United States

Simplified accounting for private companies: Common control leases

INSIGHT ARTICLE  | 

On March 20, 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-07, Consolidation (Topic 810): Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements, which resulted from a project of the Private Company Council (PCC). This ASU introduces an accounting alternative for private companies that, if elected, simplifies and reduces the costs of accounting for certain common control leasing arrangements. An example of a common control leasing arrangement involves a private company lessee owned by a father leasing its main manufacturing facility from a lessor entity owned by the father’s child. The ownership of the lessee and lessor entities may be structured in this manner (and other manners resulting in common control) for tax, estate-planning and (or) legal-liability purposes. Prior to adoption of ASU 2014-07, the private company lessee would be required to apply the complex variable interest entity (VIE) accounting model in Topic 810, Consolidation, of the FASB’s Accounting Standards Codification (ASC) to the common control leasing arrangement to determine whether the private company lessee should consolidate the lessor entity. With the issuance of ASU 2014-07, if a private company lessee elects the accounting alternative as its accounting policy, it does not apply the VIE accounting model to a common control leasing arrangement that meets certain criteria.

While the ASU is not effective until fiscal years beginning after December 15, 2014 and interim periods within annual periods beginning after December 15, 2015, early adoption is permitted in periods for which the private company has not yet made its financial statements available for issuance. As such, private companies may elect the accounting alternative in their 2013 financial statements only if those statements have not yet been made available for issuance. Prior to electing the accounting alternative, a private company needs to be certain that the users of its financial statements will accept financial statements in which the accounting alternative has been applied.

This summary provides additional information about the new accounting alternative as well as an example illustrating its application. Additional information is also provided about the ASU’s scope, disclosure requirements, effective date and transition as well as the factors a private company should consider before electing the accounting alternative.

Scope

Private companies include entities other than the following: (a) those that meet the definition of a public business entity or not-for-profit entity as defined in the Master Glossary of the ASC or (b) employee benefit plans that fall within the scope of the related topics in the ASC (Topics 960, 962 and 965). The FASB  has concluded that the accounting alternative should not be extended to: (a) public business entities and employee benefit plans because common control leasing arrangements are not as prevalent in those entities and (b) not-for-profit entities because they are already substantially excluded from the scope of the VIE accounting model.

The FASB recently issued ASU 2013-12, Definition of a Public Business Entity: An Addition to the Master Glossary, which added the definition of a public business entity to the ASC. This definition is broader than the definitions of public entity and publicly traded company included in the Master Glossary of the ASC. For additional information about the new definition, refer to our question and answer document, Q&A on the new public business entity definition.

By electing the accounting alternative, a private company must apply it to all common control leasing arrangements, which requires evaluation of each common control leasing arrangement to determine whether it meets the criteria to not apply the VIE accounting model.

Criteria that must be met to not apply the VIE accounting model

If a private company elects the accounting alternative as its accounting policy, it would not apply the VIE accounting model to a common control leasing arrangement that meets the following criteria, which are included in ASC 810-10-15-17A:

  • The private company lessee and the lessor entity are under common control.
  • The private company lessee has a lease arrangement with the lessor entity.
  • Substantially all activities between the two entities are related to the leasing activity (which includes supporting leasing activities) between the two entities.
  • If the private company lessee explicitly guarantees or provides collateral for any obligation of the lessor entity related to the leased asset, then the principal amount of the obligation at inception of the guarantee or collateral arrangement is not more than the value of the leased asset.

If a private company lessee elects the accounting alternative as its accounting policy and these criteria are met with respect to a specific common control leasing arrangement, the private company lessee does not apply the VIE accounting model to the arrangement. Instead, the private company lessee applies other applicable guidance in the ASC to the common control leasing arrangement, including the guidance in ASC 460, Guarantees, and ASC 840, Leases, as well as any of the non-VIE guidance in ASC 810. Depending on the facts and circumstances, application of ASC 840 by the private company lessee might result in capital lease treatment, which could produce accounting effects similar to those that might have resulted if the private company lessee were required to consolidate the lessor entity as a result of applying the VIE accounting model.  

Certain aspects of the criteria are discussed further below, including: (a) what constitutes common control, (b) activities that would be considered related to the leasing activity, (c) when the criteria need to be reconsidered and (d) how criteria (c) and (d) should be evaluated when the private company lessee only leases part of an asset from the lessor entity.

Common control

Criterion (a) requires the private company lessee and lessor entity to be under common control. The ASU does not provide a definition of common control. As such, the approach currently used to evaluate whether common control exists in other contexts in U.S. generally accepted accounting principles (GAAP), should be used to determine whether the private company lessee and lessor entity are under common control. Based on this approach, common control exists in the context of a leasing arrangement when:

  • An individual or entity owns more than 50 percent of the voting interests in both the private company lessee and the lessor entity
  • Immediate family members (which includes a married couple and their children) own more than 50 percent of the voting interests in both the private company lessee and the lessor entity and there is no evidence to suggest they will not vote their shares in concert
  • A group of shareholders own more than 50 percent of the voting interests in both the private company lessee and the lessor entity and there is contemporaneous written evidence that this group has agreed to vote a majority of the voting interests in a block

In addition, it is made clear in paragraph BC15 of the ASU that the definition of common control for purposes of applying the accounting alternative should go beyond the approach currently used in other accounting contexts. For example, common control could exist if the private company lessee is owned by the grandparent of the grandchild that owns the lessor entity. At the end of the day, when evaluating whether a familial relationship results in common control, the ownership structures and the voting relationships of the private company lessee and lessor entity need to be carefully evaluated.

Activities related to the leasing activity

Criterion (c) requires substantially all activities between the private company lessee and lessor entity to be related to (which includes being in support of) the leasing activity between the two entities. Activities undertaken by the private company lessee that are considered related to the leasing activity between it and the lessor entity include (but are not limited to) the following:

  • Guaranteeing the loan of the lessor entity that is secured by the leased asset
  • Providing collateral for the loan of the lessor entity that is secured by the leased asset
  • Acting as one of the obligors in a joint and several liability that is secured by the leased asset
  • Paying the property taxes related to the leased asset
  • Paying the lessor entity’s income taxes, but only if the sole asset owned by the lessor entity has been leased: (a) in whole by the private company lessee or (b) in part by the private company lessee and in part by an unrelated party
  • Negotiating the lessor entity’s financing for the leased asset
  • Paying for the maintenance of the leased asset

It is important to note that use of “substantially all” in criterion (c) allows for there to be some activity between the private company lessee and lessor entity that is not related to the leasing activities between the two parties. However, the significance of those activities needs to be carefully considered in evaluating whether criterion (c) has been met.

Examples of activities between the private company lessee and lessor entity that are not considered related to the leasing activity between the two entities (which could cause the common control leasing arrangement to fail criterion (c) depending on the significance of the activities) are the following:

  • A purchase commitment between the two entities that is not related to the acquisition or support of the leased asset
  • Actual purchases/sales between the two entities that are not associated with the leased asset (e.g., purchase of products by the private company lessee that are manufactured by the lessor entity in a manufacturing facility not leased by the private company lessee)
  • The private company lessee paying the lessor entity’s income taxes on income generated by an asset other than the asset leased by the private company lessee

Reconsideration of the criteria

If a private company lessee is applying the accounting alternative to a common control leasing arrangement, it must consider whether any of criteria (a) through (c) cease to be met in subsequent periods. (Criterion (d) is only required to be met at inception of the guarantee or collateral arrangement.) Examples of events occurring after inception that require reconsideration of whether the criteria continue to be met include: 

  • The private company lessee subsequently guaranteeing additional debt of the lessor entity on an asset not being leased by the private company lessee.
  • The lessor entity modifying the debt and, at the time of the modification, the principal amount of the debt is in excess of the value of the leased asset either due to a decline in the value of the leased asset since the previous financing or an increase in the principal amount of the debt collateralized by the leased asset.
  • The private company lessee and lessor entity entering into a purchase/supply agreement unrelated to the leased asset.

If, upon reconsideration, a private company lessee no longer meets all of the criteria, it should stop applying the accounting alternative and instead apply the VIE accounting model on a prospective basis. Application of the VIE accounting model may or may not result in consolidation.

Evaluation of criteria (c) and (d) when only part of an asset is leased

Consider a situation in which a private company lessee leases three floors of a ten-floor building from the lessor entity and the lessor entity leases the other seven floors in the building to unrelated parties. In addition, the private company lessee and lessor entity are under common control and the private company lessee has guaranteed the lessor entity’s mortgage for the entire building. The fact that the private company lessee is only leasing part of the building does not in-and-of-itself result in the common control leasing arrangement failing criterion (c) because that criterion does not prohibit the lessor entity from engaging in other activities unrelated to its leasing activity with the private company lessee. In addition, the fact that the private company lessee is only leasing part of the building while guaranteeing the mortgage on the entire building does not in-and-of-itself result in the common control leasing arrangement failing criterion (d) because that criterion is focused on the value of the building in total and not just the value of the three floors leased by the private company lessee. Situations in which the private company lessee is only leasing part of an asset should be carefully evaluated to ensure the appropriate conclusion is reached with respect to whether all of the criteria are met. Refer to Example 7 in ASC 810-10-55-205F through 205G for additional information.

Example

Facts: Reporting Entity (RE), which is a private company, is owned solely by Shareholder. LLC has two members (Shareholder and his spouse). For estate-planning purposes, LLC purchases the land and building in which RE conducts its business. To fund the acquisition, LLC must take on external debt. Lender requires RE to guarantee the debt as a condition of the loan. At the same time, LLC leases the land and building on a long-term basis to RE. RE maintains the land and building and pays property taxes on the land and building. There are no other business dealings between RE and LLC. The value of the land and building at the inception of the lease is $5 million. The principal amount of the debt guaranteed by RE is $4.5 million. RE has adopted the accounting alternative as its accounting policy.

Analysis: RE (as the private company lessee) concludes that it should not apply the VIE accounting model to the leasing arrangement it has with LLC (the lessor entity) because it has elected the accounting alternative as its accounting policy and because it meets all four of the required criteria as follows:

  • RE and LLC are under common control given that ownership of both is wholly within the same immediate family (i.e., Shareholder and his spouse).
  • RE has a lease arrangement with LLC.
  • The only activities between RE and LLC other than the lease are RE’s guarantee of LLC’s debt on the land and building, RE’s maintenance of the land and building and RE’s property tax payments for the land and building. All of these activities are related to the leasing activity between RE and LLC.
  • The principal amount of LLC’s debt guaranteed by RE is less than the value of the land and building LLC has leased to RE. 

As a result of meeting the four criteria, RE applies other relevant guidance to account for the lease and guarantee, instead of applying the VIE accounting model.
Provided below are additional facts that could arise in this example and an indication as to how they would affect this analysis:


Would the four criteria continue to be met?

Yes

No

LLC also owns a manufacturing facility it leases to an unrelated third party. RE has nothing to do with that manufacturing facility.

LLC also owns a manufacturing facility it leases to an unrelated third party. RE provided the guarantee needed to obtain financing to purchase that manufacturing facility.

LLC also owns a manufacturing facility, but does not sell any of the product it manufactures to RE.

LLC also owns a manufacturing facility and sells a substantial amount of the product it manufactures in that facility to RE.

Two years into the lease, the value of the land and building has declined below the principal amount of the debt.

Two years into the lease, LLC refinances the debt on the land and building and RE again guarantees that debt; however, the principal amount of the debt guaranteed by RE is more than the value of the leased land and building.

 

Disclosures

There are various disclosure implications for a private company lessee that elects to apply the accounting alternative and, as a result, does not apply the VIE accounting model to a common control leasing arrangement because it meets the required criteria. First, the private company lessee must disclose whether it has adopted the accounting alternative as its accounting policy. Second, while the private company lessee is not required to provide the VIE-related disclosures in ASC 810-10-50, it is required to disclose the following incremental information about the items noted if they expose the private company lessee to providing financial support to the lessor entity:

  • The amount and key terms of liabilities recognized by the lessor entity (e.g., debt, asset retirement obligations, environmental remediation liabilities)
  • A qualitative description of circumstances not recognized by the lessor entity (e.g., certain commitments and contingencies)

However, these disclosures are not required if the private company lessee consolidates the lessor entity as a result of applying other non-VIE guidance in ASC 810. For purposes of determining whether the private company lessee is exposed to providing financial support to the lessor entity, the private company lessee must consider any exposure that may arise out of implicit guarantees that exist in the facts and circumstances.

Third, the private company lessee must still satisfy the disclosure requirements in other topics of the ASC that are applicable to the common control leasing arrangement (e.g., ASC 460, ASC 840 and ASC 850, Related Party Disclosures).

Fourth, in the period it adopts the accounting alternative, the private company lessee must also provide the disclosures required by ASC 250-10-50-1 through 3 related to a change in accounting principle, except for those in ASC 250-10-50-1(b)(2).

All of the required disclosures related to a common control leasing arrangement can be aggregated in a single footnote. If that is not done, cross-references should be made between the various footnotes in which the required disclosures are provided.  

Effective date and transition

The accounting alternative is effective for years beginning after December 15, 2014 and interim periods within annual periods beginning after December 15, 2015. Early adoption is permitted in periods for which the private company has not yet made its financial statements available for issuance. As such, private companies may elect the accounting alternative in their 2013 financial statements only if those statements have not yet been made available for issuance.

If elected, the accounting alternative should be applied retrospectively to all periods presented. If doing so results in the deconsolidation of a lessor entity, the private company lessee should recognize a cumulative-effect adjustment to retained earnings as of the beginning of the earliest period presented for the difference between the following amounts as of that date:

  • The net effect of deconsolidating the lessor entity (i.e., the net debit or credit removed from the consolidated financial statements as a result of deconsolidating the lessor entity)
  • The carrying amount at which the retained interest in the lessor entity (if any) would have been reflected in the private company lessee’s financial statements if it had applied the accounting alternative from the time it first became involved with the lessor entity

The amount of any cumulative-effect adjustment to retained earnings should be disclosed separately.

Considerations related to the election of the accounting alternative

A private company should carefully consider whether electing the accounting alternative makes sense in its facts and circumstances. Factors to consider in this regard include:

  • Definition of public business entity. As indicated earlier, the new definition of a public business entity, which is integral to determining the entities that can apply the accounting alternative, is broader than the definitions of public entity and publicly traded company included in the Master Glossary of the ASC. For additional information about the new definition, refer to our question and answer document, Q&A on the new public business entity definition. Given that the new definition is broader than the pre-existing definitions, careful consideration should be given to whether an entity falls within that new definition. In addition, if a business entity concludes that it is eligible to elect the accounting alternative because it is not a public business entity, it should consider whether there is a reasonable possibility that it may go public in the future or be acquired by a public business entity in the future. If a private company goes public after it has elected the accounting alternative, absent additional standard setting, it would have to discontinue that election. A private company would also have to discontinue an election to apply the accounting alternative for purposes of any financial statements that are included in a filing with the Securities and Exchange Commission (SEC) as a result of it having been acquired by a public business entity.
  • Needs of financial statement users. A private company should explicitly and deliberately seek input and feedback from its financial-statement users before electing the accounting alternative. A private company should confirm with its financial-statement users that they will accept financial statements in which the accounting alternative has been applied. The users that should be considered in this regard include investors, lenders and regulators, among others. If a financial-statement user will not accept financial statements in which the private company elected to apply the accounting alternative, the private company would have to discontinue that election.

For additional information about the accounting alternative and assistance in the evaluation of your specific facts and circumstances, contact your RSM professional.

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