Chapter 6 — Attribution of Income, Other Comprehensive Income, and Cumulative Translation Adjustment Balances

6.2 Attributions Disproportionate to Ownership Interests

ASC 970-323

35-16 Venture agreements may designate different allocations among the investors for any of the following:

Profits and losses
Specified costs and expenses
Distributions of cash from operations
Distributions of cash proceeds from liquidation.

35-17 Such agreements may also provide for changes in the allocations at specified times or on the occurrence of specified events. Accounting by the investors for their equity in the venture’s earnings under such agreements requires careful consideration of substance over form and consideration of underlying values as discussed in paragraph 970-323-35-10. To determine the investor’s share of venture net income or loss, such agreements or arrangements shall be analyzed to determine how an increase or decrease in net assets of the venture (determined in conformity with GAAP) will affect cash payments to the investor over the life of the venture and on its liquidation. Specified profit and loss allocation ratios shall not be used to determine an investor’s equity in venture earnings if the allocation of cash distributions and liquidating distributions [is] determined on some other basis. For example, if a venture agreement between two investors purports to allocate all depreciation expense to one investor and to allocate all other revenues and expenses equally, but further provides that irrespective of such allocations, distributions to the investors will be made simultaneously and divided equally between them, there is no substance to the purported allocation of depreciation expense.

Contractual agreements often specify attributions of a subsidiary’s profits and losses, costs and expenses, distributions from operations, or distributions upon liquidation that are different from investors’ relative ownership percentages.

Although ASC 970-323 was written for equity method investments in the real estate industry, we believe that it is appropriate to refer to this literature for guidance on developing an appropriate method of allocating a subsidiary’s economic results between controlling and noncontrolling interests when a contractual agreement, rather than relative ownership percentages, governs the economic attribution of items of income or loss. ASC 970-323 implies that for the attribution of (comprehensive) income or loss to be substantive from a financial reporting perspective, it must hold true and best represent cash distributions over the life of the subsidiary. Reporting entities should focus on substance over form. Further, the reference to the allocation of depreciation expense in the last sentence of ASC 970-323- 35-17 is also instructive when guidance in other Codification topics (e.g., the guidance on reporting current-period items of profit or loss related to “partial goodwill” arising from business combinations that occurred before the effective date of ASC 805-10) may result in attribution of specific items of (comprehensive) income or loss on a basis other than the relative ownership percentages of the controlling and noncontrolling interests. For more information, see Section 6.2.2.

Given the potential impact of contractual arrangements (or financial reporting requirements of other Codification topics) on each party’s absorption of items of income or loss, we believe that reporting entities should generally perform the following three steps to allocate a subsidiary’s income or loss between the parent and noncontrolling interest holders in a manner that reflects the substance of the arrangements:

Note that the sum of the allocations in steps 2 and 3 should equal the reported income or loss of the subsidiary.

In some instances, reporting entities may use the HLBV method to achieve the result intended by steps 1, 2, and 3. For further discussion of the HLBV method, see Section 6.2.1.

Connecting the Dots

We believe that the guiding principle for attributing (comprehensive) income or loss to controlling and noncontrolling interests is to ascertain whether attributions that would otherwise be made in the current year are at significant risk of being unwound in subsequent periods on the basis of a different attribution method being used for subsequent cash distributions. In such instances, professional judgment must be used, and consideration should be given to the facts and circumstances at hand. Preparers should consider consulting with professional accounting advisers.

6.2.1 Application of the HLBV Method as a Means to Attribute (Comprehensive) Income and Loss

Although the Codification does not prescribe a specific method for attributing (comprehensive) income or loss to controlling and noncontrolling interests, reporting entities will often use the HLBV method, which is a balance sheet approach to encapsulating the change in an owner’s claim on a subsidiary’s net assets as reported under U.S. GAAP. Under the HLBV method, changes in an owner’s claim on the net assets of a reporting entity’s subsidiary that would result from the period-end hypothetical liquidation of the subsidiary at book value form the basis for allocating the subsidiary’s (comprehensive) income or loss between its controlling and noncontrolling interest holders.

The HLBV method was developed with equity method investments in mind and arose in response to increasingly complex capital structures, the lack of prescribed implementation guidance on how an equity method investor should determine its share of earnings or losses generated by the equity method investee, and the ensuing diversity in practice. In an attempt to establish in the authoritative literature the appropriate accounting for equity method investments in entities with complex structures, the AICPA issued a proposed SOP, Accounting for Investors’ Interests in Unconsolidated Real Estate Investments, in November 2000. The proposed SOP, which was not ultimately finalized, was intended for investments of unconsolidated real estate. However, the proposal led to increased use of the HLBV method as an acceptable means to allocate (comprehensive) income between a subsidiary’s controlling and noncontrolling interests when each investor’s right to participate in the (comprehensive) income of the subsidiary is disproportionate to its ownership interest.

Notwithstanding the HLBV method’s origins (or its ultimate absence from the Codification), we believe that given the FASB’s focus on substance over form, the HLBV method will often be an acceptable method for allocating (comprehensive) income or loss between the controlling and noncontrolling interest holders. Other methods may also be acceptable depending on the facts and circumstances.

Under the HLBV method, a reporting entity attributes (comprehensive) income to each investor by using the following formula:

The examples below illustrate the determination of (comprehensive) income or loss attribution under the HLBV method.

Example 6-1

Subsidiary XYZ, a subsidiary of ParentCo, is capitalized as follows:

Presented below are XYZ’s condensed balance sheets for the periods ending December 31 of 20X4, 20X5, and 20X6, respectively.

In 20X5, XYZ had net income of $150. In 20X6, it had net income of $800.

Subsidiary XYZ is a limited-life entity that does not make regular distributions to its stockholders. The preferred stockholders do not participate in distributions or have any voting rights. In each of the years presented, XYZ has not received any additional capital contributions from its investors. Subsidiary XYZ’s articles of incorporation indicate that upon XYZ’s liquidation, its net assets are distributed with the following priority:

Return of the preferred stockholder’s capital contribution.
Return of the common stockholders’ capital contributions.
100 percent to preferred stockholders until they receive a cumulative $200 return.
Remainder to common stockholders on pro rata basis.

Given XYZ’s complex capital structure, ParentCo has elected a policy of attributing XYZ’s net income to ParentCo and the noncontrolling interest holders in the consolidated financial statements by using the HLBV method. Thus, net income for 20X5 and 20X6 is attributed to the noncontrolling interest holders on the basis of the hypothetical liquidation of XYZ’s net assets as of December 31 of 20X4, 20X5, and 20X6, respectively, as shown in the tables below. Note that intercompany transactions and tax impacts have been ignored for simplicity.

Period-End Claim on Net Assets as Reported Under U.S. GAAP

Net income attributable to noncontrolling interests is calculated as follows:

Example 6-2

Partnership X (the “investee”) was formed to develop and construct a renewable solar energy facility. Partnership X will own the facility and sell electricity at a fixed rate to a local utility under a long-term power purchase agreement. Partnership X is a flow-through entity for tax purposes; therefore, the tax attributes (such as investment tax credits and accelerated tax depreciation) related to the solar energy facility are allocated to X’s partners in accordance with X’s operating agreement between the partners.

The fair market value of the solar energy facility is $35 million. The tax equity investor and sponsor (collectively, the “investors”) will contribute $15.5 million and $19.5 million, respectively, to X. Assume that (1) X is a consolidated subsidiary of the sponsor and (2) the tax equity investor’s interest in X is classified as a noncontrolling interest in the sponsor’s consolidated financial statements.1

Partnership X has a complex capital structure that requires an allocation of income, gain, loss, tax deductions, and tax credits before and after a “flip date” to the investors that is not consistent with the investors’ relative ownership percentages. The flip date is defined as the point in time when the tax equity investor receives a target after-tax internal rate of return (IRR) on its investment (in this example, tax equity’s target after-tax IRR is 8 percent). The tax equity investor achieves its IRR through cash distributions as well as the allocation of investment tax credits and other tax benefits.

Under the partnership agreement, income, gain, loss, tax deductions, and tax credits for each tax year will be allocated between the tax equity investor and the sponsor as follows:2

Cash distributions for each tax year, which are not designed to approximate GAAP earnings in each period, will be allocated between the tax equity investor and the sponsor as follows:

Tax gain (or loss) recognized upon the partnership’s liquidation will be distributed according to the following waterfall:

First, to partners with negative IRC Section 704(b)3 capital accounts, the amount needed to bring their capital accounts to zero.
Second, to the partners in accordance with their pre-flip sharing ratios (1 percent to the sponsor and 99 percent to the tax equity investor), until the tax equity investor achieves its target IRR.
Finally, to the partners in accordance with their post-flip tax sharing ratios (95 percent to the sponsor and 5 percent to the tax equity investor), any remaining gain (or loss).

Note that in this example, we assumed a generic set of liquidation provisions in using the HLBV method to attribute X’s income or loss to the controlling and noncontrolling interests in the sponsor’s consolidated financial statements. In practice, there is tremendous diversity in liquidation provisions from deal to deal.

Given X’s complex capital structure, the sponsor has elected a policy of attributing X’s earnings or losses to the controlling and noncontrolling interests by using the HLBV method. For the sponsor to apply the HLBV method in accordance with this policy, an analysis of the investors’ IRC Section 704(b) capital accounts (as adjusted per the liquidation provisions of the partnership agreement) must be performed. The mechanics of the HLBV method in this type of flip structure involve a complex combination of U.S. GAAP and tax concepts, typically consisting of the following steps (as of each reporting period end):4

Determine the partnership’s period-end U.S. GAAP capital account balance.
Determine the partnership’s and each investor’s starting IRC Section 704(b) capital account balance.
Calculate the partnership’s IRC Section 704(b) book gain (loss) on hypothetical liquidation (U.S. GAAP capital account from step 1 less starting IRC Section 704(b) capital account balance from step 2).
Allocate the partnership’s IRC Section 704(b) book gain (loss) from step 3 in the following order (specifics as determined by the liquidation provisions in the relevant agreement):
1. Allocate the gain to restore negative IRC Section 704(b) capital account balances to zero.
2. Allocate the gain to the tax equity investor until the target IRR is achieved.
3. Allocate the remaining gain (loss) in accordance with the appropriate residual sharing percentages.
Add/subtract the gain (loss) allocated in step 4 to each investor’s starting IRC Section 704(b) capital account balance determined in step 2.
Determine the change in each investor’s claim on the partnership’s book value during the period (adjusted for contributions and distributions).

The attribution of X’s earnings or losses to the controlling and noncontrolling interests under the HLBV method is calculated for the sponsor (the controlling interest holder) and the tax equity investor (the noncontrolling interest holder) in years 1 through 3, as shown below. Note that intra-entity profit and loss eliminations and tax impacts have been ignored for simplicity.

Step 1: Determine X’s period-end U.S. GAAP capital account balance:

Step 2: Determine X’s and each investor’s starting IRC Section 704(b) capital account balance:

Step 3: Calculate X’s IRC Section 704(b) book gain (loss) on hypothetical liquidation (U.S. GAAP capital account from step 1 less starting IRC Section 704(b) capital account balance from step 2):

Step 4: Allocate X’s IRC Section 704(b) book gain (loss) from step 3 (specifics as determined by the liquidation provisions in the relevant agreement) on liquidation:

Step 4(a): Allocate the gain to restore negative IRC Section 704(b) capital account balances to zero:

Step 4(b): Allocate the gain to the tax equity investor until target after-tax return (IRR) is achieved:**

Step 4(c): Allocate the remaining gain (loss) in accordance with appropriate residual sharing percentages:***

Step 5: Add/subtract the gain (loss) allocated in step 4 to each investor’s starting IRC Section 704(b) capital account balance determined in step 2:

Step 6: Determine the change in each investor’s claim on X’s book value during the period (adjusted for contributions and distributions):

In consolidation, the sponsor would have recognized in full X’s pretax income of $1,000,000, $1,250,000, and $1,500,000 in years 1, 2, and 3, respectively, as part of the sponsor’s consolidated net income before attributions to the noncontrolling interest. However, although X has net income in each of the three periods, because of the application of the HLBV method as shown above, the net income will be attributed on the basis of the change in each party’s claim on book value, which results in a net loss attributed to the noncontrolling interest. For example, in year 1, X had pretax net income of $1,000,000, which would be reflected in the sponsor’s pretax income upon consolidation. Application of the HLBV method results in the attribution of a net loss of $856,768 to the noncontrolling interest. To properly reflect the income attributable to the sponsor, the sponsor would record a credit entry to attribute earnings of $856,768 along with a debit to noncontrolling interest to reduce the noncontrolling interest balance. A similar process should be performed for years 2 and 3.

Below are the journal entries the sponsor would use to attribute X’s earnings or losses to the noncontrolling interest account in the sponsor’s consolidated financial statements.

Connecting the Dots

We believe that while it will often be acceptable for an entity to use the HLBV method to allocate (comprehensive) income between controlling and noncontrolling interests, there may be instances in which it would be inappropriate for an entity to use the HLBV method. Because the HLBV method inherently focuses on how the net assets of an entity will be distributed in liquidation, a detailed understanding of the entity’s intention with respect to cash distributions is important. We believe that when provisions governing the attribution of liquidating distributions differ significantly from those governing the attribution of ordinary distributions, it would be inappropriate to rely on the HLBV method to allocate the earnings of a going-concern entity between the controlling and noncontrolling interests if the subsidiary is expected to make significant ordinary distributions throughout its life. In such instances, stricter adherence to the three-step process described in Section 6.2 would be appropriate.

6.2.2 Financial Reporting Requirements of Other Codification Topics That Affect Attributions

As noted in Section 6.2, the financial reporting requirements of other Codification topics may make it necessary to attribute items of (comprehensive) income or loss (e.g., depreciation expense) on a basis other than the relative ownership percentages of the controlling and noncontrolling interests.

6.2.2.1 Business Combinations Consummated Before the Effective Date of FASB Statement 141(R) (Codified in ASC 805-10)

If an acquirer obtained less than a 100 percent ownership interest in an entity it acquired in a business combination consummated before the effective date of FASB Statement 141(R) (codified in ASC 805-10), the acquirer would have measured only a proportionate amount of the acquired entity’s identifiable net assets at fair value. For example, if the acquirer obtained a 75 percent interest, it would have measured the acquired entity’s identifiable net assets as of the date of the business combination at 75 percent fair value and 25 percent carryover value. Because of this mixed measurement model, attributions of the acquired entity’s post-combination amortization expense, depreciation expense, and impairment charges to the parent and noncontrolling interest holders are typically not based on each party’s proportionate ownership interests. Rather, in the absence of any other contractual arrangements identified in step 1 of the three-step process described in Section 6.2, one rational method of allocating these items between the controlling and noncontrolling interests in step 2 is to attribute the profit (loss) impact arising from the 75 percent step-up in basis to the acquirer, and the profit (loss) impact of items arising from the 25 percent carryover basis to the noncontrolling interest. Although not codified, paragraph B38 of the Background Information and Basis for Conclusions of FASB Statement 160 provides the following example:

[I]f an entity acquired 80 percent of the ownership interests in a subsidiary in a single transaction before [FASB] Statement 141(R) [codified in ASC 805-10] was effective, it likely would have recorded the intangible assets recognized in the acquisition of that subsidiary at 80 percent of their fair value (80 percent fair value for the ownership interest acquired plus 20 percent carryover value for the interests not acquired in that transaction, which for unrecognized intangible assets would be $0). If the Board would have required net income to be attributed based on relative ownership interests in [FASB Statement 160 and ASC 810-10], the noncontrolling interest would have been attributed 20 percent of the amortization expense for those intangible assets even though no amount of the asset was recognized for the noncontrolling interest. Before [FASB Statement 160] was issued, the parent generally would have been attributed all of the amortization expense of those intangible assets.

Similarly, when a reporting unit contains only goodwill or recognized intangible assets associated with a business combination consummated before the effective date of the guidance codified in ASC 805-10, a reporting entity’s attribution of 100 percent of all impairment losses on such items to the parent would generally be considered rational. This approach is consistent with ASC 350-20-35-57A, which states, in part, that “[a]ny impairment loss measured in the . . . goodwill impairment test shall be attributed to the parent and the noncontrolling interest on a rational basis.”

6.2.2.2 Business Combinations Consummated After the Effective Date of ASC 805-10

If an acquirer obtained less than a 100 percent ownership interest in an entity it acquired in a business combination consummated after the effective date of FASB Statement 141(R), the acquirer would measure the acquired entity’s identifiable net assets at their full fair value (i.e., net assets related to both the parent and the noncontrolling interest are governed by a single measurement principle). We believe that under the three-step process described in Section 6.2, the acquired entity’s post-combination amortization expense, as well as its depreciation expense and (non-goodwill-related) impairment charges, would typically be attributed to the parent and noncontrolling interest in a manner similar to how all other items of profit or loss are treated and attributed. That is, in the absence of any other contractual arrangements identified in step 1, no special consideration would be given to attributing these items in steps 2 and 3.

6.2.2.2.1 Goodwill Impairment Losses

With respect to goodwill impairment losses, we believe that rational methods for attributing such losses to the parent and noncontrolling interests may include the following approaches:

Attribute impairment losses on the basis of the relative fair values, as of the acquisition date, of the parent and noncontrolling interest. Because of a possible control premium, the amount of impairment loss attributed to the parent, as a percentage of its ownership interest, may be higher than the amount attributed to the noncontrolling interest.
Attribute impairment losses on the basis of the relative fair values, as of the impairment testing date, of the parent and noncontrolling interest. Because of a possible control premium, the amount of impairment loss attributed to the parent, as a percentage of its ownership interest, may be higher than the amount attributed to the noncontrolling interest.
Attribute impairment losses in a manner consistent with how net income and losses of the reporting unit (subsidiary) are attributed to the parent and noncontrolling interest (e.g., on the basis of the relative ownership interests of the parent and noncontrolling shareholders).

6.2.3 Attribution of Income in Carried Interest Arrangements

Many fund managers (collectively, “asset managers”) usually receive a performance fee as compensation for managing the capital of one or more investors in a fund. A common arrangement is referred to as “2 and 20” (i.e., 2 percent and 20 percent). The 2 percent refers to an annual management fee computed on the basis of assets under management. The 20 percent refers to a term in a performance fee arrangement under which the asset manager participates in a specified percentage (e.g., 20 percent) of returns after other investors have achieved a specified return on their investments, which is referred to as a hurdle rate (e.g., 8 percent).

Under a prevalent form of such an arrangement, the performance fee (“carried interest”) is allocated to a capital account embedded in a legal-form equity interest (e.g., a general partner or managing member interest). As noted above, the asset manager’s capital account receives allocations of the returns of a fund when those returns exceed predetermined thresholds. In addition to the carried interest, the asset manager or affiliates often acquire a small ownership interest in the fund through general partner or limited partner interests on the same basis as other investors.

Asset managers that do not have a controlling financial interest in the legal entity that issues the carried interest (i.e., asset managers that do not consolidate the legal entity) may account for the carried interest as revenue. In those instances, depending on the asset manager’s revenue recognition policies, the carried interest recognized as revenue in each period may or may not conform to the contractual profit and loss provisions of the fund.5

Sometimes, an asset manager with the right to the carried interest consolidates the legal entity that issues the carried interest. In those instances, the asset manager should not recognize revenue from the legal entity related to the carried interest because such revenue is eliminated in consolidation. However, the carried interest will affect the attribution of profit and loss to the legal entity’s parent and noncontrolling interest holders because the allocation of carried interest is essentially a disproportionate allocation of profit to the asset manager. A question therefore arises about whether the impact of the carried interest on the attribution of the profits and losses should conform to (1) the contractual profit and loss provisions of the consolidated fund or (2) the asset manager’s revenue recognition approach6 related to carried interest earned from legal entities that the asset manager does not consolidate.

We believe that when an asset manager attributes income or loss related to carried interest arrangements to controlling and noncontrolling interests, it would be inappropriate for the asset manager to allocate carried interest from a consolidated legal entity in a manner consistent with the asset manager’s revenue recognition approach for recognizing carried interest from a nonconsolidated legal entity unless that approach is consistent with the contractual allocation of profits and losses stipulated in the agreement establishing the rights and obligations of the holders of controlling and noncontrolling interests in the legal entity that issues the carried interest (the “legal entity agreement”). Rather, an asset manager should apply ASC 810-10-45-20 when accounting for the allocation of carried interest arrangements of its consolidated subsidiaries.

Since ASC 810-10-45-20 requires a reporting entity to attribute net income or loss to the parent and the noncontrolling interest holders, a parent entity (asset manager) should not, for example, defer allocation of a carried interest until the uncertainty associated with the ultimate outcome of the carried interest is resolved even though doing so may be the asset manager’s outcome of recognizing revenue for carried interest arrangements with nonconsolidated legal entities under ASC 606.

Instead, an asset manager should allocate carried interest between the controlling and noncontrolling interests (i.e., reflect the allocation of carried interest from the noncontrolling interest holders to the asset manager parent) in a manner consistent with the contractual profit and loss allocation (1) stipulated in the legal entity agreement and (2) reflected in the capital accounts of the consolidated legal entity. Applying this approach could lead to reflecting the carried interest in the period in which the income is earned and recorded by the consolidated investment fund rather than waiting to perform such allocation until a later reporting period. This approach is consistent with the three-step approach described in Section 6.2 for attributing a subsidiary’s income or loss in a manner disproportionate to ownership interests in the subsidiary.

Example 6-3

Company X is the general partner of Fund Y, which is a closed-end three-year limited partnership that is designed to invest in equity and debt securities issued by emerging growth companies. Company X owns a 0.1 percent general partner interest in Y and a 25 percent limited partner interest in Y. Company Y’s remaining limited partner interests are owned by unrelated parties LP 1, LP 2, and LP 3. Fund Y is a VIE consolidated by X, and the remaining limited partner interests are classified as noncontrolling interests in X’s consolidated financial statements.

In exchange for performing its services, X is entitled to receive a base management fee equal to 2 percent of the net assets under management and an incentive-based capital allocation fee (i.e., carried interest) equal to 20 percent of the net income of Y in excess of $5 million per year, evaluated on a cumulative basis over the three-year life of Y. The incentive-based capital allocation fee is to be distributed to X at the end of the three-year life of Y on the basis of Y’s cumulative performance as compared with the cumulative three-year threshold of $15 million (i.e., $5 million per year over three years).

The parties’ respective interests are illustrated in the diagram below.

Fund Y’s annual and cumulative net income (loss), inclusive of the 2 percent base management fee owed to X, is as follows:

The allocation of Y’s annual net income to X and the noncontrolling interest holders for each year is as follows (for simplicity, the amounts below do not reflect X’s 0.1 percent general partner interest):

Footnotes

Note, however, that in some arrangements, the sponsor may account for its interest in a partnership as an equity method investment rather than as a consolidated subsidiary depending on the facts and circumstances and the outcome of applying the guidance in ASC 810 and ASC 323. Nonetheless, the sponsor may calculate and record its equity method income and loss in a manner consistent with the HLBV method by using the mechanics described herein. See Example 5-4 of Deloitte’s Roadmap Equity Method Investments and Joint Ventures.

The partnership operating agreement may call for certain allocations, such as 99:1, in the pre-flip period. However, the tax equity investor and the sponsor must still perform a detailed analysis of the partners’ Internal Revenue Code (IRC) Section 704(b) capital accounts and tax basis since the operation of the partnership tax rules/limitations can often result in allocations that do not necessarily match the stated allocation percentages in the operating agreement.

IRC Section 704(b) discusses special allocations of partnership items.

This example represents a simple HLBV waterfall calculation. Depending on the complexity of the liquidation waterfall in the operating agreement, as well as the discrete items in the entity’s financial statements, additional steps may be necessary.

For additional discussion of revenue recognition considerations related to carried interest arrangements, see Section 3.2.11.2 of Deloitte’s Roadmap Revenue Recognition.

As used in this section, the term “revenue recognition approach” also contemplates situations in which an asset manager applies the equity method of accounting to record carried interest and records an equity method pickup each reporting period.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.