Accountant's reports on nonpublic financial statements of the primary beneficiary when a variable interest entity is not consolidated.
FIN No. 46 and No. 46(R) specify the conditions for consolidation by the primary beneficiary of a variable interest entity (VIE) (2) as well as the measurements to be used in consolidation. The requirement to consolidate the VIE as the primary beneficiary may be due to (1) the entity alone or (2) when the entity is part of a related party group. For the remaining discussion, we will assume that the reporting entity has determined it is the primary beneficiary and is required to consolidate, but has determined that it does not wish to consolidate.
An accountant who wishes to issue a report on the above type of reporting entity (VIE is not consolidated) has two alternatives under professional standards.
1. The accountant may issue a report on special purpose GAAP financial statements where the VIE is not consolidated.
2. The accountant may issue a report on financial statements without consolidating the VIE when the financial statements are prepared using one of the other comprehensive basis of accounting (OCBOA).
Special Purpose GAAP Financial Statements
As noted earlier, financial statements for nonpublic entities where an entity is not consolidated are sometimes referred to as "parent-only" financial statements. This term is not used here. Rather the term "reporting entity" is used to refer to the financial statements where one, or more, VIE are not consolidated since the reporting entity may be a single company or a consolidated entity because of consolidation of other entities under other GAAP requirements. (3)
Reporting entity financial statements prepared because of agreements between owners (4) or requirements by financial institutions for GAAP-based statements without consolidation are considered special purpose financial statements. (5) Statement of Standards for Accounting and Review Services (SSARS) Interpretation No. 18 (ARI 100.62-73 in the Codification of SSARS) describes the reporting in such circumstances. Essentially, ARI 100.65-67 defines this situation as an "Incomplete Presentation That is Otherwise in Conformity with GAAP." Further, ARI 100.66-67 require three items when the only GAAP exception is non-consolidation of a variable interest entity and the related disclosures. They are:
A. Disclosure of the basis of presentation in the notes to the financial statements (or the accountant's report in certain circumstances);
B. Use of non-GAAP titles for the financial statements; and
C. Inclusion of two additional paragraphs in the accountant's report.
1. Explanation of the presentation and reference to the note disclosure as specified in A. above (or when management elects to omit substantially all disclosures, reference to the selected information disclosure when included, or inclusion of the information in the accountants report when the selected information disclosure alternative is not chosen).
2. Statement that the presentation is incomplete.
The example below illustrates a situation where owners of the reporting entity created an LLC to own property, plant and equipment leased to the reporting entity. The financial statements of the LLC were also prepared by the same accountant. (6)
Note X. The financial statements were prepared without consolidation of a variable interest entity and the related disclosures. The financial statements thus do not report assets of $X,XXX and liabilities of $Y,YYY which would have been required by GAAP. (7)
The accountant's compilation report with full disclosure or the use of "Selected Information--Substantially All Disclosure Omitted" would add two paragraphs at the end of a compilation report.
* The financial statements presented comply with GAAP except for the non-consolidation of a variable interest entity as described in Note X.
* The presentation is not intended to be a complete presentation of the ABC's assets, liabilities, revenues and expenses required by GAAP.
The first paragraph above would be placed prior to the last paragraph of a review report, and the second paragraph above would be the last paragraph in a review report. The accountant's compilation report for an engagement where management elected to omit all disclosures would include the Note X information in place of the reference to Note X.
Use of OCBOA Finanical Statements
The requirement for consolidation of a variable interest entity in OCBOA financial statements is determined by the OCBOA basis utilized by the reporting entity.
A reporting entity using the income tax basis of accounting would consolidate based on whether the VIE is consolidated for income tax reporting. Thus, a reporting entity that files a consolidated tax return including the VIE is required to consolidate the VIE in its financial statements. A reporting entity that files separate tax returns for the reporting entity and the VIE would not require consolidation. The decision not to consolidate by a reporting entity where consolidated tax returns are prepared (an unlikely situation) would require reporting similar to the GAAP situation above, substituting the income tax basis for GAAP.
A reporting entity using the modified cash basis of accounting must clearly specify the consolidation principle used in the preparation of its financial statements. There are three alternatives under this basis of accounting: (1) no other entity is consolidated, (2) consolidation only occurs for entities where ownership of voting control is held by the reporting entity, or (3) consolidation is in accordance with GAAP. The first two would not require consolidation of the VIE, and thus there would be no exception to the basis of accounting for not consolidating the VIE. The third choice would either require consolidation of the VIE or following the requirements similar to GAAP where non-consolidation of a VIE occurred. The only difference in these paragraphs would be substitution of the OCBOA basis in place of GAAP in all cases. It is very unlikely that an reporting entity would chose the third consolidation principle above where a VIE is not to be consolidated.
Consolidation of VIE is required for general purpose GAAP financial statements. Handling of situations under GAAP where a VIE is not consolidated, special purpose reports, has been presented above. Determination of the requirement for consolidation under OCBOA financial statements was presented and how to handle the lack of consolidation, when required under OCBOA, was also presented.
(1) The comments of Glenn E. Roberts, CPA, are greatly appreciated. The input from many practitioners who asked penetrating questions at various continuing education presentations were important in bringing these issues to our attention. The responsibility for the issues presented in this article are our own.
(2) The effective date for applying FIN No. 46(R) for nonpublic entities that have not been previously implemented, either partially or fully, FIN No. 46 is the first day of the fiscal year beginning after Dec. 15, 2004. Thus compilations or reviews, including monthly financial statements, must meet the requirements discussed below during fiscal years starting after Dec. 15, 2004.
(3) The rest of this discussion assumes that the only departure from GAAP in the financial statements is the non-consolidation of VIE by the primary beneficiary.
(4) The accountant could undertake a SSARS No. 8 engagement without a report even for GAAP financial statements in this special case whenever all owners meet the definition of knowledgeable managers under SSARS No. 8. Distribution of the report would be limited to the knowledgeable managers. The engagement letter must note the exception of non-consolidation of specific variable interest entities. All other requirements of SSARS No. 8 would apply.
(5) Audit opinions on such financial statements should be prepared in accordance with Statement of Auditing Standards No. 87 (AU Section 532), which restricts the financial statements to specified parties. Otherwise the note disclosure about the basis of consolidation or inclusion of similar language in the auditor's report for the restricted use financial statements would be the same.
(6) This is believed to be the usual case in such circumstances; thus the departure from GAAP would be measured. In a situation where another accountant prepared the LLC financial statements and the reporting accountant did not have access to the information, the last sentence would read, "The impact on the financial statements for the non-consolidation of the variable interest entity has not been determined."
(7) The example note presumes that the LLC has GAAP financial statements. Slightly different wording would be required if the financial statements of the LLC were prepared on an OCBOA basis. The words "as measured on the income tax basis of accounting" would be inserted after "$Y,YYY" in the note.
Ray G. Stephens is the James E. Daley professor and director of the School of Accountancy at Ohio University.
Richard J. Murdock is an associate professor in the Fisher College of Business at The Ohio Sate University
By Ray G. Stephens, CPA, D.B.A., CMA (1) and Richard J. Murdock, CPA, Ph.D.