, contract consideration (see ASC 842-10-30-5 and ASC 842-10-15-35) is only allocated to lease and non-lease components. Notice that contract consideration is not assigned to non-components of the contract. This allocation can be a difficult and time-consuming process. However, the standard provides a way to simplify the accounting via an election to combine lease and non-lease components and treat all payments as lease payments.

The Consideration in a Contract. So what is consideration in a lease contract? Under ASC 842-10-30-5 – Consideration in the contract at the commencement date includes:

  • Fixed payments, including in substance fixed payments, less any lease incentives paid or payable
  • Variable lease payments that depend on an index or rate, initially measured using the index or rate at the commencement date
  • The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise the option
  • Payments for penalties for terminating the lease
  • Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction
  • Amounts probable of being owed by the lessee under residual value guarantees

Additionally, ASC 842-10-15-35 specifies that consideration in a contract includes all payments described above in paragraph 842-10-30-5 as well as the following payments made during the lease term:

  • Any fixed payments or in substance fixed payments, less any incentives paid or payable
  • Any other variable payments that depend on an index or a rate, initially measured using the index or rate at the commencement date.

Notice that consideration in a contract can include payments for lease components, non-lease components, and non-components if it meets the criteria stated above. For example, fixed payments for lease components, non-lease components, and non-components would all be included as consideration in a contract. However, the contract consideration would only be allocated to the lease and non-lease components unless the election not to allocate is made. In such a case, all the fixed payments mentioned would be considered lease component payments.

The Underlying Land in a Building Lease. Building leases are somewhat problematic. Should the underlying land be considered a separate lease? The answer is “maybe yes and maybe no—it ain’t necessarily so.”

The initial question is whether the underlying land can even be considered a lease. ASC 842-10-15-3 defines a lease as follows:

A contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.

So the overriding question is whether the lessee has the right to control the use of the underlying land. A follow-up question is, does the lessee have the right to control all or a substantial portion of the use of the building? If so, it would seem that the lessee also has the right to control the use of the underlying land. This right to control the use of identified property (land) determines that the contract contains a land lease. So how much control is “substantial”? It’s a matter of judgment, but many commentators think the ability to control 90% or more of the economic benefits of the building is substantial control that enables the lessee to control 100% of the underlying land.

Once control of the underlying land is established and considered a separate lease component, should part of the consideration in the contract be allocated to the land lease? ASC 842-10-15-29 states that:

…an entity shall account for the right to use land as a separate lease component unless the accounting effect of doing so would be insignificant (for example, separating the land element would have no effect on lease classification of any lease component or the amount recognized for the land component would be insignificant.)

Therefore, land should be considered a separate component and be allocated a portion of the consideration in the contract unless doing so would be insignificant.

A Viable GAAP Alternative?

And in This Corner – FRF for SMEs

FRF for SMEs stands for Financial Reporting Framework for Small and Medium-Sized Entities. It’s a non-authoritative, non-GAAP, special-purpose accounting framework developed by the AICPA almost a decade ago. It stands in contrast to U.S. GAAP (“GAAP”) and other special-purpose frameworks, such as the income tax and cash basis of accounting, which have been used for many decades.

The most appealing feature of FRF for SMEs is that it has much of the traditional look and feel of GAAP but without some more complex areas.

As promoted by the AICPA, FRF for SMEs was developed for small to medium-sized entities that require reliable non-GAAP financial statements for both internal and external purposes. A good fit, according to the AICPA, would include for-profit entities that:

  • Are closely held;
  • Don’t have regulatory reporting requirements that would require the use of GAAP;
  • Have no intention of going public;
  • Have management and owners that rely on financial statements to manage their business;
  • Don’t operate in an industry requiring highly specialized accounting guidance, like banking;
  • Don’t engage in complicated transactions;
  • And do not have significant foreign operations.

As stated above, FRF for SMEs’ calling card is that it has much of GAAP that is familiar while excluding more complicated areas that may not significantly enhance the usefulness of the financial statements. For example, as explained by the AICPA, under the FRF for SMEs framework, there are:

  • No other comprehensive income
  • No VIEs
  • No complicated accounting for stock compensation and derivatives
  • No hedge accounting

Additionally:

  • Disclosures are targeted and not excessive.
  • Goodwill amortization is consistent with federal tax, with no impairment testing.
  • All intangible assets are considered to have a finite life and amortized.
  • It leans toward historical cost and away from the complications of fair value accounting. There are only limited market value measurements.
  • There’s no impairment of long-lived assets.
  • It’s a policy decision to either consolidate subsidiaries (with subsidiaries defined as greater than 50% ownership) or use the equity method for such subsidiaries.
  • ASC 606 principles are not recognized for revenue recognition.
  • ASC 842 principles are not recognized for lease accounting.
  • In short, the AICPA intends that the framework have a look and feel of GAAP but, for clarity, be simplified and void of many complex and less informative areas found in GAAP.

Another benefit of FRF for SMEs is that even though it is not GAAP, it looks and feels more like GAAP than other special-purpose frameworks. And in many areas of the financial statements, the results are the same.

But there is a big caveat. Decision makers interested in switching from GAAP to FRF for SMEs should consider whether it will be acceptable to their end users of the financial statements. Many bankers, for example, may not be familiar with or even heard of FRF for SMEs. This, of course, would be a significant impediment to making such a change. Also, the impact on loan covenants must be considered. Many loan agreements require financial statements prepared under GAAP.

For those interested in exploring this more, the AICPA has placed extensive tools on its website.

Leases – Part Two

Other Things That Make You Go Hmmm

Well, it’s here for private companies. Welcome to the universe of ASC 842. The lease standard is massive and, being a principle-based standard, leaves a lot of GAAP in gray areas. Yet, the standard is also specific, especially regarding disclosure. This blog, directed at the lessee’s accounting, is a follow-up to our May 2021 blog on leases and will focus on a few of the areas of ASC 842 that have given us some — shall we say, pause.

First Things First. Before we dive into the deep gray, let’s briefly review some of the core tenants of ASC 842 as it applies to the lessee.

  • To be a lease contract, it must have two elements:
    1. There must be an identified asset, and
    2. The lessee must have a right to control the use of the asset for a period of time.
  • All leases should be accounted for under the right-of-use (“ROU”) model. This model requires the recognition of lease right-of-use assets and lease liabilities.
  • Leases with a maximum possible lease term of twelve months or less may be exempted from the right-of-use model. This exemption is a policy election.
  • There are two types of leases:
    1. Finance lease and
    2. Operating lease.
  • Both types of leases are capitalized on the balance sheet. If a lease doesn’t meet the finance lease criteria, it is accounted for as an operating lease.
  • At the implementation date, there is no grandfathering of pre-existing active leases. Accordingly, the old capital or operating leases must be capitalized on the implementation date, under ASC 842, as finance or operating leases.

Materiality. Of course, the professional decision of what is not material to financial statement presentation is not a new concept under ASC 842. However, materiality is of utmost importance under the lease standard because the standard places a heavy burden on companies performing calculations to capitalize the leases, in addition to the future effort required to account for leases to completion. Because of this burden, care must be taken not to spend precious time capitalizing immaterial leases.

So what is immaterial? Initially, the company should have a reasonable lease capitalization policy stating a threshold under which all leases will automatically be considered immaterial and, therefore, not capitalize.

Beyond the company’s capitalization policy, the overall materiality of the potential ROU assets and lease liabilities to the financial statements should be considered. While materiality is both a quantitative and qualitative assessment, in the end, the qualitative evaluation carries the most weight. For example, if capitalizing a lease liability causes the company to violate a financial loan covenant, then that lease is material to the financial statements, notwithstanding the quantitative analysis.

Reasonably Certain. The term “reasonably certain” is not defined in ASC 842. However, even though not defined, it is a critical term. The reasonably certain threshold plays a sizable part in determining the:

  • Lease term;.
  • Lease classification (finance or operating lease);
  • Amount of lease payments;
  • Amount of ROU assets; and
  • Amount of lease liabilities.

Even though the concept of reasonably certain is important, there are no bright lines. Some commentators have suggested that reasonably certain is 75% or better certainty. Others have suggested that it is “almost certain.” One thing is certain, though. The certainty rests in the minds of the company’s decision-makers. It will take sound professional judgment to ascertain the degree of reasonableness.

Related Party Transactions. Under prior GAAP (ASC 840), the economic substance of the lease agreement determined how related party leases were classified. This, in turn, determined lease accounting. New GAAP changed things. Under ASC 842, leases between related parties are classified and accounted for based on legally enforceable terms. In short, lease accounting for leases between related parties is the same as accounting for leases between unrelated parties.

It sounds straightforward. But it’s not. Consider the following example:

The company(lessee) has three unrelated stockholders. One stockholder holds 60% of the stock. The minority stockholders each hold 20%. The company leases its operating facilities from an LLC lessor that is owned 100% by the majority stockholder of the lessee company. The company made substantial leasehold improvements with a fifteen-year useful life. The lease is month-to-month (unwritten). Questions: What is the lease term? What would be legally enforceable?

This type of lease arrangement, or similar, may put accountants in a dilemma. The majority owner of the lessee company, because he understandably wants to keep the lease obligation off the company’s separate(unconsolidated) financial statements, tells you that it’s a month-to-month lease. No doubt about it. It is not a long-term lease. The unwritten monthly options to renew will not extend longer than one year. After all, “reasonably certain” is in the mind of management — right?. However, the short-term lease status doesn’t make sense for several reasons. But primarily, it does not make sense because the substantial leasehold improvements, with a fifteen-year life, reflect an obvious intent to lease the operating facilities long-term.

It may be necessary to remind the majority owner, in very carefully chosen non-technical words, of course, that GAAP generally requires the leasehold improvements to be amortized over the lease term. So in this example, the improvements would be written off over twelve months. Ouch!

ASC 842-20-35-12 states the following:

Leasehold improvements shall be amortized over the shorter of the useful life of those leasehold improvements and the remaining lease term, unless the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, in which case the lessee shall amortize the leasehold improvements to the end of their useful life.

In the above example, the underlying asset (building) will not be transferred to or purchased by the company. This would not be to the advantage of the majority stockholder. Accordingly, the leasehold improvements must be amortized over the shorter of the lease term (twelve months or less) or the useful life of the building. The lease term is obviously shorter. This may cause the majority owner of the company to reconsider the lease term.

Communication With The Predecessor Auditor

We Are Required To Talk With Each Other

It happens. From time to time, company management will decide to replace their current auditor. It can be for good reasons, wrong reasons, or no real reason at all. The predecessor auditor may be a repository of information that may be important to a potential successor auditor. Therefore, auditing standards require that before a new auditor can accept the engagement, they must inquire about certain matters of the predecessor auditor.

In June 2022, the Auditing Standards Board of the AICPA issued Statement on Auditing Standards 147, Inquiries of the Predecessor Auditor Regarding Fraud and Noncompliance With Laws and Regulations. SAS 147 amends AICPA, Professional Standards, AU-C Sec. 210 – Terms of Engagement. The amendments to AU-C Sec. 210 are effective for audits of financial statements for periods beginning on or after June 30, 2023.

SAS 147 provides guidance regarding auditor inquiries made of a predecessor auditor about matters that will help the auditor decide whether or not to accept the engagement. These inquiries may be either written or oral. SAS 147 adds more teeth to the inquiry and requires the predecessor auditor to respond. These auditor inquiries must be made after management authorizes the predecessor auditor to respond to such inquiries. Below is a snapshot of what the auditor must do before accepting an engagement for an initial audit when a predecessor auditor exists. And what the predecessor auditor must do.

  • The auditor should request management to authorize the predecessor auditor to respond fully to the inquiries.
  • The auditor should inquire about the following of the predecessor auditor:
    1. Fraud or suspected fraud involving management, employees with significant internal control roles, or others when fraud resulted in a material misstatement of the financial statements.
    2. Matters involving noncompliance or suspected noncompliance with laws and regulations.
  • The predecessor auditor must timely respond to the auditor (absent unusual circumstances and unless prohibited by law.) If the predecessor auditor decides not to respond fully, they must clearly state that the response is limited. The important thing here is that they must respond under the revised standard. The standard states that limited responses are expected to be rare.
  • The auditor should evaluate the response (or limited or no response) to determine if they will accept the new engagement.
  • If the engagement is accepted, the auditor should document:
    1. The inquiries of the predecessor auditor, and
    2. Results of those inquiries.

Additionally, the auditor may choose to inquire about the following:

  • Integrity of management
  • Disagreement with management about accounting policies, auditing procedures, or similar significant matters
  • Significant deficiencies and material weaknesses in internal control communicated to management and those charged with governance
  • The predecessor auditor’s understanding of the reason for the change in auditors
  • The predecessor auditor’s understanding of the company’s relationships and transactions with related parties and significant unusual transactions.

Information Technology

A Strange Bed-Fellow Indeed

I recall the first day of my public accounting career. Right out of college and eager. When I walked through the office door on the 19th floor that cold January morning, I was immediately issued an Addo-x adding machine. What a jewel it was. It was huge. It had to be made from cast iron and weighed enough to earn the nickname TwoTon Tessie from Tennessee. That thing was lugged around to clients in a banged-up dull black carrying case that was impregnable –designed to carry a small nuclear arsenal. And what an arsenal it was. It could perform two functions- add and subtract. That was it. (Well, it could perform multiplication. But it just took too long to use that clunky function.)

There were smaller machines in the office of a different brand, but they were reserved for those with more experience than me. But still, they could only add and subtract. However, there was one machine, a recent purchase, which could actually perform multiplication and division. Large as it was, it was a for-real calculator. It must have cost a small fortune. So remarkable was this new technology that it merited a special cart with casters—more akin to a mobile throne. If you need it, you would have to locate it and then roll it down to your office. It was a delight to use. Eventually, it migrated to the managing partner’s office, where it remained. And that was quite a shame because he never used it.

The managing partner was very savvy. The accounting practice bore his name. Everyone else, including the other partners, were his associates. He had an eye for recognizing crucial new technology. The kind of technology that would become a game-changer. Now, understand that he didn’t intend to use the technology himself, but he saw the value of his associates doing so.

However, occasionally, he would miss one. He misjudged the importance of the facsimile machine. He resisted acquiring one for the longest time because he felt that clients would become more demanding. “If you have a fax machine,” he would say, “clients will expect you to stop what you are doing and send it to them right then.” Of course, he was right about that. Finally, a client shamed him into buying one.

But he was spot-on about one bit of technology — the personal computer. When IBM premiered its first PC, the office bought one. He placed it in a vacant office and said it was up to us. “Learn to use it if you want to. But if you don’t, it will eat your lunch.”

It was an odd and scary machine. No hard drive. It had a 5.25 floppy drive. It gave you this bewildering “A>.” OK. What do you do next? And what the heck is DOS, and how do you pronounce it?

Information Technology is a Strange Bedfellow

Information technology is much like that weird college buddy who asks to spend a few days with you but doesn’t move out. Not only does he not move out, he also takes over the entire house. Information technology can be your friend but also drive you up the wall screaming for mercy. And IT is replete with odd names and nicknames, like cross-platform, cloud computing, big data, C-prompt, disaster recovery, virtualization, and, worst of all, blog—what a disgusting word.

Disruptive Technology

IT can be very disruptive. It changes the old way of doing things. Thinking back over the years, here are just a few examples of IT disrupting established business practices at firms I worked for many years ago.

Spreadsheets. I wonder how many folks practicing accounting today remember the thirteen-column spreadsheet? Probably some. But I bet many don’t. Before there was Excel, before there was Lotus 1-2-3, before there was Quattro, and yes, before there was Apple’s VisiCalc, there was the thirteen-column pad. A must-have tool of the trade.

I never understood why thirteen columns instead of twelve or fifteen. But the thirteen-column spreadsheet was very versatile and could quickly become a twenty-six-column spreadsheet with a bit of scotch tape. Nevertheless, the thirteen-column pad was used to prepare such work papers as depreciation and percentage-of-completion job schedules.

Electronic spreadsheets changed everything for accountants. Now number-crunching wasn’t quite as laborious. It reduced many careless errors often replete in a manual spreadsheet and was much faster at making corrections and running proforma calculations.

However, there was a learning curve with electronic spreadsheet applications. Some found it to be steep. A few accountants, fond of the old ways, would boast that they had their thirteen-column pad “booted up and running” long before you and your fancy spreadsheet program could say boo. And if you ever found yourself looking at the dreaded blue screen of death, you might catch a smug look out of the corner of your eye.

Tax Preparation. Preparing tax returns by hand, for the most part, had ended shortly before my career began. But not by much. Some in the office delighted in telling agonizing war stories of manual income tax preparation. But when I arrived, the firm used a couple of third-party computerized (mainframe—remember COBAL) tax processing services.

For individual tax returns, the tax information was hand-written on form sheets, picked up by the tax service at the end of the day, processed overnight, and returned the next morning. Then, upon review, invariably, errors were found. So, the process began again – picked up, processed overnight, and returned the next day. And yes. Sometimes it took a third cycle to get it right.

The business income tax return process was similar. Except the forms were shipped out of state. It took even longer.

Then came a better idea. Tax software was installed on the secretary’s PC. So now, the accountants would complete the form sheets and hand them to the secretary to input immediately. Nice.

But then came the game-changer. Someone suggested that a network be installed. Wow! Accountants could directly key the data into the tax program and receive immediate feedback, make corrections, and you’re done. But most accountants back then were men, and few of us had ever taken a typing class. That was a disruption.

Fixed Asset Accounting. As mentioned above, when I came on the scene, we did fixed asset accounting on a thirteen-column pad. As a result, it was slow and error-prone. In addition, it was a royal pain.

Electronic spreadsheets, such as Lotus 1-2-3 and Excel, helped considerably, but the methodology, mechanics, and sheet layout did not change. The format was the same as that used with the thirteen-column pad. As a result, updating the spreadsheet for statutory changes in MACRS percentage, property additions, and dispositions was still cumbersome. Therefore, the electronic format remained very error-prone. Mistakes were common, such as taking more depreciation than the asset’s cost basis and significant errors in depreciation calculations.

The game-changer, however, was applications explicitly written for fixed asset management. So now we were getting somewhere. Enter the data correctly once, and done. And you could easily slice and dice the data in several ways. However, it did have a learning curve.

Why Does New Technology Face Resistance?

Here are some of the reasons end-users resist new technology.

  1. IT is disruptive. Period! By its very nature, it disrupts the status quo. And guess what—some people do not like change of any kind. So perhaps it’s human nature combined with bad past experiences that cause a significant degree of apprehension.

    For years, I lugged around heavy briefcases full of work papers. For some clients, it was literally suitcases jammed full of stuff. And this was because of the fear of saving client work papers on an invisible network.

  2. Setup. IT can be disruptive and thus resisted by some because of an improper setup. Therefore, the company must carefully consider the user-specific design and be mindful of how people work.

    The customization of the application to address the company’s needs takes time. As a result, it is easy for some to jump to inaccurate conclusions about the software during the company’s developmental stage.

  3. Lack of Training. IT can face resistance because the company did not invest in adequate training. Without training, the IT project goes into a tailspin. And rightfully so. The people must be trained to use the application efficiently and adequately.
  4. Lack of Management Support. IT is resisted if it lacks management’s full support. Without the communicated support of management, end-users will not see the importance. Therefore, they will quietly continue doing things the same way.

  5. It Does Not Mirror. IT is resisted because it will never be able to replicate exactly what the people were doing before the new application—a favorite report, the links, the arrangement, the nomenclature–you name it.

    I’ve heard this so many times from clients. “Before the company installed that software, I was able to get a TPS report. But the new system doesn’t have it.”

    Nevertheless, new software often has the desired report or feature, especially if it’s business-critical. But it’s called under a different name, located in another section, arranged in an unfamiliar format, or available by selecting specific options.

  6. A Bad Fit or Bad Software. It could be the software is a bad fit for the company. Or perhaps the software itself is poorly designed by the developer. It’s clunky. It freezes up. It’s not intuitive. It happens, and it’s an expensive error. However, once that is determined, it’s best to cut your losses as quickly as possible and proceed in another direction.

Private Company Policy Election Not to Consolidate Variable Interest Entities

The Opt-Out Trap and the Way Around It

Last month’s blog took a look at the use of proportional consolidation in the construction industry. This month, I thought we would continue the consolidation theme by examining the topic as it relates to variable interest entities.

For two decades now, the consolidation of variable interest entity (“VIE”) has been a bane for private companies. Its application is complex, and its usefulness to the end users may be questionable.

So how did the requirement to consolidate an entity that is not majority-owned come about anyway?

Origin of Variable Interest Entity Consolidation

Those who have been practicing accounting for a couple of decades or more may recall the origin of VIE accounting in the United States. The compelling reason that demanded VIE consolidation can be traced directly to the Enron Corporation scandal. Enron’s underlying business practices resulted in its bankruptcy and the collapse of its accounting firm, Arthur Andersen, LLP, considered by some at the time to be the premier public accounting and consulting firm in the world.

Enron was a gigantic public energy company, whose business morphed into one that traded energy derivatives and various other commodities and risk protection contracts. Its approach to business emphasized aggressive trading and risk-taking. Its profits were enormous during its early years, but profits began to shrink when the boom years declined at the end of the 20th century. Some of its operations began to struggle. To address this potential hit to earnings and improve its attractiveness in the credit market, the company became a party to so-called special purpose entities (“SPEs”). Under these arrangements, the company’s troubled operations and debt would be transferred to SPEs and not reported in the company’s financial statements. The accounting rules that permitted this non-consolidation, if strictly followed, were GAAP at that time.

This lack of transparency through the use of SPEs came under intense public criticism after Enron’s seemingly overnight collapse and bankruptcy in late 2001. As part of the fallout from Enron’s bankruptcy, Arthur Andersen was convicted of obstruction of justice for its alleged actions related to the Enron audits. This conviction, by the way, was later overturned on appeal to the U.S. Supreme Court. However, the earlier conviction resulted in Arthur Andersen notifying the SEC it would cease auditing public companies, which led to its demise.

The Accounting Profession’s Response

Under intense Congressional pressure after Enron and other high-profile accounting-related business failures, the accounting profession issued a standard regarding the consolidation of VIEs in the reporting entity’s financial statements. (VIE subject matter included but was broader than SPEs.) As a result, the FASB issued Interpretation No. 46(R), Consolidation of Variable Interest Entities-An Interpretation of ARB No.51 (“FIN 46R”) in December 2003.

FIN 46(R) clarified that, in general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. The interpretation also provides that the company considered the primary beneficiary of the VIE’s activities would consolidate the VIE.

FIN 46(R) had numerous twists, turns, and difficult-to-understand provisions, resulting in many ambiguities. In addition, the interpretation applied to both public and non-public companies.

First Attempt to Provide Relief to Private Entities.

In 2014, the FASB issued Accounting Standards Update 2014-07, Consolidated (Topic 810): Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements (“ASU 2014-07”). This ASU permitted narrowly defined relief to private entities. ASU 2014-07 provided that non-public companies under common control, who were in a lessor/lessee business relationship, could elect not to consolidate if specific criteria were met.

Not consolidating in situations where the lessor was the VIE and the lessee was the primary beneficiary was considered acceptable because many users of the financial statements felt that unconsolidated financial statements were more meaningful to them. Therefore, if consolidated financial statements were prepared, those users found it necessary to de-consolidate the VIEs from the reporting entity to arrive at the information needed for their analysis.

Current Relief for Private Entities

In 2018, ASU 2014-07 was superseded, and the scope was broadened by ASU 2018-17, Consolidation (Topic 810): Targeted Improvements to Related Party Guidance for Variable Interest Entities. As a result, ASU 2018-17 not only applies to leasing situations but also to other business arrangements, provided the following criteria are met:

  • The reporting entity and the legal entity (VIE) are under common control.
  • The reporting entity and the legal entity (VIE) are not under common control of a public company.
  • The legal entity (VIE) under common control is not a public company.
  • The reporting entity does not directly or indirectly have a controlling financial interest in the legal entity (VIE.)

If the above criteria are met, the reporting entity may elect not to consolidate the related legal entities.

The accounting alternative provided under ASU 2018-17 is an accounting policy election. Accordingly, companies that elect not to consolidate under ASU 2018-17 must apply the provisions of ASU 2018-17 to all current and future legal entities (VIEs) under common control that meet the above criteria.

When Can the Election Under ASU 2018-17 Become a Problem?

The election to not consolidate a VIE under ASU 2018-17 means you cannot pick and choose the VIEs not to consolidate. It’s an election for now and future reporting periods to not consolidate any related entities that meet the criteria of ASU 2018-17. Remember the consistency principle?

When can this be a problem? Consider the following example.

The reporting entity makes a policy election under ASU 2018-17 to not consolidate a related entity that is the lessor of the reporting entity’s office building and warehouse. This election applies to current and future reporting periods and to any VIE scenario that meets the criteria under ASU 2018-17.

In a subsequent year, the owners of the reporting entity organize a separate legal entity that is germane to its operations. The new legal entity is a VIE for which the reporting entity is the primary beneficiary and meets the criteria under ASU 2018-17. However, because of the reporting entity’s prior election under ASU 2018-17, it is not permitted to consolidate the VIE.

Additionally, the new legal entity is named in the reporting entity’s modified debt facility and permitted to draw on the reporting entity’s line of credit. Accordingly, the modified debt facility has a provision that requires the reporting entity to include the assets, liabilities, and operations of the new legal entity in its financial statements.

What can be done?

Combined Financial Statements

Combined financial statements provide a workable solution.

But, is a combined presentation permitted when the reporting entity elects under ASU 2018-17 not to consolidate a VIE for which it is the primary beneficiary? We believe the answer is yes, for the following reasons.

In the “Basis for Conclusion” section of ASU 2018-17, BC23, the Board “… acknowledged that a reporting entity has the option to combine entities under common control … particularly in situations in which users wish to see the combined results of the reporting entity and another legal entity under common control.”

Additionally, AICPA Technical Questions and Answers provides some nonauthoritative guidance.

The inquiry found at Q&A Section 1400.29 was “…if a reporting entity is the primary beneficiary of a variable interest entity (VIE), would it be appropriate to issue combined financial statements rather than consolidated financial statements?”

The reply was “No. FASB ASC 810 acknowledges that combined financial statements may be permitted in certain situations in which consolidated financial statements are not required.”

In our example described above, consolidated financial statements are not required. In fact, they are not permitted under the ASU 2018-17 election. Accordingly, it seems appropriate that “combined financial statements may be permitted” since consolidated financial statements are not required.

Of course, the reporting entity’s financial statements must be identified as combined financial statements, not consolidated.

Joint Venture Proportional Consolidation

The Report of Its Death is Out of Proportion

Construction Joint Ventures

What is a construction joint venture (JV) anyway? And why do construction companies enter into such JVs? And, does US GAAP still permit the investing company the choice to use proportional consolidation, instead of the equity method, to present a construction JVs in its financial statements? This article will attempt to shed some light on these questions.

What is a Construction Joint Venture?

A construction JV is generally a legal entity of limited duration, usually between two construction companies, to join forces to bid, obtain, perform, and complete a single construction project.

Why Does a Construction Company Enter Into Such Arrangements?

These projects are often much larger than those that either construction company customarily performs. Thus, they may mutually agree to join together for the following reasons:

  • The potential contract owner considers the project too significant a risk for just one contractor
  • Each contractor’s aggregate bonding program is too small for the size of the project
  • For each contractor, the size and demands of the project exceed their individual liquidity, working capital, and equity necessary to perform and complete the project timely and successfully
  • One contractor may find a gap in their expertise in a particular project phase and therefore wishes to enlist the second contractor’s resources to supplement his capabilities
  • It permits a contractor who has not performed a project in a particular geographical territory to join forces with a local contractor, and
  • It improves backlog (and hopefully, profitable backlog.)

The JV partners will need the up-front expertise of a lawyer who specializes in construction law. A lawyer who has experience with construction JVs. Here are some of the areas the partners should seek advice:

  • JV Structure. Consideration should be given as to how the JV is structured. There are several ways to structure a construction JV. For example, will it be a line-item JV where each JV partner performs identified line-items of the project, or will it be a more traditional JV where resources (employees, working capital, financing, and equipment) are made available or contributed to the JV to perform the project?
  • Legal Form. What legal form should the JV take? This decision may impact the JV partner’s method of reporting JV assets, liabilities, and activity in their financial statements. (The methods of financial reporting are discussed in the next section.)
  • Governance. What will be the form of the JV governance?
  • Ownership Considerations. What will be the percentage ownership of the JV? If a line-item JV, how will ownership be structured?
  • Profit Allocation. How will the contract profit be split? Will one JV partner have a greater than 50% allocation?
  • Variable Consideration. How will early completion bonuses and shared savings be split? What about project delays and liquidated damages? Who will bear the brunt of this?
  • Subcontractors. Will the JV pay the subcontractors directly, or will it be the JV partners’ responsibility?
  • And the list and the clauses go on and on. Other matters to be discussed and decided include the disposition and handling of contingency funds, bonding, employee non-encroachment agreements, dispute resolutions, and non-compete agreements.

Is Proportional Consolidation Permitted?

In general, US GAAP provides the following methods of accounting for an investment in joint ventures:

  • Cost method. The cost method must be used if the investor cannot exercise significant influence over the financial or operating decisions of the investee unless such ability can be demonstrated. An investment of less than 20% of the voting stock creates the presumption that the investor does not have significant influence.
  • Equity method. The equity method should be used if the investor has significant influence. FASB ASC 323-10-15-8 clarifies that “(a)n investment (direct or indirect) of 20 percent or more of the voting stock of an investee shall lead to a presumption that in the absence of predominant evidence to the contrary an investor can exercise significant influence over an investee.” An investor with 20% to 50% of the voting stock of the investee is considered to have significant influence.
  • Full Consolidation. If it exercises control over the JV, an investor will add 100% of the joint venture’s assets, liabilities, revenue, and expenses to each applicable line of its financial statements. Any non-controlling interest will be backed-out of consolidated equity and net income. This control can take the form of financial investment in the JV greater than 50% or a variable interest structure in which the investor is the primary beneficiary.
  • Proportional Consolidation. If certain conditions under US GAAP are present, proportional consolidation may be used instead of the equity method. However, proportion consolidation cannot be used in place of the cost method or full consolidation. So what is proportional consolidation? Proportional consolidation is where the investor’s proportional share of the JV’s assets and liabilities are added to each applicable line of its own balance sheet. And the investor’s proportional share of the JV’s operations is included in each appropriate line in its income statement. There is a variation of this which we will describe in the last section.

Proportional Consolidation Criteria

Under what situations or criteria is proportional consolidated permitted in place of the one-line equity method?

Generally, proportional consolidation may be used under US GAAP in two situations:

  1. Undivided interest. FASB ASC 810-10-45-14 states, “If the investor-venturer owns an undivided interest in each asset and is proportionately liable for its share of each liability, the provisions of paragraph 323-10-45-1 may not apply in some industries.” (ASC 323-10-45-1 describes the applicability of the equity method.) Therefore, the equity method may not apply when the construction JV is an undivided interest and not a legal entity. In such cases, the venturer may use the proportional consolidation method.
  2. Construction and extractive industries subject to the equity method. FASB ASC 810-10-45-14 further states, “Specifically, a proportionate gross financial statement presentation is not appropriate for an investment in an unincorporated legal entity accounted for by the equity method of accounting unless the investee is in either the construction industry…or an extractive industry.” (Emphasis added.)Therefore, if an investor has a non-controlling interest in a construction unincorporated legal entity that may be accounted for under the equity method, it may elect to use proportional consolidation instead.

It should be noted that a limited liability company (“LLC”) is a separate legal entity. However, it is not incorporated. Therefore, it is subject to proportional consolidation in lieu of the equity method of presentation.

Therefore, an investor in a construction JV may use proportional consolidation if the JV is formed as:

  • An undivided interest
  • General partnership
  • An LLC or limited liability partnership, provided it has governance and economic characteristics more like a partnership than a corporation.

However, if the construction JV is incorporated or an unincorporated entity, such as an LLC, with the governance and economic characteristics like a corporation, then the equity method must be used instead of proportional consolidation. Additionally, all majority-owned subsidiaries in which the parent has a controlling interest must be fully consolidated. Therefore, it is not subject to proportional consolidation.

As can be seen, proportional consolidation is very restrictive under US GAAP. However, its use is established in the construction industry and therefore permitted to continue subject to the restrictions outlined above. (FASB ASC 810-10-45-14.)

Financial Reporting Under Proportional Consolidation

There are two basic approaches to proportional consolidation in practice. Each is acceptable.

  1. The investor company combines its proportional amount of the construction JV’s assets, liabilities, and operations on its balance sheet and income statement on a line-by-line basis. The JV’s construction contract is presented on the contract schedule at 100% on one line, with a reduction on the line below for the amounts that represent the other JV partner’s percentage ownership. The third line will be the net amount representing the reporting JV partner’s percentage ownership.
  2. A hybrid method is also used in practice. The investor company reports its proportional amount of the construction JV’s assets and liabilities using the one-line equity method on the balance sheet and its gross proportional amount of operations on the income statement on a line-by-line basis. Public construction company investors often use this hybrid method.

    The contract schedule presentation will be the same as number 1 above, except the over and underbillings will need adjustment since they are netted into the one-line presentation on the balance sheet.

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