Financial Reporting: VIE Rules Can Cause Confusion

Tuesday, January 19, 2016

For most construction businesses, maintaining financial statements that comply with generally accepted accounting principles (GAAP) is a fundamental requirement of doing business. Lenders and sureties require contractors to submit financial statements that have been certified to be GAAP-compliant.

Until recently, however, a common business practice used by many privately owned construction companies could have made GAAP compliance more difficult. Recent changes to GAAP standards have eased the problem somewhat, but there is still a good deal of confusion.

How VIEs Affect Financial Statements

The problem many contractors encountered revolved around variable interest entities (VIEs). These are certain types of thinly capitalized businesses that would be unable to operate without the support of another company.

For example, it is a common practice in the construction industry for the owners of a privately held construction business to set up a separate commercial real estate company. Typically, the real estate company would buy a commercial property and lease it back to the construction company as office or warehouse space. (Similar arrangements are sometimes made for the purposes of buying and leasing back equipment.)

In such instances, the commercial real estate company would likely be considered a variable interest entity. Because both businesses share common ownership and because the real estate company does not have sufficient capital to operate on its own, the construction company is considered to have a controlling financial interest in the real estate company.

When one business has a controlling interest in another, GAAP rules require that the controlling entity’s financial statements must be consolidated to include the VIE. In our example, this means the construction company’s balance sheet would have to reflect the assets and liabilities of the commercial real estate company as well. Obviously, this would have a significant impact on the construction company’s balance sheet, which could seriously affect its ability to obtain financing or bonding.

Rules for Private Company Leases

The VIE consolidation requirement was a source of contention for a number of years. The Financial Accounting Standards Board (FASB) received numerous comments from financial statement users who pointed out that the requirement was actually impeding their ability to evaluate a business accurately.

In the case of a construction company, for example, lenders and sureties are primarily interested in the cash flows and balance sheet of the construction business. The finances of the leasing company are not particularly relevant to their decisions regarding financing or bonding capacity. In effect, they argued, the VIE rules were obscuring the information they really needed – while also adding to the owners’ GAAP compliance and reporting costs.

Responding to these concerns, FASB modified its rules in 2014 to make an exception for private company leases. The new rules provide that, under certain circumstances, a GAAP-compliant private company can now choose not to consolidate the financial reporting from a VIE that leases property to it.

Key information about the leasing arrangement must still be disclosed, and other conditions must be met in order to apply the new reporting rules. But the elimination of the requirement for consolidated reporting can simplify the production of GAAP-compliant financial statements and provide users with more relevant information.

The Bigger VIE Picture

It’s important to recognize that the 2014 rules modification applies only to leasing arrangements between two privately held companies that share a common owner. There are many other types of VIE arrangements that still require consolidated reporting.

For example, if a construction company’s owner also owns another company – even one that is completely unrelated to the construction industry – this ownership could be construed as a VIE that might be subject to consolidation into the construction company’s financial reporting. Guaranteeing the debt of another company can also trigger VIE complications.

Even without such explicit contractual arrangements, a VIE situation could apply if there is only an implicit interest in the entity. For example, if the owner of a general contracting company establishes a separate subcontracting business that has no other source of business outside of the GC, the subcontractor would likely be considered a VIE. Therefore, its financial statements might need to be consolidated into the GC’s reporting.

Sharing of employees, management fees, operating leases and other common practices can also trigger a VIE situation. Before entering into any such arrangement, check with your accountant to determine how the proposed action might affect your company’s financial reporting, and thus impact its credit and bonding capacity.

We would be happy to answer any questions you have on potential financial reporting issues.