Private Company Counsel provides relief from consolidation rules

Relief, at long last!  On March 20, the Financial Accounting Standards Board (FASB) issued long-sought relief to private companies from a rule that required them to consolidate separate companies under common control when one of the companies leases from the other.

This accounting standard was originally created in the aftermath of the Enron and WorldCom accounting fiascos which saw these large companies hide significant liabilities off their balance sheets. Thus, FASB started the process to close loopholes that allowed off-balance sheet liabilities and required consolidation of these “variable interest entities.”

However, the private company world has contested these standards for many years, taking the position that they use these separate companies for income tax purposes, estate planning purposes and legal liability protection purposes and not to keep liabilities off the books.  They also felt that this could mislead users of their financial statements because the separate entity’s assets are not available to the creditors of the company.  Furthermore, in the private company world, users of financial statements (owners, bankers, etc.) typically have ready access to the company’s decision makers and, if they have questions about such entities, can ask.  Thus, the additional levels of disclosures that may indeed be very relevant to public company stakeholders are really just not relevant to private companies.

So what does this mean?

Here is a simple example.  If Companies ABC and XYZ are under common ownership or control and the only relationship between ABC and XYZ is that XYZ leases real estate to ABC, ABC would likely be required to consolidate XYZ into its financial statements.  Under this new standard, which technically is effective for years beginning after December 15, 2014 but may be early adopted now, ABC can simply disclose in its footnotes that it has made an election to not consolidate XYZ in its financial statements and would disclose basic information about the key terms of liabilities recognized by XYZ that provide exposure to ABC and a qualitative description of circumstances not recognized in the financial statements that expose ABC to providing financial support to XYZ.  And yes, this election can be applied even if ABC guarantees the debt of XYZ, so long as the obligation guaranteed does not exceed the value of the asset leased by ABC.

In practice, what we’ve seen is that many private companies over the years have decided to not “garbage up” their financial statements by consolidating.  In those cases, the companies have been willing to accept a “GAAP exception” in their annual reports, but they may have had to go to their banks and/or other users of the financial statements and get their permission for this variance from GAAP.  No more – these financials that do not consolidate would no longer be in violation of GAAP so long as they disclose their election in the footnotes to the financial statements.

Does this new accounting standard mean that your company should immediately cease consolidating these entities into your financial statements?  It depends.  This standard applies only to private companies and not public companies (or non-profits or employee benefit plans.) If you are a private company, but you are considering going public in the next few years, you probably should not adopt this standard because you would have to restate your financials when you do go public.  If you have the same lender for both companies, you should talk to your lender and confirm what they want to see in your financial statements.  Or, if the users of your financial statements find it more useful to continue to consolidate, you can also elect to not apply this exception.