Accounting Election for Common Control Leasing Arrangements

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On March 20, 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-07 Consolidations (Topic 810): Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements (hereafter ASU 2014-07 or the standard). This standard is the third accounting alternative proposed by the Private Company Council (PCC) and endorsed by the FASB. It is an accounting alternative that permits a private company reporting entity to elect to not apply the variable interest entity (VIE) guidance to certain leasing arrangements. If elected, the guidance of this standard must be applied to all qualifying lease arrangements. The adoption of ASU 2014-07 may result in the deconsolidation of commonly controlled lessor entities that were previously consolidated under the VIE guidance, the removal of disclosures prescribed by the VIE guidance for consolidated and certain non-consolidated commonly controlled lessor entities, or the reduction in the documentation and procedures necessary to evaluate these types of entities under the VIE guidance.

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  • 1. our roots run deep The Substance of the Standard Mayer Hoffman McCann P.C. An Independent CPA Firm A publication of the Professional Standards Group The Substance of the StandardTM 2014 Mayer Hoffman McCann P.C. 877-887-1090 www.mhmcpa.com All rights reserved. page 1 TM TM Contents Qualifying Private Companies..........................1 Qualifying Leasing Arrangements......................1 Applying other U.S. GAAP..........................5 Disclosure...........................6 Period of Adoption...............7 Other Changes to ASC 810 Consolidation......................8 Considerations....................8 Implementation Steps.........8 Appendix: Summary of Significant Changes..........10 On March 20, 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-07 Consolidations (Topic 810): Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements (hereafter ASU 2014-07 or the standard). This standard is the third accounting alternative proposed by the Private Company Council (PCC) and endorsed by the FASB. It is an accounting alternative that permits a private company reporting entity to elect to not apply the variable interest entity (VIE) guidance to certain leasing arrangements. If elected, the guidance of this standard must be applied to all qualifying lease arrangements. The adoption of ASU 2014-07 may result in the deconsolidation of commonly controlled lessor entities April 2014 Accounting Election for Common Control Leasing Arrangements that were previously consolidated under the VIE guidance, the removal of disclosures prescribed by the VIE guidance for consolidated and certain non-consolidated commonly controlled lessor entities, or the reduction in the documentation and procedures necessary to evaluate these types of entities under the VIE guidance. Qualifying Private Companies A reporting entity may elect to adopt the Standard if it is a private company. A private company is defined as an entity that is not: a) an employee benefit plan, b) a not-for- profit entity or c) a public business entity as defined by ASU 2013-12 Definition of a Public Business Entity (see MHM Messenger 2014-02). If a reporting entity that initially meets the criteria to be a private company and adopts ASU 2014- 07 subsequently ceased to meet the definition of a private company it would be required to apply the VIE guidance prospectively to all leasing arrangements and lessor entities that had previously qualified under this standard. Qualifying Leasing Arrangements In order to qualify to not apply the VIE guidance to a leasing arrangement, the reporting entity and lessor entity must meet four criteria. Those criteria, shown on the next page, include that the entities be under common control, that they have a leasing arrangement, that substantially all the In summary: ASU 2014-07 was issued in March 2014 and its provisions may be elected by entities that are not public business entities, not-for-profit entities or employee benefit plans. Through early adoption, qualifying entities may elect to not apply the VIE guidance to certain common control leasing arrangements under this standard for their December 31, 2013 financial statements (for calendar year companies) as long as those financial statements have not been made available for issu- ance prior to March 20, 2014. See the summary of Significant Changes for the key differences created by ASU 2014-07.

2. The Substance of the Standard TM 2014 Mayer Hoffman McCann P.C. 877-887-1090 www.mhmcpa.com All rights reserved. page 2 have a parent that is an entity, or may be owned in legal structures that have many different levels of parent entities. In these circumstances it may not be evident whether two entities share the same ultimate parent. Since common control may occur in circumstances that are not easily interpreted under the guidance of a controlling financial interest, additional interpretation of common control is necessary. The Securities and Exchange Commission (SEC) issued guidance defining common control when its activity between them relates to the leasing arrangement and that any guarantees provided by the reporting entity be fully collateralized by the leased assets at the inception of the guarantee. As with the VIE guidance, in order to apply the guidance of ASU 2014-07, the leasing arrangement must be with an entity. An entity is defined as any legal structure used to conduct activities or to hold assets. Some examples of entities that meet the definition include corporations, limited liability companies (LLCs), partnerships, trusts, as well as legal structures that are disregarded under tax regulations, such as single member LLCs. A reporting entity may not apply the standard to a leasing arrangement for an asset owned directly by an individual. Common Control Criterion a) requires that the reporting entity and the lessor entity are under common control. U.S. Generally Accepted Accounting Principles (U.S. GAAP) does not define common control. Control has been defined as the direct or indirect ability to direct management and policies through ownership, control or otherwise, or a controlling financial interest. Consistent with examples provided in ASC 805 Business Combinations, entities that share an ultimate parent (which has a controlling financial interest in both entities) would be considered under common control. However, in many instances, private companies may be owned by an individual or group of individuals and do not Leasing arrangement criteria (excerpt from ASU 2014-07): a. The private company lessee and the lessor legal entity are under common control. b. The private company lessee has a lease arrange- ment with the lessor legal entity. c. Substantially all activities between the private com- pany lessee and the lessor legal entity are related to leasing activities between those entities. d. If the private company lessee explicitly guarantees or provides collateral for any obligation of the lessor legal entity related to the asset leased by the private company, then the principal amount of the obliga- tion at inception of such guarantees or collateral arrangement does not exceed the value of the asset leased by the private company from the lessor legal entity. Controlling financial interest: A controlling financial interest is the basis used in U.S. GAAP to conclude whether a reporting entity should consolidate another entity. A reporting entity usually has a controlling financial interest in a corporation when it has greater than 50% of the voting rights of the equity of the corporation or when, through the VIE guidance, it determines that it has the power to direct the activities that most significantly impact a VIEs economic perfor- mance and it has an obligation to absorb losses of the VIE or right to receive benefits from the VIE that could potentially be significant to the VIE. The SEC staff stated the following would indicate common control exists: An individual or enterprise holds more than 50 per- cent of the voting ownership interest of each entity. Immediate family members hold more than 50 per- cent of the voting ownership interest of each entity (with no evidence that those family members will vote their shares in any way other than in concert). Immediate family members include a married couple and their children, but not the married couples grandchildren. Entities might be owned in varying combinations among living siblings and their children. Those situations would require careful consideration regarding the substance of the ownership and voting relationships. A group of shareholders holds more than 50 percent of the voting ownership interest of each entity, and contemporaneous written evidence of an agreement to vote a majority of the entities shares in concert exists. 3. The Substance of the Standard TM 2014 Mayer Hoffman McCann P.C. 877-887-1090 www.mhmcpa.com All rights reserved. page 3 staff commented on Emerging Issues Task Force (EITF) Issue Number 02-05 Definition of Common Control in Relation to FASB Statement No. 141. While the EITF did not reach consensus on Issue 02-05, the SEC staff comment (see box) is for use by SEC registrants (issuers) when applying the concept of common control. This guidance, while not authoritative for non-issuers, is often used as an interpretation of U.S. GAAP when preparing non-issuer financial statements. In the basis for conclusion to ASU 2014-07, the FASB and PCC discussed considerations related to common control and their decision to not define common control. A primary reason given to not define common control was the wider implications within U.S. GAAP of creating a definition. This impact would be beyond the scope of the activities of the PCC and the goals of this standard. The discussion did indicate that the FASB and PCC would consider the concept of common control to be broader than the SEC definition. For instance, depending on facts and circumstances, two entities may be considered to be under common control if one is owned by a grandparent and one is owned by a grandchild, which does not fit the strict definition of the SEC. Taking into consideration the factors discussed above, the evaluation of whether the reporting entity and the lessor entity are under common control may require significant analysis, but some general guidelines can be developed. Generally, entities may be considered under common control if: one entity is a consolidated subsidiary of the other entity, they are required to be consolidated by a common parent entity under U.S. GAAP, an individual owns more than 50 percent of the voting interest, controls by contract or through general partnership, or is the primary beneficiary of both entities, or a group of owners or a combination of owners, of both entities would be expected to vote together in concert to achieve greater than 50 percent of the voting interest. Such groups may include family members, and unrelated individuals with a written agreement to vote their shares together. Under certain circumstances, other arrangements amongst individuals or entities may result in common control and would require careful consideration and analysis. Example Novel Environmental Plumbing, Inc. (NEP) is a manufacturer of specialty plumbing supplies and is preparing its financial statements (NEP is the reporting entity). It leases a facility from Land and Novel Development, LLC (LAND), a lessor entity. NEP is 100 percent owned by Jane Doe. Jane Doe has three adult children. While performing estate planning in 2002, she helped create LAND, which is owned one-third by each of her children. Assuming Jane and her children are not estranged or have a conflict that would preclude them from voting in concert, NEP and LAND would be considered to be under common control and would meet criterion a). Lease Arrangement The second criterion requires that the reporting entity and the lessor entity have a lease arrangement. A lease is defined in U.S. GAAP as an agreement conveying the right to use property, plant or equipment, usually for a stated period of time. A lease arrangement is not required to be called a lease by the parties to the arrangement. Any arrangement that meets the definition would contain a lease. The EITF addressed how to determine whether an arrangement contains a lease and provided a model for evaluating arrangements. This model requires an arrangement to meet the following conditions to be considered a lease: A lease includes only property, plant or equipment. Arrangements for inventory, exploration rights, and other intangibles (for instance trademarks) would not be leases under U.S. GAAP. Arrangements involving land or depreciable assets could meet the definition of a lease. Aleasemustbeforspecificproperty.Thepropertyshould be explicitly or implicitly identified in the arrangement. This condition may not be met if the arrangement calls for the owner/seller to deliver specified quantities of goods or services, but has the right to provide those goods or services using property not specified in the arrangement. This condition is not violated by general warranty or substitution provision contained in an arrangement. An arrangement implicitly involves specific property if it is not economically feasible for the owner/seller 4. The Substance of the Standard TM 2014 Mayer Hoffman McCann P.C. 877-887-1090 www.mhmcpa.com All rights reserved. page 4 to perform under the arrangement using alternative property. The arrangement provides the user the right to use the specific property if they control more than a minor amount of output or utility of the property while also: operating or directing the operation of the property, controlling physical access to the property, or facts and circumstances indicate that it is remote that other parties will take more than a minor output or other utility of the property during the term of the arrangement, and the price is not fixed per unit of output or the current market price per unit of output at the time of delivery of the output. It is usual for a lease to be a written agreement, however, amongst related party entities, there are occasionally leasing arrangements that are unwritten or that have continued on a month-to-month basis after expiration of the original lease term. All arrangements written or otherwise, which meet the definition of a lease would qualify under criterion b). Nature of Activities The third criterion is that substantially all the activities between the reporting entity and the lessor entity are related to the leasing arrangement. This criterion includes activities that are designed to support the leasing activity. Examples of qualifying activities include a guarantee or joint and several liability for the debt related to the leased property provided by the reporting entity to the lessor entity, payment of property taxes, maintenance or repairs by the reporting entity related to the leased property, and negotiating financing for the leased property by the reporting entity on behalf of the lessor entity. In addition, payment of income taxes of the lessor entity by the reporting entity is considered to support the leasing activity when the lessor entity leases property exclusively to the reporting entity or the property is leased by the reporting entity and an unrelated party. Activities between the reporting entity and the lessor entity that are not related to the leasing arrangement would result in a failure to comply with criterion c). Examples of activities that would not meet criterion c) include the following circumstances: The reporting entity provides a guarantee for a liability of, or enters into joint and several liabilities for, the lessor entity and that liability is for assets that are not leased by the reporting entity. This situation may occur when the lessor entity owns two buildings,...

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