Consolidated and other financial statements

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1 Financial reporting developments A comprehensive guide Consolidated and other financial statements Noncontrolling interests, combined financial statements, and parent company financial statements Revised October 2012

2 To our clients and other friends This Financial reporting developments ( FRD ) publication is designed to help you understand financial reporting issues related to the accounting for noncontrolling interests. This publication also includes interpretive guidance on consolidation procedure and on the presentation of combined and parent-only financial statements. The publication reflects our current understanding of the provisions in ASC 810, Consolidations, based on our experience with financial statement preparers and related discussions with the FASB and SEC staffs. The accounting for noncontrolling interests is based on the economic entity concept of consolidated financial statements. Under the economic entity concept, all residual economic interest holders in an entity have an equity interest in the consolidated entity, even if the residual interest is relative to only a portion of the entity (that is, a residual interest in a subsidiary). Therefore, a noncontrolling interest is required to be displayed in the consolidated statement of financial position as a separate component of equity. Likewise, the consolidated net income or loss and comprehensive income or loss attributable to both controlling and noncontrolling interests is separately presented on the consolidated statement of comprehensive income. Consistent with the economic entity concept, after control is obtained, increases or decreases in ownership interests that do not result in a loss of control should be accounted for as equity transactions. However, changes in ownership interests that result in a loss of control of a subsidiary or group of assets generally result in corresponding gain or loss recognition upon deconsolidation. The decrease in ownership guidance generally does not apply to transactions involving non-businesses, in-substance real estate or oil and gas mineral rights conveyances. The primary revisions made to this publication include the reorganization of certain content and the removal of the discussion of the transition guidance in FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51 (primarily codified in ASC 810). We also enhanced the interpretive guidance in Chapter 2 related to the presentation of noncontrolling interests when derivatives are issued with or as part of those interests. We also added certain other interpretive guidance (for example, to reflect the issuance of new guidance for deconsolidating insubstance real estate). These important changes are summarized in Appendix C. Practice and authoritative guidance interpreting the provisions of ASC 810 continue to evolve and therefore readers should monitor developments in this area closely. October 2012 Financial reporting developments Consolidated and other financial statements

3 Contents 1 Consolidated financial statements Objectives and scope Consolidation procedure time of acquisition Acquisition through single step Acquisition through multiple steps Proportionate consolidation Differing fiscal year-ends between parent and subsidiary Nature and classification of the noncontrolling interest Noncontrolling interests Equity derivatives issued on the stock of a subsidiary Is the equity derivative embedded in the noncontrolling interest or freestanding? Equity derivatives considered embedded Equity derivatives considered freestanding Equity derivatives deemed to be financing arrangements Application of the redeemable equity guidance Measurement and reporting issues related to redeemable equity securities Earnings per share considerations Examples of the presentation of noncontrolling interests with equity derivatives issued on those interests Redeemable or convertible equity securities and UPREIT structures Redeemable noncontrolling interest denominated in a foreign currency Attribution of net income or loss and comprehensive income or loss Attribution procedure Substantive profit sharing arrangements Attribution of losses Distributions in excess of the noncontrolling interest s carrying amount Attribution to noncontrolling interests held by preferred shareholders Attribution of goodwill impairment Attributions related to business combinations effected before Statement 160 and Statement 141(R) were adopted Effect on effective income tax rate Changes in a parent s ownership interest in a subsidiary while control is retained Increases and decreases in a parent s ownership of a subsidiary Increases in a parent s ownership interest in a subsidiary Increases in a parent s ownership interest in a consolidated VIE Decreases in a parent s ownership interest in a subsidiary without loss of control Accounting for a stock option of subsidiary stock Scope exception for in-substance real estate transactions Scope exception for oil and gas conveyances Decreases in ownership of a subsidiary that is not a business or nonprofit activity Financial reporting developments Consolidated and other financial statements i

4 Contents Issuance of preferred stock by a subsidiary Decreases in ownership through issuance of partnership units that have varying profit or liquidation preferences Accumulated other comprehensive income considerations Accounting for foreign currency translation adjustments upon a change in parent s ownership interest without loss of control Allocating goodwill upon change in parent s ownership interest Accounting for transaction costs incurred in connection with changes in ownership Chart summarizing accounting for changes in ownership Comprehensive example Consolidation at the acquisition date Consolidation in year of combination Consolidation after purchasing an additional interest Consolidation in year Consolidation after selling an interest without loss of control Consolidation in year Intercompany eliminations Procedures for eliminating intercompany balances and transactions Effect of noncontrolling interest on elimination of intercompany amounts Loss of control over a subsidiary or a group of assets Deconsolidation of a subsidiary or derecognition of certain groups of assets Loss of control Nonreciprocal transfers to owners Gain/loss recognition Measuring the fair value of consideration received and any retained noncontrolling investment Accounting for contingent consideration in deconsolidation Accounting for a retained creditor interest in deconsolidation Accounting for accumulated other comprehensive income in deconsolidation Deconsolidation through multiple arrangements Deconsolidation through a bankruptcy proceeding Gain/loss classification and presentation Subsequent accounting for retained noncontrolling investment Comprehensive example Deconsolidation by selling entire interest Deconsolidation by selling a partial interest Combined financial statements Purpose of and procedures for combined financial statements Common management Procedures applied in combining entities for financial reporting Parent-company financial statements Purpose of and procedures for parent-company financial statements Investments in subsidiaries Investments in non-controlled entities Disclosure requirements Financial reporting developments Consolidated and other financial statements ii

5 Contents 9 Presentation and disclosures Certain presentation and disclosure requirements related to consolidation Consolidated statement of comprehensive income presentation Reconciliation of equity presentation Presentation of redeemable noncontrolling interests in equity reconciliation Interim reporting period requirements Consolidated statement of financial position presentation Consolidated statement of cash flows presentation Presentation of transaction costs in statement of cash flow Disclosure Comprehensive example A Comprehensive example... A-1 B Comparison of ASC 810 to IAS 27(R)... B-1 C Summary of important changes... C-1 D Abbreviations used in this publication... D-1 E Index of ASC references in this publication... E-1 Financial reporting developments Consolidated and other financial statements iii

6 Contents Notice to readers: This publication includes excerpts from and references to the FASB Accounting Standards Codification (the Codification or ASC). The Codification uses a hierarchy that includes Topics, Subtopics, Sections and Paragraphs. Each Topic includes an Overall Subtopic that generally includes pervasive guidance for the topic and additional Subtopics, as needed, with incremental or unique guidance. Each Subtopic includes Sections that in turn include numbered Paragraphs. Thus, a Codification reference includes the Topic (XXX), Subtopic (YY), Section (ZZ) and Paragraph (PP). Throughout this publication references to guidance in the codification are shown using these reference numbers. References are also made to certain pre-codification standards (and specific sections or paragraphs of pre-codification standards) in situations in which the content being discussed is excluded from the Codification. This publication has been carefully prepared but it necessarily contains information in summary form and is therefore intended for general guidance only; it is not intended to be a substitute for detailed research or the exercise of professional judgment. The information presented in this publication should not be construed as legal, tax, accounting, or any other professional advice or service. Ernst & Young LLP can accept no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. You should consult with Ernst & Young LLP or other professional advisors familiar with your particular factual situation for advice concerning specific audit, tax or other matters before making any decisions. Portions of FASB publications reprinted with permission. Copyright Financial Accounting Standards Board, 401 Merritt 7, P.O. Box 5116, Norwalk, CT , U.S.A. Portions of AICPA Statements of Position, Technical Practice Aids, and other AICPA publications reprinted with permission. Copyright American Institute of Certified Public Accountants, 1211 Avenue of the Americas, New York, NY , USA. Copies of complete documents are available from the FASB and the AICPA. Financial reporting developments Consolidated and other financial statements iv

7 1 Consolidated financial statements 1.1 Objectives and scope Excerpt from Accounting Standards Codification Consolidation Overall Objectives General The purpose of consolidated financial statements is to present, primarily for the benefit of the owners and creditors of the parent, the results of operations and the financial position of a parent and all its subsidiaries as if the consolidated group were a single economic entity. There is a presumption that consolidated financial statements are more meaningful than separate financial statements and that they are usually necessary for a fair presentation when one of the entities in the consolidated group directly or indirectly has a controlling financial interest in the other entities. Scope and Scope Exceptions Entities The usual condition for a controlling financial interest is ownership of a majority voting interest, and, therefore, as a general rule ownership by one reporting entity, directly or indirectly, of more than 50 percent of the outstanding voting shares of another entity is a condition pointing toward consolidation. The power to control may also exist with a lesser percentage of ownership, for example, by contract, lease, agreement with other stockholders, or by court decree A reporting entity shall apply consolidation guidance for entities that are not in the scope of the Variable Interest Entities Subsections (see the Variable Interest Entities Subsection of this Section) as follows: a. All majority-owned subsidiaries all entities in which a parent has a controlling financial interest shall be consolidated. However, there are exceptions to this general rule. 1. A majority-owned subsidiary shall not be consolidated if control does not rest with the majority owner for instance, if any of the following are present: i. The subsidiary is in legal reorganization ii. iii. iv. The subsidiary is in bankruptcy The subsidiary operates under foreign exchange restrictions, controls, or other governmentally imposed uncertainties so severe that they cast significant doubt on the parent's ability to control the subsidiary. In some instances, the powers of a shareholder with a majority voting interest to control the operations or assets of the investee are restricted in certain respects by approval or veto rights granted to noncontrolling shareholder (hereafter referred to as noncontrolling rights). In paragraphs through 25-14, the term noncontrolling shareholder refers to one or more noncontrolling shareholders. Those noncontrolling rights may have little or no impact on the ability of a shareholder with a Financial reporting developments Consolidated and other financial statements 1

8 1 Consolidated financial statements majority voting interest to control the investee's operations or assets, or, alternatively, those rights may be so restrictive as to call into question whether control rests with the majority owner. v. Control exists through means other than through ownership of a majority voting interest, for example as described in (b) through (e). 2. A majority-owned subsidiary in which a parent has a controlling financial interest shall not be consolidated if the parent is a broker-dealer within the scope of Topic 940 and control is likely to be temporary. 3. Except as discussed in paragraph , consolidation by an investment company within the scope of Topic 946 of a non-investment-company investee is not appropriate. b. Subtopic shall be applied to determine whether the rights of the limited partners in a limited partnership overcome the presumption that the general partner controls, and therefore should consolidate, the partnership. c. Subtopic shall be applied to determine the consolidation status of a research and development arrangement. d. The Consolidation of Entities Controlled by Contract Subsections of this Subtopic shall be applied to determine whether a contractual management relationship represents a controlling financial interest. e. Paragraph addresses the circumstances in which the accounts of a rabbi trust that is not a VIE (see the Variable Interest Entities Subsections for guidance on VIEs) shall be consolidated with the accounts of the employer in the financial statements of the employer. ASC 810 defines a subsidiary as an entity in which a parent has a controlling financial interest, whether that controlling interest comes through voting interests or other means (for example, variable interests). While consolidation policy is not the subject of this publication, in general, the first step in determining whether an entity has a controlling financial interest in a subsidiary is to establish the basis on which the investee is to be evaluated for control (that is, whether the consolidation determination should be based on ownership of the investee s outstanding voting interests or its variable interests). Accordingly, the provisions of ASC s variable interest model 1 should first be applied to determine whether the investee is a variable interest entity (VIE). Only if the entity is determined not to be a VIE should the consolidation guidance for voting interest entities within ASC be applied. Once it is determined a parent has a controlling financial interest in an entity, the assets, liabilities and any noncontrolling interests of that entity are accounted for in the parent s consolidated financial statements in accordance with the consolidation principles in ASC These principles are generally the same for entities consolidated under the voting interest and variable interest models. Illustration 1-1 summarizes how ASC 810 s control framework should generally be applied to interests in an entity. 1 Generally ASC includes guidance with respect to the consolidation considerations for voting interest entities and variable interest entities for each of ASC s sections. In each of ASC s sections there is a General subsection with respect to the consolidation model. This guidance applies to voting interest entities and also may apply to variable interest entities in certain circumstances. The Variable Interest Entities subsection within each of ASC s sections contains considerations with respect to variable interest entities. In referring to the Variable Interest Model in ASC , we are referring to the guidance applicable to variable interest entities in each of ASC s sections. Financial reporting developments Consolidated and other financial statements 2

9 1 Consolidated financial statements Illustration 1-1: ASC 810, Consolidation Decision Tree Variable Interest Model Is the entity being evaluated for consolidation a legal entity? No Yes Does a scope exception to consolidation guidance (ASC 810) apply? Employee benefit plans Governmental organizations Certain investment companies Yes Apply other GAAP No Consider whether fees paid to a decision maker or a service provider represent a variable interest Does a scope exception to the Variable Interest Model apply? Not-for-profit organizations Separate accounts of life insurance companies Lack of information Certain businesses No Yes Does the enterprise have a variable interest in a legal entity? No Apply other GAAP Consider whether silos exist or whether the interests or other contractual arrangements of the entity (excluding interests in silos) qualify as variable interests in the entity as a whole 1 Yes Is the legal entity a variable interest entity? Does the entity have sufficient equity to finance its activities without additional subordinated financial support? Do the equity holders, as a group, lack the characteristics of a controlling financial interest? Is the legal entity structured with non-substantive voting rights (i.e., anti-abuse clause)? Yes No Variable Interest Model (cont.) Voting model Is the enterprise the primary beneficiary (i.e., Does the enterprise individually have both power and benefits)? Consolidation of partnerships and similar entities Consolidation of corporations and other legal entities No No No Does the enterprise, including its related parties and de facto agents, collectively have power and benefits? Do not consolidate Does a related party or de facto agent individually have power and benefits? Yes Party most closely associated with VIE consolidates Yes Related party or de facto agent consolidates entity Yes Consolidate entity The general partner (GP) is presumed to have control unless that presumption can be overcome by one the following conditions: No Can a simple majority vote of limited partners remove a general partner without cause and there are no barriers to the exercise that removal right? Do limited partners have substantive participating rights? GP consolidates entity Yes No GP does not consolidate the entity. In limited circumstances a limited partner may consolidate (e.g., a single limited partner that has the ability to liquidate the limited partnership or kick out the general partner without cause). Does a majority shareholder, directly or indirectly, have greater than 50% of the outstanding voting shares? Do not consolidate No Consolidate entity Yes Do the minority shareholders hold substantive participating rights or do certain other conditions exist (e.g., legal subsidiary is in bankruptcy)? Yes Do not consolidate 1 See our Financial reporting developments publication, Consolidation of variable interest entities, for guidance on silos and specified assets. Financial reporting developments Consolidated and other financial statements 3

10 1 Consolidated financial statements Note: The FASB currently has a consolidation project on its agenda to amend ASC 810. The FASB s tentative decisions would modify the provisions for evaluating an enterprise as a principal or an agent and the provisions for evaluating the substance of kick-out rights and participating rights, among other things. Additionally, the tentative decisions would modify the literature in ASC used to reach consolidation conclusions for limited partnerships and similar entities. Readers should monitor developments in this area closely. 1.2 Consolidation procedure time of acquisition An entity may acquire a controlling financial interest in a subsidiary through a single step or through multiple steps over time Acquisition through single step ASC 805 provides guidance when an acquirer obtains control of an acquiree through a single investment, often referred to as a single-step acquisition. Single step acquisitions are perhaps the most recognizable form of business combination. ASC 805 requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree, generally measured at their fair values as of the acquisition date. These concepts are discussed further in our FRD, Business combinations. The comprehensive example in Chapter 4 includes an example of the accounting for a single-step acquisition. See Section 4.2, Illustration 4-9; Section 4.2.1, Illustration 4-10; and Section 4.2.2, Illustration Acquisition through multiple steps An acquirer may obtain control of an acquiree through a series of two or more investments, which is commonly referred to as a step acquisition. or, in ASC 805, as a business combination achieved in stages. Under ASC 805, if the acquirer holds a noncontrolling equity investment in the acquiree immediately before obtaining control, the acquirer should first remeasure that investment to fair value as of the acquisition date and recognize any remeasurement gain or loss in earnings. If, before obtaining control, an acquirer recognized changes in the value of its noncontrolling investment in the target in other comprehensive income (that is, the investment was classified as available-for-sale in accordance with ASC 320), the amount recognized in other comprehensive income as of the acquisition date should be reclassified from other comprehensive income and included in the recognized remeasurement gain or loss as of the acquisition date. The acquirer then should apply ASC 805 s business combination guidance, as discussed in our FRD, Business combinations. After taking control of a target company, further acquisitions of ownership interests (i.e., acquisitions of noncontrolling ownership interests with no changes in control) are accounted for as transactions among shareholders within equity pursuant to the guidance in ASC 810 (refer to Chapter 4). Illustration 1-2 summarizes these concepts. Financial reporting developments Consolidated and other financial statements 4

11 1 Consolidated financial statements Illustration 1-2: Summary of guidance applied for acquisitions of an interest in an entity Acquisition of an interest prior to obtaining control Apply other GAAP (ASC 320, ASC 323 and ASC 815, among others). Acquisition of an additional interest, which provides control Acquisition of an additional interest, after control has already been obtained* First, remeasure the previously held interest (i.e., the interest held before obtaining control, if any) at fair value, recognizing any gain or loss in earnings. Next, measure and consolidate (generally at fair value) the net assets acquired and any noncontrolling interests, in accordance with ASC 805. (Refer to our FRD, Business combinations, for further interpretive guidance). Reduce the carrying amount of the noncontrolling interest. Recognize any difference between the consideration paid and the reduction to the noncontrolling interest in equity attributable to the controlling interest. (See Chapter 4 for further interpretive guidance). * See Section for further discussion of this accounting. 1.3 Proportionate consolidation Excerpt from Accounting Standards Codification Consolidation Overall Other Presentation Matters If the investor-venturer owns an undivided interest in each asset and is proportionately liable for its share of each liability, the provisions of paragraph may not apply in some industries. For example, in certain industries the investor-venturer may account in its financial statements for its pro rata share of the assets, liabilities, revenues, and expenses of the venture. Specifically, a proportionate gross financial statement presentation is not appropriate for an investment in an unincorporated legal entity accounted for by the equity method of accounting unless the investee is in either the construction industry (see paragraph ) or an extractive industry (see paragraphs and ). An entity is in an extractive industry only if its activities are limited to the extraction of mineral resources (such as oil and gas exploration and production) and not if its activities involve related activities such as refining, marketing, or transporting extracted mineral resources. Real Estate General Investments Equity Method and Joint Ventures Recognition If real property owned by undivided interests is subject to joint control by the owners, the investorventurers shall not present their investments by accounting for their pro rata share of the assets, liabilities, revenues, and expenses of the ventures. Most real estate ventures with ownership in the form of undivided interests are subject to some level of joint control. Accordingly, such investments shall be presented in the same manner as investments in noncontrolled partnerships. Financial reporting developments Consolidated and other financial statements 5

12 1 Consolidated financial statements The use of the proportionate gross financial statement presentation method (that is, proportionate consolidation, as described in ASC ) is permitted only in the following circumstances: a) investments in certain unincorporated legal entities in the extractive or construction industry that otherwise would be accounted for under the equity method of accounting (i.e., a controlling interest does not exist), and b) ownership of an undivided interest in real property when each owner is entitled only to its pro rata share of income and expenses and is proportionately (i.e., severally) liable for its share of each liability, and the real property owned is not subject to joint control by the owners. 1.4 Differing fiscal year-ends between parent and subsidiary Excerpt from Accounting Standards Codification Consolidation Overall Objectives General Differing Fiscal Year-Ends Between Parent and Subsidiary A difference in fiscal periods of a parent and a subsidiary does not justify the exclusion of the subsidiary from consolidation. Other Presentation Matters Differing Fiscal Year-Ends Between Parent and Subsidiary It ordinarily is feasible for the subsidiary to prepare, for consolidation purposes, financial statements for a period that corresponds with or closely approaches the fiscal period of the parent. However, if the difference is not more than about three months, it usually is acceptable to use, for consolidation purposes, the subsidiary's financial statements for its fiscal period; if this is done, recognition should be given by disclosure or otherwise to the effect of intervening events that materially affect the financial position or results of operations A parent or an investor should report a change to (or the elimination of) a previously existing difference between the parent's reporting period and the reporting period of a consolidated entity or between the reporting period of an investor and the reporting period of an equity method investee in the parent's or investor's consolidated financial statements as a change in accounting principle in accordance with the provisions of Topic 250. While that Topic generally requires voluntary changes in accounting principles to be reported retrospectively, retrospective application is not required if it is impracticable to apply the effects of the change pursuant to paragraphs through The change or elimination of a lag period represents a change in accounting principle as defined in Topic 250. The scope of this paragraph applies to all entities that change (or eliminate) a previously existing difference between the reporting periods of a parent and a consolidated entity or an investor and an equity method investee. That change may include a change in or the elimination of the previously existing difference (lag period) due to the parent's or investor's ability to obtain financial results from a reporting period that is more consistent with, or the same as, that of the parent or investor. This paragraph does not apply in situations in which a parent entity or an investor changes its fiscal year-end. Financial reporting developments Consolidated and other financial statements 6

13 1 Consolidated financial statements Disclosure An entity should make the disclosures required pursuant to Topic 250. This paragraph applies to all entities that change (or eliminate) a previously existing difference between the reporting periods of a parent and a consolidated entity or an investor and an equity method investee. This paragraph does not apply in situations in which a parent entity or an investor changes its fiscal year-end. If there is a difference between a parent s fiscal year end and a subsidiary s fiscal year end, the parent may use the subsidiary s financial statements for consolidation purposes, provided the difference is not more than about three months (i.e., 93 days per Rule 3A-02(b) of Regulation S-X). When the fiscal year ends do differ, a parent should disclose the effect of intervening events that, if recognized, would materially affect the consolidated financial position or results of operations. If a parent elects to change or eliminate an existing difference in fiscal periods, the parent would report this as a change in accounting principle in accordance with the provisions of ASC 250. This guidance does not apply, however, in situations in which a parent entity changes its fiscal year-end. Financial reporting developments Consolidated and other financial statements 7

14 2 Nature and classification of the noncontrolling interest 2.1 Noncontrolling interests Excerpt from Accounting Standards Codification Consolidation Overall Glossary Noncontrolling Interest The portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent. A noncontrolling interest is sometimes called a minority interest. Other Presentation Matters Nature and Classification of the Noncontrolling Interest in the Consolidated Statement of Financial Position The ownership interests in the subsidiary that are held by owners other than the parent is a noncontrolling interest. The noncontrolling interest in a subsidiary is part of the equity of the consolidated group The noncontrolling interest shall be reported in the consolidated statement of financial position within equity, separately from the parent s equity. That amount shall be clearly identified and labeled, for example, as noncontrolling interest in subsidiaries (see paragraph ). An entity with noncontrolling interests in more than one subsidiary may present those interests in aggregate in the consolidated financial statements A Only either of the following can be a noncontrolling interest in the consolidated financial statements: a. A financial instrument (or an embedded feature) issued by a subsidiary that is classified as equity in the subsidiary s financial statements b. A financial instrument (or an embedded feature) issued by a parent or a subsidiary for which the payoff to the counterparty is based, in whole or in part, on the stock of a consolidated subsidiary, that is considered indexed to the entity s own stock in the consolidated financial statements of the parent and that is classified as equity A financial instrument issued by a subsidiary that is classified as a liability in the subsidiary s financial statements based on the guidance in other Subtopics is not a noncontrolling interest because it is not an ownership interest. For example, Topic 480 provides guidance for classifying certain financial instruments issued by a subsidiary. Financial reporting developments Consolidated and other financial statements 8

15 2 Nature and classification of the noncontrolling interest A An equity-classified instrument (including an embedded feature that is separately recorded in equity under applicable GAAP) within the scope of the guidance in paragraph C shall be presented as a component of noncontrolling interest in the consolidated financial statements whether the instrument was entered into by the parent or the subsidiary. However, if such an equity-classified instrument was entered into by the parent and expires unexercised, the carrying amount of the instrument shall be reclassified from the noncontrolling interest to the controlling interest. Note: This chapter introduces certain concepts related to the accounting for financial instruments that may have embedded features. Given the complexity of the relevant authoritative literature and the significant judgment required to apply that literature, it may be important to consult additional guidance when accounting for these instruments and their related features. ASC indicates that a noncontrolling interest in an entity is any equity interest in a consolidated entity that is not attributable to the parent. ASC requires that the noncontrolling interest be classified as a separate component of consolidated equity. In ASC , the FASB concluded that a noncontrolling interest in an entity meets the definition of equity in Concepts Statement 6, which defines equity (or net assets) as, the residual interest in the assets of an entity that remains after deducting its liabilities. A noncontrolling interest represents a residual interest in the assets of a subsidiary within a consolidated group and is, therefore, consistent with the definition of equity in Concepts Statement 6. The noncontrolling interest is presented separately from the equity of the parent so that users of the consolidated financial statements can distinguish the parent s equity from the equity attributable to the noncontrolling interest (that is, equity of the subsidiary held by owners other than the parent). To be classified as equity in the consolidated financial statements, the instrument issued by the subsidiary should be classified as equity by the subsidiary based on other authoritative literature. If the instrument is classified as a liability in the subsidiary s financial statements (e.g., under any of the guidance in ASC 480), it cannot be presented as noncontrolling interest in the consolidated entity s financial statements because that instrument does not represent an ownership interest in the consolidated entity under US GAAP. For example, mandatorily redeemable preferred shares issued by a subsidiary would be classified as a liability in the subsidiary s financial statements pursuant to ASC 480. The preferred shares would not be classified as noncontrolling interest in the consolidated financial statements. 2.2 Equity derivatives issued on the stock of a subsidiary It is common for a parent and the noncontrolling interest holders of a subsidiary to enter into arrangements whereby they may do one or more of the following: Grant the noncontrolling interest holders an option to sell their equity interests in the subsidiary to the parent Grant the parent an option to acquire the equity interests in the subsidiary held by the noncontrolling holders Obligate the parent to acquire and the noncontrolling holders to sell their equity interests in the subsidiary Financial reporting developments Consolidated and other financial statements 9

16 2 Nature and classification of the noncontrolling interest Those arrangements can take the form of options (written or purchased, puts or calls), forwards (datecertain or contingent) or even swap-like contracts. In some cases, the arrangements may be papered between the parent and the noncontrolling interest holders, and in other cases between the subsidiary and the noncontrolling interest holders. The various options and forwards described above are contracts on the shares (common or preferred) of a subsidiary. If the underlying share is classified in equity (as noncontrolling interest), the equity derivatives 2 on the noncontrolling interest should be separately evaluated to determine their classification. The accounting in this area can be complex because of the variety of authoritative guidance that should be considered and the terms of the transaction. For example, (1) the equity derivative may be entered into contemporaneously with the creation of the noncontrolling interest or subsequent to its creation, (2) the form of the equity derivative (that is, whether it is embedded or freestanding) can be determinative and (3) the strike price of the equity derivative may be set at either a fixed or variable (formulaic) price or at fair value. Each of those variations can affect the accounting. The following summarizes, at a high level, the relevant accounting considerations applicable to equity derivatives associated with noncontrolling interest Is the equity derivative embedded in the noncontrolling interest or freestanding? The first step in accounting for an equity derivative associated with a noncontrolling interest is to determine whether the equity derivative is an embedded feature in the noncontrolling interest or a freestanding financial instrument, because the accounting can be significantly different. For example, the accounting for a freestanding written put on a subsidiary s shares is different than that for puttable shares issued by the subsidiary. While ASC 480 provides little interpretive guidance on the definition of a freestanding financial instrument, we believe that the substance of a transaction should be considered in making this determination. The determination of whether an instrument is embedded or freestanding involves understanding both the form and substance of the transaction, and may involve substantial judgment. In this regard, documenting an instrument in a separate contract is not necessarily determinative that it is freestanding, particularly when a contract is entered into in conjunction with another transaction. If the transactions are between the same parties and involve the same underlying (in this context, the issuer s shares), it is important to assess whether the instruments are (1) legally detachable and (2) separately exercisable. Those concepts can be further described as follows: Legally detachable Generally, whether two instruments can be legally separated and transferred such that the two components may be held by different parties. Separately exercisable Generally, whether one instrument can be exercised without terminating the other instrument (e.g., through redemption, simultaneous exercise, or expiration). If the exercise of one instrument must result in the termination of the other, the instruments would generally not be considered freestanding pursuant to ASC 480. On the other hand, if one instrument can be exercised while the other instrument continues to be outstanding, the instruments would be considered freestanding under ASC This chapter refers to derivatives in the common use of the word, not just instruments that meet the definition of a derivative in ASC Financial reporting developments Consolidated and other financial statements 10

17 2 Nature and classification of the noncontrolling interest For example, if a parent enters into a contract with the only minority shareholder of its privately held subsidiary that permits the shareholder to put its shares in the subsidiary to the parent at a fixed price, that put option generally would be considered to be embedded in the related shares. In contrast, if the same parent enters into a put option on publicly traded common stock of a different subsidiary, and that put option permits the counterparty to put any common shares of the subsidiary to the parent at a fixed price (e.g., the counterparty could put shares of the subsidiary already owned or buy shares in the market), that written put option would be considered freestanding, provided that it is also legally detachable from the shares Equity derivatives considered embedded If the equity derivative is considered a feature embedded in the subsidiary s shares, that embedded feature should be analyzed to determine whether the shares should be a mandatorily redeemable financial instrument subject to ASC 480 or, if the shares are not a liability, whether the feature should be bifurcated. To determine whether the embedded feature should be bifurcated, the hybrid instrument (the subsidiary s shares and embedded feature) should be evaluated under ASC In many cases, unless the subsidiary itself is a publicly traded entity, the feature will not meet the definition of a derivative pursuant to ASC because those features usually require gross physical settlement or the transfer of the full amount of consideration payable in exchange for the full number of underlying nonpublic subsidiary shares. As the underlying nonpublic shares are not readily convertible to cash, this gross physical settlement does not meet any of the forms of net settlement pursuant to ASC However, if the instrument meets the definition of a derivative, it should be evaluated under ASC (a) to determine if an exception from bifurcation is available. 3 The exception in ASC (a) is applicable if the feature is considered indexed to the issuer s own stock and would be classified in equity. ASC includes guidance that should be considered in making this determination. There are special considerations as to whether the feature is considered indexed to the issuer s own stock when subsidiary shares are involved, as discussed in ASC C. If an equity derivative is (1) deemed to be embedded and (2) the entire instrument is not a liability, the redeemable equity guidance should be considered (see Section below) Equity derivatives considered freestanding An equity derivative that is considered a freestanding financial instrument should be evaluated pursuant to ASC 480 to determine whether liability classification is required as, for the purposes of ASC 480, an issuer s equity share includes the equity shares of any entity whose financial statements are included in the consolidated financial statements. Instruments that may require the issuer to transfer cash or other assets in exchange for its own shares are among those classified as liabilities pursuant to ASC 480. For example, a physically settled forward contract that requires the parent to pay cash in exchange for the subsidiary s shares is within the scope of ASC 480. Further, a freestanding written put option on the subsidiary s shares is also a liability under ASC 480 regardless of whether it settled gross or net. If the equity derivative is not a liability pursuant to ASC 480, the instrument should be evaluated to determine whether it is a derivative pursuant to ASC 815. Similar to the analysis of an embedded feature in the subsidiary s shares, frequently, it will not meet the definition of a derivative because it lacks net settlement. Even if the contract meets the definition of a derivative, it may still qualify for a scope exception from derivative accounting pursuant to ASC (a), which considers the guidance in ASC If the equity derivative does not meet the definition of a derivative, that same guidance in ASC is applied to determine the contract s classification. 3 The embedded feature would be considered a derivative if the underlying shares were publicly traded. If the feature meets the net settlement criterion by way of a required or alternative settlement in net cash or net shares, the conclusion that the feature was embedded should be revisited. Financial reporting developments Consolidated and other financial statements 11

18 2 Nature and classification of the noncontrolling interest Equity derivatives deemed to be financing arrangements In limited situations, a parent may enter into an equity derivative to acquire a subsidiary s shares that should be accounted for as a financing of the parent s purchase of the minority interest. In those situations, equity derivatives are entered into between the parent and minority interest holder at the inception of noncontrolling interest that require physical settlement. The contracts may be either (1) a fixed-priced forward to buy the remaining interest in the subsidiary at a stated future date and the forward is considered freestanding or (2) combination of a purchased call option and written put option with same (or not significantly different) fixed strike price and same fixed exercise date that are embedded in the shares. 4 Essentially, the parent consolidates 100% of the subsidiary and does not recognize the noncontrolling interest at the consolidated entity level, but rather a liability for the financing (i.e., the future purchase of the noncontrolling interest). In those circumstances, the risks and rewards of owning the noncontrolling interest have been obtained by the parent during the period of the equity derivative, even though the legal ownership of the noncontrolling interest is still retained by the noncontrolling interest holders. Essentially, combining the equity derivative and the noncontrolling interest reflects the substance of the transaction; that is, the noncontrolling interest holder is financing the noncontrolling interest. ASC states that the forward contract should be recognized as a liability, initially measured at the present value of the fixed forward price. Subsequently, the liability is accreted to the fixed forward price over the term of the forward contract with the resulting expense recognized as interest cost. Similar accounting and measurement would be applied to the combined noncontrolling interest and embedded options. The initial measurement guidance in ASC is not consistent with the general initial measurement requirement of ASC 480 for physically settled forward purchase contracts. The general measurement guidance in ASC states that a freestanding physically settled forward contract should be measured initially at the fair value of the underlying shares at inception, adjusted for any consideration or unstated rights or privileges. While the methods are different, we generally believe that they should result in approximately the same initial measurement. Any significant differences would require additional analysis to determine if there are additional rights or privileges in the transaction Application of the redeemable equity guidance Generally, an embedded feature, whether or not bifurcated, that permits or requires the noncontrolling interest holder to deliver the subsidiary s interests in exchange for cash or other assets from the controlling entity (or the subsidiary itself) will result in the noncontrolling interest being considered redeemable equity. Public entities should consider the SEC staff s guidance (included in codification at ASC S99-3A) on redeemable equity securities when classifying redeemable noncontrolling interest. Those interests should first follow the accounting and measurement guidance in ASC (including allocation of earnings, adjustments for dividends, etc.). The SEC s guidance should then be considered, which could affect the classification (presented in the mezzanine rather than in equity), and if so, may also adjust the measurement of any noncontrolling interest and the related earnings per share calculations. 4 ASC through describe three different derivative instruments indexed to the stock of a consolidated subsidiary. One instrument includes a written put and purchased call. ASC provides for three different ways to account for the written put and purchased call, based on how the instruments were issued relative to the noncontrolling interest (i.e., freestanding from or embedded in the noncontrolling interest). ASC suggests that when the written put/purchased call are freestanding, they should be combined with the noncontrolling interest and accounted for as a financing. This accounting is not one of the three ways described in ASC We believe the guidance in ASC is inconsistent with the guidance formerly in EITF 00-4, Majority Owner's Accounting for a Transaction in the Shares of a Consolidated Subsidiary and a Derivative Indexed to the Minority Interest in That Subsidiary. As the Codification was not intended to change GAAP, we believe ASC should be followed unless ASC 815 requires the options to be combined with the noncontrolling interest, in which case the accounting described in ASC through should be followed. Financial reporting developments Consolidated and other financial statements 12

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