Private company variable interest entity relief

No. US2014-03 July 17, 2014 What s inside: Background... 1 Key provisions... 2 Common control... 3 Lease arrangement... 4 Leasing activities... 4 Sufficient collateral... 5 Examples... 6 Transition from private to public... 7 Removal of implicit variable interest... 8 Disclosure... 8 What s next... 8 Transition and effective date... 8 Private company variable interest entity relief FASB provides option to exempt certain common control leasing arrangements from the VIE model At a glance The FASB issued a new standard in March 2014 to provide private companies relief from the variable interest entity (VIE) model. The new guidance is likely to result in reduced consolidation of lessor entities by lessees. The purpose of the standard was to reverse these consolidations since users indicated the resulting financial statements were not useful. Adoption of the new standard is optional. Private companies that elect to adopt the new standard must meet specific criteria. Those that qualify will likely need to classify and record the lease (as capital or operating) and account for any executory contracts between the lessee and lessor (that had previously been eliminated in consolidation). The standard is effective from the beginning of 2015 for calendar year-end companies and requires full retrospective application. Early adoption is permitted if a company s financial statements have not yet been made available for issuance. Background.1 Many private companies lease properties from sister entities that are under the control of a common parent. These arrangements are required to be analyzed under the VIE consolidation guidance, which often leads to the lessee consolidating the lessor..2 For example, the owner of an operating company also owns a property company. The operating company and property company are under common control. The property company was created to hold the operating company s manufacturing facility. The property company issued third party debt to acquire the facility, and the owner guaranteed the debt. The operating company leases the facility from the property company. The property company s only source of income is lease payments from the operating company which are used to pay down the third party debt..3 Under the VIE model, the operating company (lessee) may have an implicit variable interest in the property company (lessor) if, for example, it (1) has effectively guaranteed the owner s investment in the property company, (2) has historically funded the property company to prevent the owner s guarantee to the lender from being called, and/or (3) has an economic incentive to act as a guarantor to the property company. If the lessee has a variable interest in the property company, then the lessee must often consolidate the property company. This is because the lessee will have power and economics over the property company through its variable interest or because the related party tiebreaker is applied under ASC 810, Consolidation. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 1

.4 Assessing the VIE guidance is often complex and costly to apply. In addition, during their deliberations, the Private Company Council (PCC) and FASB obtained input from users, including lenders, indicating that lessee financial statements that consolidated a lessor legal entity are often not useful. This outreach indicated that lenders often request a consolidating schedule to understand the standalone financial results of the lessee..5 On March 20, 2014, the FASB issued Accounting Standards Update (ASU) No. 2014-07, Applying Variable Interest Entity Guidance to Common Control Leasing Arrangements, which provides private companies an exemption alternative from the VIE consolidation guidance if certain conditions are met. We expect that adoption of this new standard will cause many private companies to deconsolidate lessor entities, provided the qualifying conditions are met. Arrangements that do not meet the conditions will continue to be subject to the VIE guidance. If the new standard is elected and the lease is accounted for as an operating lease, the impact of adoption may be a significant reduction in the lessee s assets and liabilities (i.e., no longer consolidating the assets and liabilities of the VIE). If the lease is accounted for as a capital lease, the impact of adoption may be less significant. Key provisions.6 To be eligible to adopt the new standard, a private company must ensure it does not meet the definition of a public business entity, as defined in ASU 2013-12, Definition of a Public Business Entity. Not-for-profit entities and employee benefit plans are not eligible to apply the new standard. If a private company is contemplating an initial public offering (IPO) in the future, it may wish to forgo adopting this new standard since it would need to unwind the adoption of the standard in its public company financial statements. Gathering and evaluating the information to apply the VIE model after the fact, including accounting for the assets, liabilities and equity after initial consolidation, may be time consuming, costly and challenging. In addition, if a public company investor holds an equity method investment in a private company that elects this alternative, it would need to adjust the private company s financial statements to apply the VIE model before applying the equity method of accounting..7 Under the new standard, a private company could elect to not evaluate a legal entity for consolidation under the VIE guidance if all of the following criteria are met: 1) The private company lessee (the reporting entity) and the lessor legal entity are under common control. 2) The private company lessee has a lease arrangement with the lessor. 3) Substantially all activities between the private company lessee and the lessor are related to leasing activities (including supporting leasing activities) between those two entities. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 2

4) If the private company lessee explicitly guarantees or provides collateral for any obligation of the lessor related to the asset leased by the private company, then the principal amount of the obligation at inception of such guarantee or collateral arrangement does not exceed the value of the asset leased by the private company from the lessor..8 A private company lessee must meet all four criteria in order to apply the accounting alternative. If any arrangements with the lessor legal entity do not meet the four criteria, then the private company cannot adopt the accounting alternative for that lessor legal entity. The last criterion is only applicable if the lessee has explicitly guaranteed or provided collateral for any obligations of the lessor either at inception or at any time during the arrangement..9 The first three criteria need to be reassessed at each reporting date. The last criterion is only required to be assessed at inception of the guarantee or collateral arrangement or when those contracts are amended. If any of the criteria cease to be met, the private company is required to apply the VIE guidance on a prospective basis, as of the date that the arrangement no longer qualifies for the alternative. For example, if the owner sells its shares in the lessor, the common control criterion would not be met and the VIE model would need to be applied from the date the owner sells its shares in the lessor..10 A company that meets the conditions to adopt the new standard would still need to apply the existing voting consolidation guidance in ASC 810. Assuming the lessee has no other interests in the lessor, such as equity in the lessor, the lessee would likely not consolidate the lessor under the voting consolidation guidance. Therefore, the lessee would likely account for its related party lease under the existing leasing guidance in ASC 840, Leases, as a capital or operating lease. The IASB and FASB are currently redeliberating lease accounting, with a goal of issuing a new leasing standard in 2015. The new leasing standard will likely require lessees to report most leases on the balance sheet. A private company that elects this VIE accounting alternative may account for the lease as an operating lease under today s leasing guidance. However, when the new leasing standard becomes effective, that private company may be required to report the lease on its balance sheet. Therefore, future leasing guidance may reduce and in some cases undo the simplification and transparency benefits achieved in this project. Criterion 1 Common control.11 The first criterion requires the private company lessee and lessor to be under common control. While the term common control is used in other areas of GAAP for example, in business combination guidance, the term is not explicitly defined in the FASB s Codification. The VIE exemption alternative does not attempt to define common control..12 The EITF originally deliberated the definition of common control as part of EITF 02-5, Definition of Common Control in Relation to FASB Statement No. 141, but a consensus was never reached. Over time, practice has evolved and many public companies interpret common control by analogizing to EITF 02-5 and a 1997 SEC Staff speech on the topic. Based on the speech, a legal entity controlled by a grandparent and a separate legal entity controlled by a grandchild would not be considered to be under common control unless there was contemporaneous written evidence of an agreement to vote a majority of each entity s shares in concert. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 3

.13 In the basis for conclusions of the final standard the FASB indicated that, for purposes of applying the VIE exemption alternative, the definition of a common control transaction is broader than the definition established through the SEC observations on EITF 02-5. However, the FASB provided limited guidance on how to apply a broader definition. Management will need to apply significant judgment in assessing common control. We understand that the FASB s intention was for this broader interpretation of common control to apply only to the VIE exemption alternative. Therefore, we would not expect private companies judgments related to common control under the business combinations guidance or other areas to be affected by this standard. This broader interpretation of common control also has no impact on public companies common control interpretations. Criterion 2 Lease arrangement.14 The second criterion requires that there be a leasing arrangement between the two entities under common control. A private company will need to ensure that it has considered all leasing arrangements, including any service arrangements that qualify as a lease under ASC 840-10-15-6. Criterion 3 Substantially all activities relate to leasing.15 The third criterion requires substantially all activities between the private company lessee and the lessor to be related to leasing activities between the two entities. The standard provides a number of examples of what constitutes a leasing activity (or supporting a leasing activity)..16 Activities that qualify as leasing activities, or supporting leasing activities, include the following: The private company lessee makes a guarantee or pledges collateral to the lender of the lessor for debt that is also secured by the leased asset. The private company lessee enters into an arrangement whereby it becomes jointly and severally liable for the lessor s debt that is also secured by the leased asset. The private company lessee pays the property taxes, negotiates the financing and/or maintains the leased asset. The private company lessee pays all of the lessor s income taxes when the lessor s only asset is being partially or fully leased to the private company..17 Activities that do not qualify as leasing activities include the following: The private company lessee makes a guarantee or pledges collateral to the lender of the lessor for debt that is also secured by both the leased asset and other assets not leased by the private company lessee. The private company lessee purchases materials from the lessor legal entity. The private company lessee pays all of the lessor legal entity s income taxes when the lessor s assets consist of more than just the asset being leased to the private company. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 4

.18 The new standard permits the lessor to perform activities outside the lease as long as the lessee is not involved. For example, the lessor would be permitted to have manufacturing operations only if the private company lessee does not participate in such activities. It will be important for a private company to carefully evaluate this criterion and understand the specific terms of the debt agreement, including whether the lessor has any other properties that secure the debt. In some situations, it may be clear that this criterion has been met for example, when the lessor has only a single property and it is being leased to the lessee. However, when the lessor has other activities or assets outside of the leased asset, this assessment may not be as simple. If the lessee guarantees debt that is secured by assets other than the leased asset, this criterion would not be met. For example, assume the lessor has two buildings that secure a single debt arrangement with its creditor. The lessee only leases one of the buildings and the second building is leased to an unrelated party. In this case, the substantially all aspect of the criterion would not be met. Conversely, if the lessee s guarantee covers debt secured by a building partially leased to the lessee and an unrelated third party, the substantially all criterion would be met. For example, the lessee may be leasing 3 floors and an unrelated party may be leasing 7 floors. This would not preclude the substantially all criterion from being met for the company leasing 3 floors. Criterion 4 Sufficient collateral.19 The last criterion is only applicable if the lessee explicitly guarantees or provides collateral for an obligation of the lessor. When such an arrangement exists, the criterion requires that, at inception of the guarantee or collateral arrangement, the principal amount of the obligation does not exceed the value of the asset leased by the lessee from the lessor..20 Many have termed this the anti-abuse provision since it was designed to prevent companies from keeping debt off balance sheet by leasing an insignificant asset in a highly leveraged lessor entity. By requiring that the leased asset s value exceed the lessor s debt related to that asset, it also reduces the likelihood that the lessee s guarantee will ever be called upon (which aligns with the argument that the VIE model should not apply)..21 This criterion does not need to be assessed by the lessee if it has only implicitly guaranteed the lessor s obligations. That is, a lessee that implicitly guarantees the obligations of the lessor is eligible to apply the standard, as long as it meets the other three criteria for eligibility. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 5

Under the alternative, a lessee would not need to continually monitor the value of the asset being leased compared to the lessor s debt principal. Reassessment of the fourth criterion would only be required when the lessor s debt is restructured and as a result, the private company lessee issues a new pledge or guarantee. For example, a private company lessee that guarantees the debt of a lessor legal entity concludes that it qualifies to apply the standard. Changes in the value of the leased asset would not affect whether the private company continues to qualify, unless the guarantee or collateral pledge is amended or issued for the first time. If the lessor legal entity subsequently refinances its debt and the private company lessee issues a new guarantee, the sufficient collateral criterion would need to be reevaluated. If the asset value on the reevaluation date has declined below the debt principal, the private company would not be eligible to apply the standard on a prospective basis. Examples.22 The following examples illustrate the application of the new standard: Example 1 Arrangement qualifies to apply the new standard Background: On January 1, 2012, a private company (Company) enters into a leasing arrangement with a lessor (Lessor). The Company and the Lessor are owned and controlled by the same individual, and the Company does not have any ownership in the Lessor. The Lessor has a single property, which it leases to the Company. The Lessor acquired the property on June 30, 2011 for $1,000,000 and entered into a mortgage with a bank for $800,000 on that same date. The property is pledged as collateral for the mortgage. On January 1, 2012 (the lease inception date), the Company agrees to explicitly issue a guarantee to the bank for the Lessor s mortgage. The property has not declined in value from June 30, 2011 to January 1, 2012. As part of its lease, the Company agrees to pay all property taxes of the property, pay the Lessor s income taxes and maintain the property (e.g., remove snow from the parking lot, cut the grass, perform routine building maintenance, etc.). The Company has historically assessed the Lessor for consolidation under the VIE model, and has concluded that its guarantee of the Lessor s debt represents a variable interest, that the Lessor is a VIE, and the Company is the primary beneficiary of the Lessor. Accordingly, the Company consolidated the Lessor in its financial statements for the years ended December 31, 2013 and 2012. Question: Can the Company adopt the new standard for this arrangement? Analysis: Assuming the Company does not meet the criteria to be a public business entity and is within the scope of ASU 2014-07, the Company would evaluate the criteria as follows: 1. Common control: The same individual controls both the Company and the Lessor, and so they are under common control. 2. Lease arrangement: The Company has a lease arrangement with the Lessor. 3. Substantially all activities relate to leasing: Substantially all activities between the Company and the Lessor are related to the lease of the property. Issuing the guarantee, paying the property taxes, paying the Lessor s income taxes (since all National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 6

of its income is generated from its ownership of the property), and maintaining the property are all considered to be leasing activities between the Company and the Lessor. 4. Sufficient collateral: On the date the guarantee is issued by the Company (January 1, 2012), the value of the property exceeds the principal amount of the Lessor s mortgage. The Company s arrangement with the Lessor meets all of the criteria required by the new standard, so the Company could adopt the alternative and deconsolidate the Lessor. Example 2 Arrangement does not qualify to apply the new standard Background: Assume the same facts as Example 1 except: The Lessor owns two buildings instead of one and an unrelated third party leases the other building. There is only one mortgage and the Company guarantee covers that mortgage, which is secured by both buildings. The Company has a contract to purchase widgets manufactured by the Lessor. Question: Can the Company adopt the new standard for this arrangement? Analysis: The Company would fail the third criterion which requires substantially all activities be related to leasing. Therefore, the Company could not apply the new standard to this arrangement and would continue consolidating the lessor. While paying the property taxes and maintaining the property are considered to be leasing activities between the Company and the Lessor, the following other activities between the two parties are unrelated to leasing activities: The mortgage is also secured by an asset not being leased to the Company. The Company is participating in activities of the Lessor outside of its leased asset since it is purchasing widgets manufactured by the Lessor. Transition when private company becomes a public business entity.23 The new guidance does not specify transition provisions when a company is no longer eligible to apply the alternative because it is now considered a public business entity (e.g., due to an IPO). A public business entity is not eligible to apply any of the PCC s accounting alternatives, including this new standard. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 7

We believe a private company that adopts the new standard but later becomes a public business entity will be required to retrospectively adjust its historical financial statements to apply the requirements of the VIE consolidation model for all periods in which the model was not applied. This is different than a situation where a private company no longer meets one or more of the criteria for applying the alternative. In that circumstance, the VIE consolidation model would be applied on a prospective basis, beginning on the date the arrangement no longer qualifies for the alternative. Removal of implicit variable interest.24 The new standard also eliminates the example of implicit variable interests that was previously codified in ASC 810-10-55-87 through 55-89 for all companies. The decision to remove the example of implicit variable interests from ASC 810 impacts both public and private companies. However, the FASB staff does not intend for this to change public companies accounting for these types of arrangements under ASC 810. It was removed because the FASB believed it contradicted this new standard for private companies. Disclosure.25 A company electing to apply the new standard is subject to the following disclosure requirements: The amount and key terms of liabilities of the lessor legal entity that expose the private company lessee to providing financial support to the lessor should be disclosed. Examples of such obligations may include debt, environmental liabilities and asset retirement obligations. If the private company lessee has explicitly guaranteed or pledged collateral for the lessor legal entity s debt, the terms of such an arrangement should be disclosed. The private company lessee should also disclose a qualitative description of any unrecognized commitments or contingencies of the lessor legal entity that expose the private company to providing financial support to the lessor..26 The new standard does not change the disclosure requirements of other guidance, such as ASC 460, Guarantees, ASC 850, Related Party Disclosures, and ASC 840, Leases. What s next Transition and effective date.27 The alternative will be effective for annual periods beginning after December 15, 2014, and interim periods within annual periods beginning after December 15, 2015. Early application is permitted, including application to any period for which the company s annual or interim financial statements have not yet been made available for issuance. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 8

.28 Private companies electing the option should do so on a full retrospective basis for all periods presented if the conditions were met in each period. If the private company retains an interest in a VIE that is deconsolidated as a result of the adoption of the alternative, the retained interest should be measured at its carrying amount at the date the arrangement initially qualifies for the exemption alternative. The transition provisions require a company to go back in time to when the company first became involved with the lessor legal entity, as if the provisions of this standard had been effective since that time. For example, assume on the date of adoption of January 1, 2015, the company concludes a VIE should be deconsolidated. The company first became involved with the lessor legal entity (VIE) in 2010. First, the company would identify the contractual arrangements between the lessee and lessor that had previously been eliminated in consolidation. Assume the only arrangement to account for is a capital lease. Second, the company would account for that arrangement in 2010 under the applicable accounting guidance, ASC 840, Leases. Third, the company would rollforward that capital lease from 2010 to January 1, 2015, accounting for the asset depreciation, lease payments, interest expense, and any potential impairment. Finally, the company would derecognize the net assets of the lessor legal entity as of January 1, 2015 that were previously consolidated and record the rolled-forward carrying amounts of the capital lease on January 1, 2015. Any difference between those two amounts would be recorded as a cumulative effect adjustment to retained earnings on January 1, 2015. This type of transition sometimes can take more time to prepare than initially expected. Questions? PwC clients who have questions about this InDepth should contact their engagement partner. Engagement teams who have questions should contact the Consolidations team in the National Professional Services Group (1-973-236-7805). Authored by: Stephanie L Stewart Partner Phone: 1-973-236-7186 Email: stephanie.l.stewart@us.pwc.com Paul Francis Director Phone: 1-973-236-5100 Email: paul.w.francis@us.pwc.com John Bishop Partner Phone: 1-973-236-7662 Email: john.bishop@us.pwc.com Kirsten Schofield Partner Phone: 1-973-236-4054 Email: kirsten.schofield@us.pwc.com 2014 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, visit www.cfodirect.pwc.com, PwC s online resource for financial executives.