Should You Consolidate Your Common-Control Leasing Agreements?
Accounting standards in the past had made it cumbersome for dealerships to set up a separate leasing entity for their real estate or heavy equipment investments. That was because of the complicated financial reporting requirements to combine (or “consolidate”) the entity’s financial results. But it’s easier now to create a separate legal entity as an effective way to achieve various tax and financial planning objectives or to limit your legal liability.
Effective in 2015 for calendar year-end dealerships, the Financial Accounting Standards Board (FASB) allows a simplified reporting alternative for privately held companies. This option eliminates the need to consolidate common-control leasing arrangements. It also may be worthwhile for dealerships that have established qualifying leasing arrangements but haven’t yet adopted the simplified reporting option.
Seeking a less difficult way
Consolidated financial statements can be confusing. Under Generally Accepted Accounting Principles (GAAP), before the FASB offered the simplified reporting option, all dealerships that leased real estate or equipment from one or more owners were subject to the consolidation requirements of variable interest entities (VIEs). Now consolidation of leasing entities can be a thing of the past for qualifying privately held dealerships that elect an alternative reporting method.
This is especially beneficial for private dealerships that in the past have submitted consolidated financial statements to their lenders or manufacturers only to then be asked to provide consolidating schedules to reverse the effects of consolidating the operations of common-control entities. Users of dealership financial statements are typically more interested in cash flow and tangible net worth of the stand-alone dealership than in the combined performance of a consolidated group presented under GAAP.
Meeting certain conditions
In response to pressure from private business owners and their stakeholders to simplify GAAP, the FASB granted private companies the option to elect not to consolidate financial reporting from VIEs that lease property to them, if the following conditions are met:
Common control. The dealership (the lessee) and the VIE (the lessor, or leasing entity) must be under common control, and substantially all of the activity between the dealership and the VIE must be related to the leasing activities between those two companies (including supporting leasing activities, such as issuance of a guarantee or providing collateral on the obligations related to the leased asset).
Collateral. The dealership explicitly guarantees or provides collateral for any obligation of the VIE related to the leased asset, and the principal amount of the obligation at inception doesn’t exceed the value of the leased asset.
If you elect to apply the alternative method to a leasing arrangement, you must apply it to all current and future leasing arrangements satisfying the above conditions.
Even with the simplified reporting option, footnote disclosures must list the amount and key terms of debt, asset retirement obligations and other liabilities that could result from your activities with the VIE. It’s also important to explain any commitments or contingencies that might cause your dealership to provide financial support to the VIE.
Revisiting leasing arrangements
Common control leasing arrangements have certain benefits that make them worth revisiting now that the financial reporting has been simplified. For instance, a retiring dealer-owner may lease the dealership’s real estate to the operating business at a rental rate commensurate with comparable properties. This setup generates a steady income stream for the retiree — without burdening lower-net-worth, second-generation owners with property ownership and management obligations.
Leasing arrangements also help protect dealership operations from legal claims if someone is injured on the property. And they may safeguard the dealership’s operating assets from creditors if the leasing entity defaults on its debt or files for bankruptcy.
Making the switch
As you work on your dealership’s December 31, 2015, financial statements, revisit the reporting options for existing common-control leasing arrangements. In many cases, opting out of the consolidation requirement will simplify matters, if you’re eligible.
On the other hand, if you’re contemplating setting up a new leasing entity for financial, tax or legal reasons, your financial advisors can help determine whether it makes sense to create a new legal entity and elect this accounting alternative.