Certain borrowers that lease assets from related parties may now qualify for an alternative accounting method under Generally Accepted Accounting Principles (GAAP) that doesn’t require consolidation. That’s good news for lenders who often request supplemental schedules to reverse the effects of consolidation to get a clearer picture of financial results.

Common control leasing basics

GAAP generally requires borrowers to consolidate the financial reporting from entities in which they have controlling financial interests. A common example occurs when an operating business leases its real estate from a separate entity owned by one or more of its shareholders.

Common control leasing arrangements are routinely used by private companies to achieve legitimate tax, financial and legal objectives. So the Financial Accounting Standards Board has issued new guidance that permits certain private companies that follow GAAP to elect not to consolidate the financial reporting from variable interest entities that lease property to them.

4 qualifications

In addition to being for-profit and privately held, these four conditions must be met for your borrower to opt out of the consolidation requirement:

  1. The borrower and the lessor entity are under common control.
  2. The borrower has a leasing arrangement with the lessor.
  3. Substantially all of the activity between the borrower and the lessor is related to the leasing activities (including supporting leasing activities) between those two companies.
  4. The borrower explicitly guarantees or provides collateral for any obligation of the lessor related to the asset leased by the borrower, and the principal amount of the obligation at inception doesn’t exceed the value of the asset leased by the borrower from the lessor.

If a borrower elects to apply the accounting alternative, it must be applied to all current and future leasing arrangements that satisfy these four conditions.

Not for every borrower

Some borrowers may unexpectedly violate loan covenants by adopting the accounting alternative, however. Covenant violations are especially likely if a borrower previously asked you to modify its loan covenants to accommodate GAAP consolidation requirements.

Electing this alternative also may be unwise for borrowers that could someday file an initial public offering or merge with a publicly held company. Adjusting historical results to reflect public company accounting can be cumbersome and costly.

Review carefully

This accounting alternative promises to simplify your due diligence and reduce companies’ compliance costs. But beware that dishonest borrowers could use off-balance-sheet items to hide questionable accounting practices. Fortunately, borrowers that elect this alternative must continue to provide detailed disclosures about their leasing activities. Review these disclosures carefully — and ask questions if anything seems awry