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Article Author:

New Consolidation Standards — Who Put the VIE in Related-Party Lease Arrangements?

 What's ahead in this article: 

• What Is This About? Let's Cut to the Chase
• Background — How Did We Get Here?
• Do the New Standards Apply to My Company?
• Other Common Questions and Answers
• Possible Reactions to the VIE Standard in Your Entity’s Financial Statements
• A Final Important Note

What Is This About? Let's Cut to the Chase

The new consolidation guidance has snagged the most common sort of related-party transaction in our practice today — the related-party lease. The basic scenario covered by this alert is the following:

• An entity needs a building to contain its operations.
• The owner of the business entity finds such a building, buys it, and leases it to the entity.

There are all sorts of variations on this arrangement. Maybe the building entity is owned by a trust with beneficiaries being the business owner’s children, spouse or parents, or key employees. Maybe the business entity or its owner provides security for the bank debt of the building entity. Maybe not.

Many more of these building entities will be required to be consolidated by the business entity beginning in calendar year 2010 than in the past. The determining factor in many of these arrangements is an implicit motivation to protect the leasing entity or its owners — which I call the "Protecting Arms of Love."

Background — How Did We Get Here?

The consolidation standards were first changed for variable-interest entities (VIEs) in 2003, in response to the FASB’s perception of abuses in the publicly held entity community, where all sorts of entities were structured primarily to achieve a certain accounting, rather than economic, purpose. And that was to keep debt off the balance sheet.

The FASB wrote one of the least comprehensible standards in its history. Even with the changes that were made to clarify it in 2009, it is still hard to read. In all fairness to the FASB, part of the difficulty in reading the standard comes from the new concepts that were introduced, such as “variable interest,” “expected losses,” and “primary beneficiary,” which either were not previously used in practice or don’t mean what you would expect.

The FASB has been struggling over the years with the definition of control for purposes of developing a consolidation principle. It has finally come up with “power to direct the activities of a VIE that most significantly impact the entity’s economic performance and the reporting entity’s exposure to the entity’s losses or benefits,” to be used when equity voting interests by themselves don’t seem to result in control. Simple enough, I suppose, but kind of gives you a headache when you try to wrap your brain around it.

The FASB at some point would have gotten around to settling the accounting for these related-party arrangements. The abuses of others got us a standard sooner than we might have expected one.

Do the New Standards Apply to My Company?

The following four steps can help you to analyze these basic arrangements in relation to your company.

Step 1. Is the building owned by an entity? If yes, go to Step 2. If not, you are done. (Trusts and single-person LLCs are entities, by the way.)

Step 2. Does the business entity have a variable interest in the building entity? If yes, go to Step 3. If not, you are done.

To figure out the variable-interest step, you need to think through the motivations of the related parties and how they might be motivated to protect one another or how the related parties might be blocked from protecting each other. We refer to this step as the evaluating the strength of the “Protecting Arms of Love.”

With related parties, you have to look beyond what are called the explicit variable interests, such as the business entity loaning money to the building entity. Or guaranteeing its bank debt.

You also have to look at the implicit variable interests. If the business entity can be completely blocked from protecting the building entity or its owners (e.g., by its lender), then perhaps it is arguable that implicit variable interest is not present. This would be highly unusual, however, for the typical related-party lease. 

Consider whether or not there are any of the following factors to incent the business entity to protect the building entity or its owners:

1. Are the business entity and the building entity under common control?
2. How important is the building entity to the business entity?
3. Does the business entity or its owner have any fiduciary responsibility to the building entity or its owners?
4. What would be the ramifications to the business entity or its owner if the building entity was in default of its bank loan?
5. Has the business entity or its owner provided any protection to the building entity or its owners in the past?

In most related-party lease arrangements, the “Protecting Arms of Love” are going to cause there to be an implicit variable interest, even in the absence of explicit interests. In most cases, you will be moving on to Step 3.

Step 3. Is the building entity a variable-interest entity (VIE)? If yes, go to Step 4. If not, add some disclosures to your footnotes, if significant.

There are five characteristics to analyze to determine if the building entity is a VIE. If you hit any one of them, the building entity is a VIE. We will only address a couple of the ones that more commonly result in a “yes” result.

1. Is the building entity thinly capitalized? If the building entity has “insufficient equity at risk” (as defined), then it is a VIE. The source of the money that the equity holders invest can be a key factor. Also, we have seen many entities with only nominal amounts contributed.
2. Do the owners of the building entity lack the power to direct activities that most significantly impact the entity’s economic performance? In most cases, these key activities are the maintenance and operation of the leased property. And the business entity generally has this power, rather than the building entity.
3. Do parties other than the building-entity owners have the obligation to protect the building entity? The “Protecting Arms of Love” from Step 2 can also greatly influence the outcome of this step.

In most related-party lease arrangements, the building entity will be determined to be a VIE.

Step 4. Is the business entity the primary beneficiary of the building entity? If yes, the business entity will consolidate the building entity.

If you’ve gotten this far in the analysis, then hopes should be dimming that you won’t have a consolidatable VIE for the business entity.

When determining who is going to consolidate the VIE, in related-party leases, you typically look for other related parties that might be more involved. If the business entity leases 100% of the space, these other parties will be difficult to find.

However, if the owner of the building entity uses 60% of the facility to house her personal and quite valuable fine art collection, and the business entity only uses 40% of the space for its offices, you may be able to argue that some other party is the primary beneficiary of the building entity.

Let’s say that the business entity and another related party use the space absolutely equally — is this a case in which no one is the primary beneficiary?

Unfortunately, no. If related parties are involved, one of them must be determined to be the primary beneficiary.

Other Common Questions and Answers

Why, Why, Why Is the FASB Doing This to Us All? The FASB is working to find a definition of control for consolidation purposes that is principles-based and based upon the economic realities of arrangements, including the more subtle nuances of “real” control, rather than merely voting control of equity interests.

Are There Any Exceptions? Primary carve-outs are:

1. not-for-profits, unless used by a for-profit entity to circumvent the VIE rules;
2. separate accounts of life insurance companies; and
3. certain investments held by an investment company.

Can We Just Go to Final Step If We Don’t Use Most of the Building? It is actually important to go through the entire thought process. Even if the business entity turns out NOT to be the primary beneficiary, there are additional disclosures to be made if (1) the building entity is a VIE, and (2) the business entity has a significant variable interest in it. These disclosures are in addition to the related-party disclosures already made.

Possible Reactions to the VIE Standard in Your Entity’s Financial Statements

If your situation doesn’t match up with the scenario that we have addressed in this article, please contact your Blackman Kallick accounting team. Describe and discuss your specific circumstances. Not all related-party leases end up being consolidatable VIEs.

Give it up and accept the new standard — it is a done deal and I’m not seeing any signs of the FASB changing its mind.

Determine if a departure from GAAPUSA in your financial statements is OK. In most related-party lease situations, the users of your financial statements understand the lease arrangements and will not be harmed by a GAAPUSA departure. Be sure to check with them though and be sure it doesn’t mess up any covenants.

Also, look down the road and think through if future users will want to see GAAPUSA-compliant financial statements. It’s usually easier to adopt the standard now when the data is fresh than later when you have to dig through old files and brain cobwebs.

A Final Important Note

This issue includes a brief overview of the VIE standard specifically focused on related-party lease arrangements. If you have any questions on this or another standard please contact us. We will address your question in a subsequent issue, space permitting.

Also, please do contact your Blackman Kallick accounting team for assistance in addressing your specific facts and circumstances. Your Blackman Kallick accounting team is happy to help you sort through this new standard, or just help you get started on the “road ahead.”

Blackman Kallick’s The Road Ahead-Accounting Updates publication has been prepared for general information on the specified topic. Application to your particular facts and circumstances should be carefully considered in light of the actual accounting standard or exposure draft and in consultation with your Blackman Kallick accounting team. This assessment was prepared by Joan E. Waggoner, Partner in Charge of Quality Assurance for Blackman Kallick.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.