Back in 2001, we witnessed the Enron accounting scandal, which led to one of America’s largest corporate bankruptcies and the demise of the prestigious accounting firm Arthur Andersen. A key ingredient in Enron’s accounting plot involved the use of special purpose entities (SPEs). These entities held billions of dollars of debt and incurred substantial losses, yet through loopholes in the accounting standards, they were never reported (i.e. consolidated) into Enron’s accounting records.
Several years later, the Financial Accounting Standards Board (FASB), responded by issuing FIN 46, which established the concept of a Variable Interest Entity (VIE). In short, the new standard requires that these types of entities be consolidated into the financial statements of the entity that benefits the most from their operating income and who holds the risk to absorb any operating losses and liabilities (i.e. the “primary beneficiary”).
Demystifying Financial Statement Standards
It sounds easy enough, but as practitioners can attest, the standards are extensive and a bit confusing, which continues to result in ‘diversity in practice'. For instance, with the advent of FIN 46, many in public and private accounting practice interpreted the new literature as precluding the use of combined financial statement presentation. In fact, financial statements that were once presented on a combined basis were often switched to consolidated presentation. However, this appears to be a misinterpretation, as the new accounting rules on VIEs did not abolish or change in any way the use of combined financial presentation.
At the end of the day, both presentation methods report the aggregate results of operations and financial position of two or more entities. In a consolidated presentation, there is a parent company that has a controlling interest in one or more subsidiary entities and/or is the primary beneficiary of one or more VIEs. Conversely, a combined presentation is appropriate when two or more entities are under common control, but no actual parent company exists.
When a Combined Financial Statement is Preferred
For example, in the construction industry, it is common to form separate legal entities to hold real estate and/or construction equipment that is leased to the operating company and at times to third parties. Often, an individual (or group of individuals) controls each entity, but there is no parent company that holds an interest in the real estate and/or equipment entity.
In these situations, accounting standards are clear that a combined financial statement presentation is likely more meaningful and therefore preferred over a consolidated presentation (ASC 810-55-1b). Nonetheless, we still see practitioners evaluating the real estate and equipment entities as VIEs and consolidating them into the operating company. Again, the results from operations and the financial position of the group remains the same; however, the consolidated presentation of controlling interest in the balance sheet and income statement is often misleading.
Specifically, the equity and income of the real estate entity and the equipment entity are reported as non-controlling interest, in that the operating company has no direct ownership in these entities. Again, these entities are controlled by an individual (or group of individuals) and not by a parent company. Under a combined presentation, there is no non-controlling interest and all equity and results from operations are combined.
To illustrate how consolidated presentation can be misleading to users of the financial information, let’s assume that the operating company, real estate, and equipment entities reported the following financial position and results of operations:
| Construction Company |
Real Estate |
Equipment | |
| Assets | $1,250,000 | $500,000 | $175,000 |
| Liabilities | 850,000 | 350,000 | 135,000 |
| Equity | 400,000 | 150,000 | 40,000 |
| Income (less inter-company leases) | 125,000 | 15,000 | 10,000 |
The Differences Between Consolidated and Combined Financial Statement Reporting Methods:
| Consolidated | Combined | |
| Assets | $1,925,000 | $1,925,000 |
| Liabilities | 1,335,000 | 1,335,000 |
| Controlling Equity | 400,000 | 590,000 |
| Non-controlling Equity | 190,000 | - |
| Total Liabilities and Equity | $1,925,000 | $1,925,000 |
| Controlling Income | $125,000 | $150,000 |
| Non-controlling Income | 25,000 | - |
| Net Income | $150,000 | $150,000 |
Notice that under the consolidated presentation there is a separate line item for non-controlling equity as well as non-controlling income. These amounts represent the total equity of the real estate entity and the equipment entity as well as any third-party rentals (i.e. inter-company rentals are eliminated in either presentation method.
This is misleading as it suggests that there is a third party that holds interest in the real estate entity and equipment entity (i.e. non-controlling interest) when in fact all interest is under common control. Certainly there might be situations where a VIE would exist under a common controlled group, but under this often seen real-world example, it is clear that the VIE literature is not applicable and instead a combined presentation is appropriate.
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