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.