Dataline A look at current financial reporting issues

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1 Dataline A look at current financial reporting issues Cumulative translation adjustment A compromise to achieve consistency May 16, 2013 What s inside: Overview... 1 At a glance... 1 Background and scope of the project... 1 The main details... 3 What is a foreign entity... 3 Transactions within a foreign entity... 4 Transactions involving an interest in a foreign entity... 4 CTA releases related to step acquisitions... 5 Pro rata release of CTA through earnings for equity method investments.. 6 Reclassifications of CTA caused by changes in ownership interest that do not result in a change of control... 6 Transition and effective date... 6 Questions... 7 Appendix... 8 Overview At a glance On March 5, 2013 the FASB issued Accounting Standards Update (the ASU ), which amends ASC 830, Foreign Currency Matters, and ASC 810, Consolidation, to address diversity in practice related to the release of cumulative translation adjustments ( CTA ) into earnings upon the occurrence of certain derecognition events. The ASU reflects a compromise between the CTA release guidance in ASC and the loss of control concepts in the consolidation guidance in ASC It precludes the release of CTA for derecognition events that occur within a foreign entity, unless such events represent a complete or substantially complete liquidation of the foreign entity. Derecognition events related to investments in a foreign entity result in the release of all CTA related to the derecognized foreign entity, even when a noncontrolling financial interest is retained. The ASU also amends ASC 805, Business Combinations, for transactions that result in a company obtaining control of a business in a step acquisition by increasing an investment in a foreign entity from one accounted for under the equity method to one accounted for as a consolidated investment. The ASU is effective for fiscal years beginning after December 15, 2013 for public entities, and fiscal years beginning after December 15, 2014 for nonpublic entities. It should be applied prospectively, and prior periods should not be adjusted. Early adoption is permitted as of the beginning of the entity s fiscal year. Background and scope of the project.1 The objective of the Emerging Issues Task Force issue and the resulting ASU is to resolve the diversity in practice related to releasing CTA by clarifying whether ASC , Consolidation Overall, or ASC , Foreign Currency Matters Translation of Financial Statements, applies to the release of CTA into earnings when an entity ceases to have a controlling financial interest in a subsidiary or group of assets that is a nonprofit activity or a business. Because ASC A specifically excludes sales of National Professional Services Group CFOdirect Network Dataline 1

2 in substance real estate and conveyances of oil and gas mineral rights from the guidance related to deconsolidation of a subsidiary or derecognition of a group of assets that is a nonprofit activity or a business, these transactions were also scoped out of ASU However, as noted below, the ASU does not amend the guidance in ASC Accordingly, when transactions involving in substance real estate or oil and gas mineral rights result in a complete or substantially complete liquidation of a foreign entity as described in ASC , all CTA related to that foreign entity must be released to earnings..2 The diversity in practice the ASU is intended to eliminate started in 2010 when preparers began to apply the deconsolidation guidance in FAS 160, ncontrolling Interests in Consolidated Financial Statements (now ASC ), and ASU , Consolidation (Topic 810): Accounting and Reporting for Decreases in Ownership of a Subsidiary a Scope Clarification..3 Specifically, while ASC and ASU were predicated on units of account of a subsidiary and a business, respectively, neither amended ASC in regard to a CTA release for derecognition events. Further, neither reconciled the subsidiary or business units of account in ASC with the foreign entity unit of account in ASC As a result, some preparers applied ASC and released CTA into earnings upon the loss of a controlling financial interest in a subsidiary or group of assets that is a nonprofit activity or a business for both events within a foreign entity and events involving an interest in a foreign entity. Others applied the guidance in ASC and released CTA into earnings only if the transaction represented the sale or complete or substantially complete liquidation of a foreign entity..5 The Task Force concluded that preparers should not release CTA related to derecognition events within a foreign entity, consistent with the historical guidance in ASC 830. The basis for this conclusion rests primarily on the belief that the unit of account used to derecognize CTA should be consistent with the same unit of account used to recognize it..6 ASC s requirement to recognize a gain or loss upon a remeasurement event has also driven diversity in practice related to CTA releases. Specifically, there were different opinions on whether CTA should be considered in determining a retained noncontrolling investment s carrying amount and fair value. The differences centered on where CTA lives (e.g., at the business, subsidiary, foreign entity, or parent levels) and which currency (functional or reporting) should be used to determine fair value..7 As a result, some preparers treated CTA as part of a deconsolidated subsidiary s net investment, even when the subsidiary was part of a larger foreign entity. Thus, upon a remeasurement event they included CTA in the recognized gain or loss. To these preparers, to ignore CTA would result in carrying the retained noncontrolling investment at an amount other than fair value, which would be inconsistent with ASC Other preparers did not consider CTA as part of a subsidiary s net investment. Instead, they considered CTA a product of the translation process required to consolidate a foreign entity s financial statements with those of its parent. They believed CTA should only be released upon complete or substantially complete liquidation of a foreign entity as described in ASC They would not consider CTA in a remeasurement gain or loss calculation because fair value is measured in the functional currency, not the reporting currency. For example, impairments of long-lived assets are performed using functional currency cash flows (not reporting currency cash flows). When the impairment test indicates that the functional currency carrying amount exceeds fair value, the resulting write down of the long-lived asset to fair value does not consider CTA. National Professional Services Group CFOdirect Network Dataline 2

3 .9 After much discussion, the Task Force concluded that preparers should consider CTA in the calculation of remeasurement gains and losses that occur as a result of derecognition events occurring in a foreign entity. The main details What is a foreign entity.10 While the ASU did not amend the definition of foreign entity, a prerequisite to applying the ASU is having a working understanding of the definition. Prior to a review of the definition of foreign entity, which has been unchanged since the issuance of FAS 52 in 1981, it is important for readers to become sensitive to the distinction in the meaning of the prepositions within and in as those terms are used in the ASU. Proper application of the provisions of this ASU will require companies to determine whether a transaction involves derecognition of a part of a foreign entity (i.e., within a foreign entity) or derecognition of an entire foreign entity (i.e., investment in a foreign entity). The distinction between events within a foreign entity and events involving an interest in a foreign entity, as those terms are used in the ASU, will determine if and when CTA will be released into earnings..11 The appendix to this Dataline includes a flowchart from the ASU. The flowchart illustrates the distinction between within and in and is not intended to illustrate all derecognition events that could be within the scope of ASC The ASC Master Glossary defines a foreign entity as follows. An operation (for example, subsidiary, division, branch, joint venture, and so forth) whose financial statements are both: a) Prepared in a currency other than the reporting currency of the reporting entity b) Combined or consolidated with or accounted for on the equity basis in the financial statements of the reporting entity..13 Additional guidance on the attributes of a foreign entity is found in ASC , which indicates that each foreign entity should be distinct and separable from the other foreign entities..14 In order to be considered distinct and separable, a foreign entity should demonstrate the following: Its activities should be managed as a separate operation and be easy to distinguish from the activities of other foreign entities. Its assets and liabilities should be discernible from other foreign entities. Its assets and liabilities should be directly related to its activities. It should have the ability to produce a complete set of meaningful all-inclusive financial statements. National Professional Services Group CFOdirect Network Dataline 3

4 PwC observation: In practice, we find that most foreign entities are also legal entities. However, the definition of foreign entity does not mandate this. In fact, it is possible for a foreign entity to comprise several legal entities. Less commonly, a single legal entity could comprise several foreign entities. Given the distinct and separable criteria, we believe it would be very unusual for a foreign entity not to meet the definition of a business. Transactions "within" a foreign entity.15 When a reporting entity ceases to have a controlling financial interest in a subsidiary or a group of assets that is a nonprofit activity or a business within a foreign entity (i.e., the derecognition event did not involve the entire foreign entity), CTA is not released into earnings unless the derecognition event resulted in a complete or substantially complete liquidation of the entire foreign entity, as described in ASC PwC observation: While not a bright line, we believe the term substantially complete is interpreted in practice to mean that generally at least 90% or more of the net assets of the foreign entity have been liquidated. Further, the term liquidate means that any proceeds have been transferred out of the liquidated foreign entity. Accordingly, even when a derecognition event within a foreign entity involves the retention of a noncontrolling financial interest that has been remeasured to fair value through earnings, CTA should not be released into earnings unless the derecognition event represents a substantially complete liquidation of the foreign entity..16 Example 1 A US company has a multi-tiered foreign operation where the first-tier and second tier foreign subsidiaries, both separate legal entities, have similar operations, and, thus are considered a single foreign entity. If the second tier foreign subsidiary is sold and the proceeds are distributed out of the foreign entity, CTA should not be released into earnings unless the disposition represents a complete or substantially complete liquidation of the foreign entity. This would likely only be the case where the second tier foreign subsidiary constitutes substantially all of the foreign entity..17 Example 2 A legal entity, which is also considered a foreign entity, sells a group of assets constituting a business comprising 95% of the legal entity s net assets, and the proceeds remain in the legal entity to be reinvested. Such a sale would not trigger release of CTA into earnings because the disposition merely re-characterized the entity s assets, which would not be considered a complete or substantially complete liquidation of the foreign entity..18 Example 3 A US multi-national company decides to wind down the operations of a wholly-owned foreign subsidiary, which is also a foreign entity. In the year following the beginning of the wind down stage, the foreign subsidiary sells 95% of its net assets and remits the proceeds to its US parent. As a result of this sale and remittance, all CTA related to the foreign entity would be released into earnings, as the sale represents a substantially complete liquidation of the foreign entity. Transactions involving an interest "in" a foreign entity.19 When a reporting entity ceases to have a controlling financial interest in a foreign entity, for example, a subsidiary or a group of assets that is a nonprofit activity or a business and is itself a foreign entity (thus, the derecognition event involves the entire National Professional Services Group CFOdirect Network Dataline 4

5 foreign entity), all of the CTA related to the foreign entity is released to net income, even when a noncontrolling interest is retained..20 Example 1 A US multi-national company reduces its ownership of a foreign subsidiary, which represents a foreign entity, from 100% to 40%, and as a result records a deconsolidation gain in accordance with ASC 810, Consolidations. Since the parent ceases to have a controlling financial interest in the foreign entity, all of the CTA related to the foreign entity should be released into earnings..21 Example 2 Similar to the above example, a US multi-national reduces its ownership of a foreign subsidiary, which represents a foreign entity, from 100% to 51%. Since the parent did not lose control of the foreign entity, no CTA would be released into earnings as a result of this sale..22 Example 3 A US multi-national company has a wholly-owned foreign subsidiary that comprises two distinct operations, each constituting a business. Because the two operations are managed and accounted for separately, and meet the definition of a foreign entity, each business is considered a foreign entity. One of the businesses is exchanged for an equity method investment in another entity. As a result, the operation is derecognized and a remeasurement gain is recorded. Since the derecognized operation was a foreign entity, all of the CTA related to the derecognized foreign entity should be released into earnings. PwC observation: The definition of foreign entity and the related guidance are predicated on several broad, principle-based attributes that must be applied to a reporting entity s own unique facts and circumstances. As a result, we are aware of significant diversity in the application of the foreign entity concept. Accordingly, the examples above do not reflect all fact patterns that will be encountered in practice. CTA releases related to step acquisitions.23 ASC describes a step acquisition as a business combination where an acquirer obtains control of an acquiree in which it held an equity interest immediately before the date control was obtained. In a step acquisition, the acquirer remeasures its previously held equity interest in the acquiree at fair value and recognizes the resulting gain or loss in earnings. If the previously held equity method investment represented a foreign entity in its entirety (i.e., an investment in a foreign entity) all of the CTA related to that foreign entity would be released to earnings as part of the recognized remeasurement gain or loss. If the previously held equity method investment was only in part of a foreign entity (i.e., an investment within a foreign entity) no CTA would be released into earnings..24 The basis for the full release of CTA to earnings when the previously held equity method investment represented an investment in a foreign entity is predicated on a step acquisition being analogous to two distinct events; the first being the disposition of the previously held equity method investment, and the second being the acquisition of the controlling financial interest. While many believe that releasing CTA for a transaction that actually increases an acquirer s currency risk is inconsistent with ASC , the Task Force noted that such a release is consistent with full CTA release under the ASU for the deconsolidation of an investment in a foreign entity when a noncontrolling financial interest is retained, as discussed above. National Professional Services Group CFOdirect Network Dataline 5

6 Pro rata release of CTA through earnings for equity method investments.25 Without changing its substance, the ASU clarified the guidance in ASC that requires a pro rata release of CTA when a reporting entity sells part of its ownership interest in an equity method investment that is a foreign entity. For example, a US dollar reporting company has a 40% equity method investment that represents an entire foreign entity. If the respective CTA balance is $100 at the time the ownership interest in the equity method investment is reduced to 30%, 25% of CTA would be released into earnings. If the reporting entity sells part of its ownership interest in an equity method investment that is part of a larger foreign entity (i.e., an investment within a foreign entity), no CTA should be released into earnings, unless the disposition represented the complete or substantially complete liquidation of the foreign entity that contained the equity method investment..26 The ASU also clarifies that when a reporting entity sells a portion of an equity method investment comprising all of a foreign entity and as a result can no longer exercise significant influence, any CTA remaining after the pro rata release into earnings should become part of its cost method carrying value. For example, a reporting company has a 40% equity method investment that comprises all of a foreign entity. If the foreign entity has a $100 debit CTA balance when the equity method investment is reduced to 10%, the reporting company would release $75 of CTA into earnings (i.e., the pro rata portion of CTA related to the decrease in ownership from 40% to 10%) and the remaining $25 balance of CTA would become part of the cost method investment s carrying value. Reclassifications of CTA caused by changes in ownership interest that do not result in a change of control.27 The ASU did not directly amend the guidance related to reclassifications of CTA caused by changes in ownership interest that do not result in a change of control. However, it is appropriate to discuss this topic given the ASU s focus on derecognition events and CTA..28 Changes in ownership interest that do not result in a change of control should be accounted for as equity transactions. When a reporting entity s ownership interest in a foreign entity changes, but control is maintained, a pro rata share of the CTA related to the foreign entity will be reallocated between the controlling interest and the noncontrolling interest. For example, if a reporting company sells a 30% interest in a wholly owned subsidiary that is a foreign entity (i.e., an investment in a foreign entity) while maintaining control, only 30% of the foreign entity s CTA is reallocated to the noncontrolling interest from the controlling interest. Correspondingly, if the change in ownership that did not result in a change of control occurred within a foreign entity, no reallocation of CTA would be made. Transition and effective date.29 The amendments in this ASU are effective prospectively for fiscal years (and interim reporting periods within those years) beginning after December 15, For nonpublic entities the amendments are effective prospectively for the first annual period beginning after December 15, 2014, and interim and annual periods thereafter..30 The amendments should be applied prospectively to derecognition events occurring after the effective date. Due to the inconsistencies that existed in the guidance prior to the ASU, the diversity in practice related to CTA releases into earnings is not considered an error; accordingly, prior periods should not be adjusted. The Task Force concluded that a retrospective transition was not appropriate because CTA releases are associated with nonrecurring events and thus the cost of a retrospective transition would likely exceed any estimated comparability benefit. National Professional Services Group CFOdirect Network Dataline 6

7 .31 Early adoption of the ASU is permitted. If an entity elects to early adopt, it should apply the amendments as of the beginning of the fiscal year in which it early adopts. Accordingly, fiscal year public entities that have already issued interim period financial statements for fiscal years beginning before the issuance of the ASU cannot early adopt. Questions.32 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group ( ). National Professional Services Group CFOdirect Network Dataline 7

8 Appendix: Release of cumulative translation adjustment 1 Is the deconsolidation or derecognition of a subsidiary or group of assets that is a nonprofit activity or a business within a foreign entity? Does the deconsolidation or derecognition result in a complete or substantially complete liquidation of the foreign entity? Release 100% of cumulative translation adjustment. Do not release cumulative translation adjustment. Has there been a change in an investment in a foreign entity? What is the type of foreign entity investment? Foreign Entity Equity Method investment that is a Foreign Entity Did the parent lose control of the foreign entity? Does the change qualify as a step acquisition as described in paragraphs through 25-10? Do not release cumulative translation adjustment. Account for the change in ownership interest in accordance with paragraphs through Release 100% of cumulative translation adjustment. Is the entire equity method investment derecognized? t within the scope of this Update. Refer to other guidance in Topic 830. Release a pro rata portion of cumulative translation adjustment related to the equity method investment. Release a pro rata portion of cumulative translation adjustment related to the equity method investment and apply guidance in paragraphs through te: This flow chart does not illustrate all derecognition events that could be within the scope of ASC This flowchart has been reproduced from the Summary section of ASU The FASB material is copyrighted by the Financial Accounting Foundation, 401 Merritt 7, rwalk, CT 06856, and is reproduced with permission. National Professional Services Group CFOdirect Network Dataline 8

9 Authored by: Ken Miller Partner Phone: kenneth. Mike Yenchek Senior Manager Phone: Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. They are for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network ( PwC s online resource for financial executives PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details.