Private manufacturers often set up legal entities to hold real estate or operate separate business ventures. Under current accounting rules, these entities are typically considered variable interest entities (VIEs) that must be consolidated on the controlling entity’s financial statements under current U.S. Generally Accepted Accounting Principles (GAAP).
In one respect, consolidation provides a clear, big-picture view of the overall financial position and operating performance of the commonly controlled and related entities. In another respect, consolidation involves cumbersome accounting to combine what many small business owners feel are very distinct and separate legal entities, the consolidation of which distorts the balance sheet of the primary operating company. Fortunately, an updated accounting standard will soon allow private companies to opt out of the complicated consolidation rules. Here’s what you should know.
Purpose of the VIE guidance
In 2003, the Financial Accounting Standards Board (FASB) issued the VIE guidance in Accounting Standards Codification Topic 810, Consolidation, on the heels of the Enron scandal.
Under the guidance, a business has a controlling financial interest when it has:
- The power to direct the activities that most significantly affect an entity’s economic performance;
- The right to receive significant benefits from the entity; and
- The obligation to absorb its losses.
“Enron figured out a way within the standard [that applied at the time] to create off-balance-sheet structures with financing that was completely guaranteed by the host company but yet was off the balance sheet—and the VIE guidance was written to fix that,” said Billy Atkinson, former chair of the FASB’s Private Company Council.
Private businesses vs. public companies
Private companies found the consolidation rules difficult to interpret and challenging to implement, and they found the results to often be impractical for their needs. They told the FASB that their business relationships are not structured to mislead investors. In fact, many private companies are closely held by family members active in the business. Rather, their choices of separate entities are made primarily for tax and estate planning purposes and to limit legal liability.
Private companies also said that combining subsidiary businesses onto a parent company’s balance sheet was frustrating to them as users of the financial statements and to lenders, who often reversed the effects of consolidation when reviewing the performance of private companies. In addition, in companies where family members share ownership, determining who holds the power is not always clear.
More than leases
In response to these concerns, in March 2014, the FASB issued Accounting Standards Update (ASU) No. 2014-07, Consolidation (Topic 810): Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements. The update allows private companies to disregard the VIE guidance for certain leasing transactions. Private companies; however, told the FASB that problems continued to persist with the consolidation guidance for transactions that did not involve leases.
So, in October 2018, the FASB issued ASU No. 2018-17, Consolidation (Topic 810): Targeted Improvements to Related Party Guidance for Variable Interest Entities. The updated standard supersedes the amendments in ASU No. 2014-07. The new exception applies to all private, common control transactions that meet certain criteria. This update provides private companies the choice, though not the requirement, to ignore the VIE guidance to their common control arrangements in an effort to simplify reporting and reduce costs, without compromising the relevance of the financial reporting information to the users of the financial statements.
A privately owned company that takes advantage of this simplified alternative still must provide footnote disclosures about its involvement with, and exposure to, the legal entity under common control.
Early adoption option
The updated standard goes into effect for fiscal years beginning after December 15, 2020 and interim periods beginning after December 15, 2021. Early adoption is also permitted, and many companies plan to opt out of the consolidation rules before the effective date. Discuss the issues with your certified public accountant, and consider which financial reporting alternative is right for your manufacturing business.