Chapter 6 — Attribution of Income, Other Comprehensive Income, and Cumulative Translation Adjustment Balances
Chapter 6 — Attribution of Income, Other Comprehensive Income, and Cumulative Translation Adjustment Balances
6.1 Overview
ASC 810-10
45-2 The retained earnings or
deficit of a subsidiary at the date of acquisition by the
parent shall not be included in consolidated retained
earnings.
45-4 When a subsidiary is initially
consolidated during the year, the consolidated financial
statements shall include the subsidiary’s revenues,
expenses, gains, and losses only from the date the
subsidiary is initially consolidated.
45-19 Revenues, expenses, gains,
losses, net income or loss, and other comprehensive income
shall be reported in the consolidated financial statements
at the consolidated amounts, which include the amounts
attributable to the owners of the parent and the
noncontrolling interest.
45-20 Net income or loss and
comprehensive income or loss, as described in Topic 220,
shall be attributed to the parent and the noncontrolling
interest.
As defined in the ASC master glossary, a noncontrolling interest
represents the “portion of equity (net assets) in a subsidiary not attributable,
directly or indirectly, to a parent.” It follows then that the measurement of
noncontrolling interests on the reporting entity’s balance sheet is affected, in
part, by the manner in which elements of a subsidiary’s income and comprehensive
income are attributed to the parent’s controlling interest and the noncontrolling
interests held by parties other than the parent.
While ASC 810-10 requires a reporting entity to allocate a
subsidiary’s income or loss and comprehensive income or loss between the controlling and noncontrolling interests, it does not prescribe a specific means for doing so. That lack of detail was acknowledged by the FASB in paragraph B38 of the Background Information and Basis for Conclusions of FASB Statement 160:
[E]ntities were making attributions before [FASB Statement
160] was issued and . . . those attributions generally were reasonable and
appropriate. Therefore, the Board decided that detailed guidance was not
needed.
Although items of income or loss and comprehensive income or loss
are commonly attributed on the basis of the relative ownership interests of the
parent and noncontrolling interests, there are many instances, as explained in
Sections 6.2.1 through
6.3, in which it would be inappropriate to attribute income or loss
solely on the basis of relative ownership percentages.
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
Subsidiary X, a partnership, was formed to develop and construct a renewable solar energy facility. Subsidiary X will own the facility and sell electricity at a fixed rate to a local utility under a long-term power purchase agreement. Subsidiary 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
Subsidiary 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 subsidiary’s period-end U.S. GAAP capital account balance.
-
Determine the subsidiary’s and each investor’s starting IRC Section 704(b) capital account balance.
-
Calculate the subsidiary’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 subsidiary’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):
-
Allocate the gain to restore negative IRC Section 704(b) capital account balances to zero.
-
Allocate the gain to the tax equity investor until the target IRR is achieved.
-
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 subsidiary’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
Private equity, hedge, real estate, and similar investment 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
1
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.
2
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.
3
IRC Section 704(b) discusses special allocations
of partnership items.
4
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.
5
For additional discussion of revenue recognition considerations
related to carried interest arrangements, see Section
3.2.11.2 of Deloitte’s Roadmap Revenue Recognition.
6
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.
6.3 Attribution of Losses in Excess of Carrying Amount
ASC 810-10
45-21
Losses attributable to the parent and the noncontrolling
interest in a subsidiary may exceed their interests in the
subsidiary’s equity. The excess, and any further losses
attributable to the parent and the noncontrolling interest,
shall be attributed to those interests. That is, the
noncontrolling interest shall continue to be attributed its
share of losses even if that attribution results in a
deficit noncontrolling interest balance.
Before FASB Statement 160 was issued, reporting entities were required under ARB
51 to attribute losses solely to the parent once losses allocated to the
noncontrolling interest equaled the noncontrolling interest’s equity. The reasoning
behind this requirement was that the noncontrolling interest could not be compelled
to provide additional capital to the subsidiary, whereas the parent would most
likely have an implicit obligation to keep the subsidiary a going concern. After adoption of FASB Statement 160, noncontrolling interests are considered equity of the consolidated group that participate fully in the risks and rewards of the subsidiary. Accordingly, with limited exception (described after the example below), losses generally continue to be attributed to noncontrolling interests regardless of whether a deficit would be recorded. As explained in paragraphs B41 through B43 of the Background Information and Basis for Conclusions of FASB Statement 160, the FASB
based its decision to change historical practice on the observation that although a
controlling interest holder may be more likely to provide additional support to a
subsidiary than a noncontrolling interest holder, it cannot be forced to do so.
Given that observation, the Board was uncomfortable with requiring the allocation of
losses between the controlling and noncontrolling interest holders to be predicated
on probability.
Example 6-4
On January 1, 20X9, Company A acquired 80 percent of Subsidiary C in a transaction accounted for as a business combination under ASC 805-10. As of the acquisition date, the equity attributable to A (the parent) is $80 million, and the equity attributable to Entity B (the noncontrolling interest holder) is $20 million. Subsidiary C has only one class of common stock outstanding, and no shareholders have an explicit obligation to support the ongoing operations of C. During 20X9, C incurred net losses of $150 million.
The net earnings (losses) of C are attributed to A and B on the basis of their relative ownership interests (i.e., 80 percent/20 percent).
Of C’s 20X9 net losses, $30 million (20 percent of $150 million) would be attributed to the noncontrolling interest. As a result, the carrying amount of the noncontrolling interest will reflect a deficit balance of $10 million at the end of 20X9 ($20 million beginning balance reduced by $30 million of current-period losses). The remaining $120 million (80 percent of $150 million) of C’s 20X9 net losses would be attributed to A’s controlling interest, resulting in a 20X9 ending deficit balance for A’s controlling interest of $40 million.
The equity interests at acquisition and after the attribution of 20X9 losses are
illustrated below.
Equity interests as of January 1, 20X9:
Equity interests as of December 31, 20X9 (after the attribution of losses):
Note that ASC 810-10-45-21 states that losses allocated to noncontrolling
interests may exceed their interest in subsidiary equity.
Thus, while ASC 810-10 acknowledges that a reporting entity may report
noncontrolling interest balances as a negative amount in some situations, there are
also circumstances in which it may not be appropriate to do so. Given that the
FASB’s decision to permit the attribution of losses in excess of the noncontrolling
interests’ equity balance was based on the Board’s belief that holders of
controlling and noncontrolling interests in a typical entity could not be compelled
to provide additional support to the entity, it remains appropriate to attribute
losses in a manner disproportionate to ownership interests when a contractual
arrangement does compel one investor to absorb more losses than another. For
example, contractual arrangements outside of the shareholder agreement itself (e.g.,
debt guarantees), coupled with the perennial need to consider substance over form,
may require attribution of losses on a basis different from proportionate ownership
interests or loss-sharing percentages specified in the shareholder agreement.
Similarly, in subsequent periods of net income, disproportionate attribution of
income may be required until losses that have been disproportionately attributed are
fully recovered.
We believe that a subsidiary’s losses in excess of each party’s investment in
the subsidiary’s equity should be allocated between the parent and noncontrolling
interest holders in accordance with the three-step allocation process described in
Section 6.2. That
is, as illustrated in the example below, a reporting entity with a controlling
financial interest in a legal entity should consider the impact of its other
interests in the legal entity (e.g., debt and other forms of financial support) when
determining the attribution of current-period losses, especially when the amount of
losses attributed in prior periods exceeds the ownership interests of the parent and
noncontrolling interest holders. A reporting entity should also use this three-step
process when attributing income generated in subsequent reporting periods.
Example 6-5
In 20X1, Company A and Entity B enter into a partnership agreement under which Subsidiary C is formed. Company A has invested $75 million for a 75 percent equity controlling interest in C, and B has invested $25 million for the remaining 25 percent noncontrolling interest in C. Company A consolidates C accordingly.
In addition to the equity interests that C has issued, C has obtained the
following forms of financing:
-
$110 million of senior bank financing, fully guaranteed for repayment by A.
-
$50 million of unsecured debt financing provided by third parties. This debt is not guaranteed by A or B.
The equity interests and financing at formation are illustrated in the diagram below.
In its first five years of operations, C had no intercompany transactions with A or B. During this time, C generated annual net income (loss) as follows:
- Year 1 — $(90 million).
- Year 2 — $(100 million).
- Year 3 — $(40 million).
- Year 4 — $50 million.
- Year 5 — $200 million.
Subsidiary C’s partnership agreement requires income to be distributed on a pro
rata basis in accordance with the respective ownership
percentages of A and B, but it is silent on attribution of
losses and does not impose on A or B any explicit obligation
to support the continued operations of C. Although the
partnership agreement does not explicitly specify a formula
for attributing losses, A would apply the three-step process
described in Section 6.2 as
follows:
-
Step 1 — Identify all contractual arrangements between the parent, noncontrolling interest holders, subsidiary, and third parties (or financial reporting requirements of other Codification topics) that have the potential to shift income or loss between the parties on a basis other than their relative equity ownership percentages.Company A’s full (and sole) guarantee of C’s $110 million of senior bank financing serves to shift to A the responsibility for absorbing C’s cumulative losses that are in excess of $100 million (C’s initial equity balance) but less than or equal to $210 million.
-
Step 2 — Allocate the economic results of the subsidiary between the controlling and noncontrolling interests to reflect the contractual arrangements (or financial reporting requirements of other Codification topics) identified in step 1.In consolidating C’s financial results, A would (1) allocate the first $100 million of C’s cumulative losses (years 1 and 2) proportionately between its controlling interest and B’s noncontrolling interest and (2) attribute the next $110 million of C’s cumulative losses (years 2 and 3) solely to A’s controlling financial interest.
-
Step 3 — Allocate residual items of income and loss (which may differ from net income [loss] because of the adjustments made in step 2) between the controlling and noncontrolling interest holders in accordance with each party’s pro rata equity ownership interest in the subsidiary.In consolidating C’s financial results, A would allocate the remaining $20 million of C’s cumulative losses (year 3) proportionately between A’s controlling interest and B’s noncontrolling interest.
Attributions of the first $130 million of net income in years 4 and 5 would essentially unwind (in reverse chronological order) the attributions made in steps 3 and 2 above, with the remaining $120 million of net income occurring in year 5 being allocated proportionately between A’s equity interests in C and those of B.
The following table details the attribution of C’s income (loss) and its
associated impact on A’s equity interests in C and those of
B for each reporting period (dollar amounts in millions):7
Similarly, as illustrated in the example below, a reporting entity with a controlling
financial interest in a legal entity should also consider the impact of liquidation
preferences associated with investments in the legal entity when determining the
attribution of current-period losses, especially when the amount of losses
attributed in prior periods exceeds the ownership interests of the parent and
noncontrolling interest holders. A reporting entity should also use this three-step
process when attributing income generated in subsequent reporting periods.
Example 6-6
Company A has a controlling financial
interest in Company C and made an $80 million investment in
C's preferred stock that represents 80 percent of C’s equity
capitalization. Company B made a $20 million investment in
C's common stock that represents the remaining 20 percent
noncontrolling interest in C. The preferred stock held by A
has a substantive liquidation preference.
The equity interests in C as of January 1, 20X1, are
illustrated in the diagram below.
In its first three years of operations, C had no intercompany
transactions with A or B. During this time, C generated
annual net income (loss) as follows:
- Year 1 — $(90 million).
- Year 2 — $(100 million).
- Year 3 — $(40 million).
Assume the above facts for both scenarios below (Case A and
Case B).
Case A — No Obligation to Fund Subsidiary Losses
Company C’s articles of incorporation require income to be
distributed on a pro rata basis in accordance with the
respective ownership percentages of A and B, but they are
silent on attribution of losses and do not impose any
explicit obligation to support the continued operations of
C.
Although the articles of incorporation do not explicitly
specify a formula for attributing losses, A would apply the
three-step process described in Section 6.2 as follows:
-
Step 1 — Identify all contractual arrangements between the parent, noncontrolling interest holders, subsidiary, and third parties (or financial reporting requirements of other Codification topics) that have the potential to shift income or loss between the parties on a basis other than their relative equity ownership percentages.Company A’s substantive liquidation preference serves to protect A from absorbing C’s cumulative losses before B’s equity balance is entirely depleted.
-
Step 2 — Allocate the economic results of the subsidiary between the controlling and noncontrolling interests to reflect the contractual arrangements (or financial reporting requirements of other Codification topics) identified in step 1.In consolidating C’s financial results, A would (1) allocate the first $20 million of C’s cumulative losses (year 1) to B’s noncontrolling interest and (2) attribute the next $80 million of C’s cumulative losses (years 1 and 2) solely to A’s controlling financial interest.
-
Step 3 — Allocate residual items of income and loss (which may differ from net income [loss] because of the adjustments made in step 2) between the controlling and noncontrolling interest holders in accordance with each party’s pro rata equity ownership interest in the subsidiary.In consolidating C’s financial results, A would allocate the remaining $130 million of C’s cumulative losses (years 2 and 3) proportionately between A’s controlling interest and B’s noncontrolling interest.
The following table details the attribution of C’s income
(loss) and its associated impact on A’s equity interests in
C and those of B for each reporting period (dollar amounts
in millions):
Case B — Explicit Obligation to Fund Subsidiary
Losses
Company C’s articles of incorporation
require income to be distributed on a pro rata basis in
accordance with the respective ownership percentages of A
and B, and they explicitly require A to support the
continued operations of C. Therefore, A is required to fund
the operating losses of C. Accordingly, A would again apply
the three-step process described in Section 6.2 as follows:
-
Step 1 — Identify all contractual arrangements between the parent, noncontrolling interest holders, subsidiary, and third parties (or financial reporting requirements of other Codification topics) that have the potential to shift income or loss between the parties on a basis other than their relative equity ownership percentages.Company A’s substantive liquidation preference serves to protect A from absorbing C’s cumulative losses before B’s equity balance is entirely depleted.
-
Step 2 — Allocate the economic results of the subsidiary between the controlling and noncontrolling interests to reflect the contractual arrangements (or financial reporting requirements of other Codification topics) identified in step 1.In consolidating C’s financial results, A would (1) allocate the first $20 million of C’s cumulative losses (year 1) to B’s noncontrolling interest.
-
Step 3 — Allocate residual items of income and loss (which may differ from net income [loss] because of the adjustments made in step 2) between the controlling and noncontrolling interest holders in accordance with each party’s pro rata equity ownership interest in the subsidiary.In consolidating C’s financial results, A would allocate the remaining $210 million of C’s cumulative losses (years 1, 2 and 3) solely to A’s controlling financial interest as a result of A’s explicit obligation to support C’s losses.
The following table details the attribution of C’s income
(loss) and its associated impact on A’s equity interests in
C and those of B for each reporting period (dollar amounts
in millions):
Connecting the Dots
As demonstrated above, it remains appropriate to
attribute losses in a manner disproportionate to
ownership interests when a contractual arrangement
compels one investor to absorb more losses than
another. Case B illustrates a fact pattern in which
one investor is explicitly required to absorb such
losses. However, careful consideration is warranted
when the obligation is implicit rather than
explicit. For example, a parent company may have a
historical practice of funding its subsidiary’s
losses that would support a conclusion that the
parent company is implicitly obligated to keep the
subsidiary a going concern. To the extent that a
reporting entity believes that an implicit
obligation to fund subsidiary losses is present and
substantive, the reporting entity should consider
consulting with its professional accounting
advisers.
Footnotes
7
For purposes of this example, tax
implications have been ignored.
6.4 Attribution of Eliminated Income or Loss (Other Than VIEs)
ASC 810-10
45-1 In
the preparation of consolidated financial statements,
intra-entity balances and transactions shall be eliminated.
This includes intra-entity open account balances, security
holdings, sales and purchases, interest, dividends, and so
forth. As consolidated financial statements are based on the
assumption that they represent the financial position and
operating results of a single economic entity, such
statements shall not include gain or loss on transactions
among the entities in the consolidated group. Accordingly,
any intra-entity profit or loss on assets remaining within
the consolidated group shall be eliminated; the concept
usually applied for this purpose is gross profit or loss
(see also paragraph 810-10-45-8).
45-18
The amount of intra-entity income or loss to be eliminated
in accordance with paragraph 810-10-45-1 is not affected by
the existence of a noncontrolling interest. The complete
elimination of the intra-entity income or loss is consistent
with the underlying assumption that consolidated financial
statements represent the financial position and operating
results of a single economic entity. The elimination of the
intra-entity income or loss may be allocated between the
parent and noncontrolling interests.
As discussed in Section
10.2.1 of Deloitte’s Roadmap Consolidation — Identifying a Controlling Financial
Interest, ASC 810-10-45-1 and ASC 810-10- 45-18 require
intercompany balances and transactions to be eliminated in their entirety. The
amount of profit or loss eliminated is not affected by the existence of a
noncontrolling interest (e.g., intra-entity open accounts balances, security
holdings, sales and purchases, interest, or dividends). Since consolidated financial
statements are based on the assumption that they represent the financial position
and operating results of a single economic entity, the consolidated statements do
not include any gain or loss transactions between the entities in the consolidated
group.
Some companies record all intercompany transactions at cost. However, other
companies that operate each component entity as a profit center may measure
profitability for each entity and thus may record intercompany transactions at fair
value. This is likely to be the case if the subsidiary is not wholly owned. In any
event, intercompany profits not realized through transactions with third parties are
to be eliminated upon consolidation; that is, if products are sold between a parent
and a subsidiary at a price in excess of the cost to the transferor, the unrealized
intercompany profit in the transferee’s inventory should be eliminated upon
consolidation.8 Although full elimination of intercompany profit is required for all
subsidiaries, the elimination of intercompany profit may be allocated
proportionately between the parent and the noncontrolling interest.
If there are other charges between a parent and subsidiary (e.g., for management services or for interest on intercompany advances), those charges also should be eliminated in consolidation. However, an intercompany charge that is capitalized as part of fixed assets (e.g., direct labor costs incurred in preparing a piece of equipment for its intended use) or included as overhead in inventory should not be eliminated if the charge is simply a pass-through of the cost of an item incurred by the transferor or paid by an entity within the consolidated group to an outside third party that would have been considered an asset in the accounts of the originating company.
As summarized in the table below, attribution of the eliminating entry depends
on (1) the nature of the intercompany transaction (downstream vs. upstream) and (2)
the accounting policy elected by the parent (for upstream transactions only).
Acceptable Eliminating Entry Attribution Methods for Intercompany Transactions With Partially Owned Subsidiaries | |||
|---|---|---|---|
Transaction | Intercompany Profit (Loss) Elimination | Attribution of Eliminating Entry | Notes |
Downstream Transaction Sale from parent to partially owned subsidiary | Fully eliminate all intercompany profit (loss) | Eliminating entry is attributed to parent; 100 percent of eliminated income (loss) reduces (increases) net income attributed to controlling interests. | |
Upstream Transaction Sale from partially owned subsidiary to parent | Fully eliminate all intercompany profit (loss) | Policy Election Must be consistently applied to all consolidated, partially owned subsidiaries. | |
Parent-Only Attribution Method Eliminating entry is attributed to parent; 100 percent of eliminated income (loss) reduces (increases) net income attributable to controlling interests. | Consolidated net income will be the same as that under the parent/noncontrolling
interest attribution method. In periods in which net income on an upstream transaction is being deferred (eliminated), net income attributable to controlling interests will be lower than that under the parent/noncontrolling interest attribution method. In the same period, the noncontrolling interest holder’s ownership interest in net assets of subsidiary will be higher than that under the parent/noncontrolling interest attribution method. | ||
Parent/Noncontrolling Interest Attribution Method Eliminating entry is attributed to parent and noncontrolling interests; eliminated income (loss) attributed to noncontrolling interests increases (decreases) net income attributable to controlling interests. | Consolidated net income will be the same as that under the parent-only
attribution method. In periods in which net income on an upstream transaction is being deferred (eliminated), net income attributable to controlling interest will be higher than that under the parent-only attribution method. In the same period, the noncontrolling interest holder’s ownership interest in net assets of the subsidiary will be lower than that under the parent-only attribution method. | ||
6.4.1 Eliminating Profit (Loss) on Downstream Transactions
In a downstream transaction, a parent sells goods (or services) to a subsidiary.
To the extent that the goods are sold for more (less) than the parent’s cost
basis in such goods, a profit (loss) will be recorded in the parent-only
financial statements. In a manner consistent with the single economic entity
concept articulated in ASC 810-10-45-1 and ASC 810-10-45-18, this type of
transaction must be eliminated in the consolidated financial statements. Any
associated profit or loss is deferred until the goods are ultimately sold to a
third party. We believe that 100 percent of the eliminating entry arising from
downstream transactions should be attributed to the parent’s controlling
interest regardless of the parent’s ultimate ownership interest in the
subsidiary because in the absence of any contractual arrangements identified in
step 1 of the three-step process described in Section 6.2, holders of noncontrolling
interests in the subsidiary will never participate economically in the profit or
loss associated with downstream intercompany transactions. Consequently,
attributing any portion of the deferral (or recognition in subsequent periods)
of such profit or loss to the noncontrolling interest holders would ignore the
substance of the transactions. However, because all of the subsidiary’s
shareholders (which include the parent) will participate in any subsequent
profit (loss) arising from the subsidiary’s ultimate sale of the goods to
third parties for amounts greater (less) than the purchase price the subsidiary
paid to the parent, incremental profits or losses arising from the subsidiary’s
ultimate sale of the goods to third parties are attributed to controlling and
noncontrolling interests in accordance with steps 2 and 3.
Some reporting entities apply the equity method of accounting in their
parent-only financial statements when accounting for the parent’s investment in
a subsidiary. Others use the cost method, under which the parent-only financial
statements include subsidiary income only to the extent that a dividend has been
declared by the parent’s subsidiary. While the financial results reported in the
consolidated financial statements will be the same under either approach, the
consolidation process will vary depending on the approach selected for preparing
the parent-only financial statements. The example below illustrates the impact
of a downstream transaction in the consolidated financial statements of a parent
that has elected to apply the equity method to its investment in its subsidiary
when preparing its parent-only financial statements.
Example 6-7
Company A has a 75 percent controlling interest in Subsidiary B. The remaining 25 percent of B’s common stock is owned by an unrelated third party, Entity C. Company A and Entity C split all earnings of B in a manner proportionate to their ownership interests. There are no contractual or other provisions that would make it necessary to allocate B’s earnings between A and C on other than a proportionate basis.
During 20X2, in addition to third-party transactions conducted by A and B, A has $125,000 of sales to B. As illustrated in the diagram below, the inventory sold to B has a cost basis of $60,000.
As of December 31, 20X2, the inventory that B has purchased from A is not yet resold to third parties.
In 20X3, B sells to third parties all inventory purchased from A in 20X2. There are no changes to B’s ownership structure, and no additional intercompany transactions are executed between A and B in 20X3.
Illustrated below are the following:
- The financial statements of A and B, respectively, for the year ended December 31, 20X2, together with the consolidating entries that would be recorded as of December 31, 20X2.
- The financial statements of A and B, respectively, for the year ended December 31, 20X3, together with the consolidating entries that would be recorded as of December 31, 20X3.
- The eliminating entries related to the downstream sale of inventory for the years ended December 31 of 20X2 and 20X3, respectively.
Note that in A’s stand-alone financial statements, A accounts for its investment in B under the equity method.
For simplicity:
- Tax implications have been ignored.
- Each of the transactions (including intercompany sales) is presumed to have been cash settled in the year it occurred.
- Intercompany sales have been presented separately from third-party sales to highlight the consolidation and elimination impact of intercompany transactions.
- Investments in B and noncontrolling interest accounts have been broken down by their contributed capital and retained earnings components.
Note that in the year ended December 31, 20X3, the
consolidating entry of $222,000 represents the
consolidating entry from the prior year.
6.4.2 Eliminating Profit (Loss) on Upstream Transactions
In an upstream transaction, a subsidiary sells goods (or services) to its
parent. To the extent that the intercompany sales price is greater (less) than
the subsidiary’s cost basis in such goods, a profit (loss) will be recorded in
the subsidiary’s financial statements. Thus, unlike a downstream transaction, in
which there is no gain or loss on the subsidiary’s books to ultimately
attribute, an upstream transaction typically gives rise to a gain or loss on the
subsidiary’s books that needs to be deferred, with the effect of such deferral
being allocated to the controlling and (depending on the parent’s policy
election) noncontrolling interests. The eliminating entry itself highlights the
competing requirements of ASC 810-10.
As previously noted, the ASC master glossary defines a noncontrolling interest as the “portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent.” The single economic entity concept articulated in ASC 810-10-45-1 and ASC 810-10-45-18 requires a reporting entity to eliminate intercompany transactions (including any associated gain or loss) in the consolidated financial statements. While ASC 810-10 also requires the reporting entity to allocate a subsidiary’s income and comprehensive income between the controlling and noncontrolling interests, it stops short of prescribing a specific means for doing so. Further clouding the picture, the last sentence of ASC 810-10-45-18 states that the “elimination of the intra-entity income or loss may be allocated between the parent and noncontrolling interests” (emphasis added), leaving open the possibility of attributing the effect of the eliminating entry to noncontrolling interests while stopping short of requiring such attribution outright.
In light of the competing requirements summarized above, we believe that there are two acceptable methods for attributing to controlling and noncontrolling interests the effect of the eliminating entry on an upstream transaction:
- Parent-only attribution method — Under the parent-only attribution method, 100 percent of the deferred income (loss) reduces (increases) net income attributable to the controlling interests on the basis that from the perspective of a single economic entity, until the parent resells the inventory to third parties (as addressed below), no transaction has occurred with an external party, and therefore no profit should flow through to the consolidated entity’s bottom line (i.e., net income attributable to the parent). While this method results in reported net income attributable to controlling interests that is lower (higher) than that under the parent/noncontrolling interest attribution method in the period of profit (loss) deferral, amounts reported as noncontrolling interests in the consolidated balance sheet in the same period will equal the noncontrolling interest holders’ portion of the subsidiary’s net assets after the upstream sale. That is, under the parent-only attribution method, the carrying amount of the noncontrolling interests in the consolidated balance sheet reflects the noncontrolling interest holders’ increased (decreased) claim on the subsidiary’s net assets in recognition that the subsidiary’s net assets increase (decrease) as a result of the upstream transaction even though 100 percent of the income (loss) on the upstream sale is deferred in consolidation.
- Parent/noncontrolling interest attribution method — Under the parent/noncontrolling interest attribution method, a reporting entity attributes the eliminating entry necessary to defer income (loss) on the upstream transaction to the parent and noncontrolling interest holders in proportion to their ownership interests (in the absence of any identified contractual arrangements in step 1 of the three-step process described in Section 6.2). Thus, although reported net income (loss) will be the same under this method as under the parent-only attribution method, reported net income (loss) attributable to the parent’s controlling interest will be higher (lower) in the period of profit (loss) deferral. Essentially, this method immediately affects the consolidated reporting entity’s bottom line (through the attribution of income as opposed to net income) for the portion of income (loss) on the upstream transaction that is related to noncontrolling interests in the subsidiary. Consequently, under the parent/noncontrolling interest attribution method, until the parent resells the inventory to third parties, the consolidated financial statements reflect higher net income (loss) attributable to the controlling interests but a lower (higher) overall balance sheet amount associated with the noncontrolling interest holders’ claim on the subsidiary’s net assets.
Connecting the Dots
The existence of two attribution methods allows for reporting entities with similar transactions to temporarily report different amounts for net income attributable to the controlling and noncontrolling interest holders, as well as different carrying amounts for noncontrolling interests, on their individual consolidated balance sheets. However, as illustrated in the example below, these differences reverse themselves upon the parent’s ultimate sale of the inventory to third parties. Notwithstanding the temporary nature of the differences that result from a reporting entity’s decision to choose one attribution method over the other, we believe that the selection of an attribution method is an accounting policy election that a reporting entity should apply consistently when consolidating all of its partially owned subsidiaries.
The example below illustrates the impact of applying both attribution methods to
an upstream transaction in the consolidated financial statements of a parent
that has elected to apply the equity method to its investment in its subsidiary
when preparing its parent-only financial statements.
Example 6-8
Company A has a 75 percent controlling interest in Subsidiary B. The remaining 25 percent of B’s common stock is owned by an unrelated third party, Entity C. Company A and Entity C split all earnings of B in a manner proportionate to their ownership interests. There are no contractual or other provisions that would make it necessary to allocate B’s earnings between A and C on other than a proportionate basis.
During 20X2, in addition to third-party transactions conducted by A and B, B has $125,000 of sales to A. As illustrated in the diagram below, the inventory sold to A has a cost basis of $60,000.
As of December 31, 20X2, the inventory that A has purchased from B is not yet resold to third parties.
In 20X3, A sells to third parties all inventory purchased from B in 20X2. There are no changes to B’s ownership structure, and no additional intercompany transactions are executed between A and B in 20X3.
Illustrated below are the following:
- The financial statements of A and B, respectively, for the years ended December 31, 20X2, and December 31, 20X3, together with the consolidating entries that would be recorded as of the end of each of those years under the parent-only attribution method.
- The eliminating entries related to the upstream sale of inventory for the years ended December 31 of 20X2 and 20X3, respectively, under each alternative attribution method.
- The financial statements of A and B, respectively, for the years ended December 31, 20X2, and December 31, 20X3, together with the consolidating entries that would be recorded as of the end of each of those years under the parent/noncontrolling interest attribution method.
Note that in A’s stand-alone financial statements, A accounts for its investment in B under the equity method.
For simplicity:
- Tax implications have been ignored.
- Each of the transactions (including intercompany sales) is presumed to have been cash settled in the year it occurred.
- Intercompany sales have been presented separately from third-party sales to highlight the consolidation and elimination impact of intercompany transactions.
- Investments in B (A) and noncontrolling interest (consolidated) accounts have been broken down by their contributed capital and retained earnings components.
Footnotes
8
ASC 980-810-45-1 provides an exception under which profit on
sales to regulated affiliates would not be eliminated when specific criteria
are met.
6.5 Attribution of Eliminated Income or Loss (VIEs)
ASC 810-10
35-3 The principles of
consolidated financial statements in this Topic apply to
primary beneficiaries’ accounting for consolidated
variable interest entities (VIEs). After the initial
measurement, the assets, liabilities, and noncontrolling
interests of a consolidated VIE shall be accounted for
in consolidated financial statements as if the VIE were
consolidated based on voting interests. Any specialized
accounting requirements applicable to the type of
business in which the VIE operates shall be applied as
they would be applied to a consolidated subsidiary. The
consolidated entity shall follow the requirements for
elimination of intra-entity balances and transactions
and other matters described in Section 810-10-45 and
paragraphs 810-10-50-1 through 50-1B and existing
practices for consolidated subsidiaries. Fees or other
sources of income or expense between a primary
beneficiary and a consolidated VIE shall be eliminated
against the related expense or income of the VIE. The
resulting effect of that elimination on the net income
or expense of the VIE shall be attributed to the primary
beneficiary (and not to noncontrolling interests) in the
consolidated financial statements.
As explained in Section
6.4, ASC 810-10-45-1 and ASC
810-10-45-18 require intercompany balances and
transactions to be eliminated in their entirety.
Further, for entities other than VIEs, the means
of attributing the eliminating entry between the
controlling and noncontrolling interests depends
on (1) the nature of the intercompany transaction
(downstream vs. upstream) and (2) the policy
elected by the parent (for upstream transactions
only).
Under the VIE model, it may be the existence of intercompany transactions (e.g.,
supply arrangements under which the primary beneficiary takes a
majority of the VIE’s output under a cost-plus arrangement) between a
parent and its VIE subsidiary that causes the parent to be the primary
beneficiary of the VIE subsidiary. ASC 810-10-35-3 specifies that the
effect of the eliminating entry for intercompany transactions between
a primary beneficiary and its VIE subsidiary should not be attributed
to the noncontrolling interest. Rather, as explained in paragraph D55
of FASB Interpretation 46(R)'s Background Information and Basis for
Conclusions, the FASB believed that “any effects on income of
eliminating intercompany fees or other sources of income or expense
between the variable interest entity and its primary beneficiary
should be attributed to the primary beneficiary in the consolidated
financial statements. For example, if the primary beneficiary has no
equity interest in the variable interest entity and receives a fee
from the entity, the amount of the fee that is eliminated in
consolidation would be attributed to the primary beneficiary even if
the remainder of the entity’s net income is allocated to the entity’s
noncontrolling interest, the equity holders.”
On a consolidated basis, the primary beneficiary will continue to eliminate intercompany amounts
received from or paid to a consolidated VIE. After elimination, these amounts will not be included in
revenue or other income. However, the effect (i.e., the benefit or obligation) of these amounts received
from or paid to the VIE should still be recognized in net income attributable to the primary beneficiary.
Such recognition reflects the primary beneficiary’s legal claim to profits and losses.
In practice, the guidance on eliminating intercompany profit or loss against the related expense or
income of the VIE can prove difficult to apply. On the other hand, the elimination of intercompany
transactions with respect to a voting interest entity is generally more straightforward because the
elimination of intercompany profit or loss is allocated proportionately between the controlling and
noncontrolling interests.
The example below compares the approach to intercompany eliminations under the VIE model
(specifically, ASC 810-10-35-3) with that under the voting interest entity model.
Example 6-9
Company X is a VIE capitalized by an equity investment of $10 from Enterprise Y and a loan of $990 from
Enterprise Z. Enterprise Z has determined that it is the primary beneficiary of X. Each year, Z recognizes $75 of
interest income as a result of its 7.6 percent interest rate on the debt.
Because X is a VIE, the guidance in ASC 810-10-35-3 should be applied. The table below illustrates the impact
on Z’s financial statements of accounting for intercompany eliminations under ASC 810-10-35-3.
To better understand the unique aspects of accounting for intercompany eliminations under the VIE model,
consider the table below, which shows how such eliminations would be accounted for if X were a voting interest
entity. If the voting interest entity model were used, the effect of eliminating intercompany interest income or
expense would be allocated in proportion to equity ownership. Since Z does not have an equity interest in X, all
income after eliminations would be allocated to the noncontrolling interest.
6.6 Attribution of Income in the Presence of Reciprocal Interests
ASC 810-10
45-5
Shares of the parent held by a subsidiary shall not be
treated as outstanding shares in the consolidated statement
of financial position and, therefore, shall be eliminated in
the consolidated financial statements and reflected as
treasury shares.
As discussed in Section
4.3.2.2, a subsidiary may hold shares
of its parent. In such instances, in a manner consistent
with the single economic entity concept in ASC 810-10-10-1
and the provisions of ASC 810-10-45-5, 100 percent of those
reciprocal interests should generally be presented as
treasury shares on the parent’s consolidated balance sheet
regardless of whether the subsidiary is wholly owned by the
parent.
In the parent’s consolidated income statement, the existence of reciprocal
interests affects the allocation of the consolidated
entity’s earnings between third-party shareholders of the
parent and the subsidiary’s noncontrolling interest holders.
This is because the subsidiary’s noncontrolling interest
holders indirectly own a portion of the parent’s common
stock. In practice, there are two methods of attributing
earnings of the consolidated entity: the treasury stock
method and the simultaneous equations method. Application of
the treasury stock method tends to be more common since, as
demonstrated below, most preparers would have to dust off
their algebra textbook before applying the simultaneous
equations method. Although income attributable to the
parent’s shareholders may differ under the two methods,
consolidated net income will be the same under both methods.
Further, because of accompanying differences in the number
of parent shares that will be included in the computation of
a public parent’s EPS, each method will also produce the
same reported EPS figure. Thus, we believe that either
method is acceptable as long as a reporting entity applies
its selected method consistently to all reciprocal
interests.
The example below illustrates the application of each method.
Example 6-10
Company A is a public entity whose common shares are actively traded on the New
York Stock Exchange. Company A has 10,000 shares
of its common stock issued and outstanding. In
addition, it has an 85 percent controlling
interest in Subsidiary B.
Subsidiary B is a privately held company that has 5,000 shares of its common stock issued and outstanding. Third parties own the remaining 15 percent (750 shares) of B’s common shares.
Subsidiary B purchases 1,000 shares (10 percent) of A’s stock in an open-market transaction at $35 per share.
The diagram below illustrates the respective ownership interests of A, B, and third parties.
In 20X6:
- Company A’s earnings (excluding those arising from its equity interest in B) equaled $100,000.
- Subsidiary B’s earnings (excluding those arising from its equity interest in A) equaled $60,000.
Treasury Stock Method
The table below shows direct income from third-party transactions (i.e., exclusive of A’s and B’s equity interests in each other), consolidated net income, income attributions, and A’s basic EPS under the treasury stock method. For simplicity, intercompany transactions and tax implications have been ignored.
Simultaneous Equations Method
Under the simultaneous equations method, the income of A and B should first be computed as follows:
Let A = income of Company A.
Let B = income of Subsidiary B.
Let 0.85B = Company A’s ownership interest in Subsidiary B.
Let 0.1A = Subsidiary B’s ownership interest in Company A’s common stock issued and outstanding.
A = $100,000 + 0.85B
B = $60,000 + 0.1A
A = $100,000 + [0.85 × ($60,000 + 0.1A)]
A = $100,000 + $51,000 + 0.085A
A – 0.085A = $100,000 + $51,000
0.915A = $151,000
A = $165,027
B = $60,000 + (0.1 × 165,027)
B = $76,503
The table below shows direct income, consolidated net income, income attributions, and A’s basic EPS under the simultaneous equations method.
As illustrated in Example
6-10, the treasury stock method and the
simultaneous equations method produce the same reported EPS
figure.
6.7 Attribution of Other Comprehensive Income or Loss
ASC 810-10
45-20
Net income or loss and comprehensive income or loss, as
described in Topic 220, shall be attributed to the parent
and the noncontrolling interest.
As stated in ASC 810-10-45-20, OCI or other comprehensive loss must also be attributed to the parent and noncontrolling interest. This paragraph was added to ARB 51 by FASB Statement 160 to address ambiguities that existed in ARB 51 before the adoption of FASB Statement 160 and to eliminate the diversity in practice that arose when some reporting
entities did not attribute OCI or other comprehensive loss to noncontrolling interests.
6.7.1 Impact of FASB Statement 160 Transition Method on Attribution of OCI in Subsequent Periods
ASC 220-10
45-5
Paragraph 810-10-50-1A(a) states that, if an entity has an outstanding
noncontrolling interest, amounts for both net income and comprehensive income
attributable to the parent and net income and comprehensive income
attributable to the noncontrolling interest in a less-than-wholly-owned
subsidiary shall be reported in the financial statement(s) in which net income
and comprehensive income are presented in addition to presenting consolidated
net income and comprehensive income. For more guidance, see paragraph
810-10-50-1A(c).
45-15
Reclassification adjustments shall be made to avoid double counting of items
in comprehensive income that are presented as part of net income for a period
that also had been presented as part of other comprehensive income in that
period or earlier periods. For example, gains on investment securities that
were realized and included in net income of the current period that also had
been included in other comprehensive income as unrealized holding gains in the
period in which they arose must be deducted through other comprehensive income
of the period in which they are included in net income to avoid including them
in comprehensive income twice (see paragraph 320-10-40-2). Example 3 (see
paragraphs 220-10-55-18 through 55-27) illustrates the presentation of
reclassification adjustments in accordance with this paragraph.
Although adoption of FASB Statement 160 was required for fiscal years beginning on or after December 15, 2008, decisions made at the time that guidance was adopted may continue to affect attributions of items of comprehensive income that originated before adoption when such items are recognized in the income statement (i.e., reclassified from AOCI to income) in subsequent reporting periods. Specifically, before the adoption of FASB Statement 160, two methods of attributing OCI or other comprehensive loss were prevalent
in practice:
-
Method 1 — Attribute items of comprehensive income or loss solely to the controlling interest.
-
Method 2 — Attribute items of comprehensive income or loss to the controlling and noncontrolling interests, but limit attribution if the carrying amount of the noncontrolling interest had been reduced to $0.
Although FASB Statement 160 did not provide transition guidance for reporting entities that had historically applied Method 1, we believe that there were two acceptable transition alternatives:
- Transition Alternative 1 — Apply the provisions in ASC 810-10-45-20 and ASC 220-10-45-5, both added by FASB Statement 160, retrospectively as if OCI or other comprehensive loss had been attributed to the noncontrolling interests in all prior periods.
- Transition Alternative 2 — Apply the provisions in ASC 810-10-45-20 and ASC 220-10-45-5, both added by FASB Statement 160, prospectively.
Entities that chose Transition Alternative 2 should have a policy in place for
attributing future reclassification adjustments described in ASC 220-10-45-15 to the
controlling and noncontrolling interests. For example, such a policy should address how
previously unrealized holding gains from available-for-sale securities that were reported
in OCI and were attributed solely to the parent (Method 1) should be reclassified into net
income and attributed to the controlling and noncontrolling interests once the gain is
realized.
The flowchart below illustrates the application of the guidance discussed in this section to the current-period reclassification (to net income) of items that had previously been recorded as OCI before adoption of FASB Statement 160.
6.7.2 Foreign Currency Translation Adjustments
ASC 220-10
45-10A
Items of other comprehensive income include the following:
a. Foreign currency translation adjustments
(see paragraph 830-30-45-12) . . . .
ASC 810-10
45-19
Revenues, expenses, gains, losses, net income or loss,
and other comprehensive income shall be reported in the
consolidated financial statements at the consolidated
amounts, which include the amounts attributable to the
owners of the parent and the noncontrolling
interest.
ASC 830-30
45-17
Accumulated translation adjustments attributable to
noncontrolling interests shall be allocated to and
reported as part of the noncontrolling interest in the
consolidated reporting entity.
In accordance with ASC 830-30, to allow for combination or consolidation of a
subsidiary that is a foreign entity, all elements of the foreign currency financial
statements must be translated to the reporting currency. The cumulative impact of such
translation is recorded as a cumulative translation adjustment (CTA) in AOCI. The
cumulative translation gains and losses are reclassified out of AOCI and into earnings
upon the sale or substantially complete liquidation of the investment in the foreign
entity. (For information on what constitutes a substantially complete liquidation of an
investment in a foreign entity, see Section 5.4.1 of Deloitte’s Roadmap Foreign Currency Matters.) To the extent that a
CTA is attributable to a noncontrolling interest, ASC 830-30-45-17 requires the CTA to be
attributed to and reported as part of the noncontrolling interest in the consolidated
financial statements.
When determining whether a CTA can be attributed to noncontrolling interest holders, the reporting
entity should note that the CTA exists at the consolidated level as a result of differences between the
subsidiary’s functional currency and the reporting currency. Accordingly, the CTA is directly related to
the parent entity’s reporting currency and may not reflect the reporting currency of the noncontrolling
interest holders.
In light of these factors, we believe that in a manner consistent with the guidance in ASC 830-30-45-17 and the attribution guidance in ASC 810-10, a CTA should be attributed to the partially owned
subsidiary’s noncontrolling interest that gives rise to the adjustment. That is, the objective of a
noncontrolling interest is to give investors of the consolidated entity visibility into how their claim on the
net assets of a partially owned subsidiary changes from period to period.
Accordingly, we believe that it would be misleading to allocate to the controlling interest 100 percent of
a CTA associated with a foreign, partially owned subsidiary that reflects the impact of changing currency
rates on the subsidiary’s total net assets. Thus, it would be appropriate to allocate a proportionate
amount of the CTA to the noncontrolling interest.
Example 6-11
Company M is a multinational financial services company with global operations whose functional currency
is the U.S. dollar. Company M holds a controlling interest of 60 percent in Subsidiary ABC. The remaining 40
percent is held by an unrelated third party, Entity DEF, and represents a noncontrolling interest.
Subsidiary ABC, which is located in Germany and operates there, uses the euro as its functional currency.
Company M has determined that ABC is a foreign entity. There are no agreements in place that would
otherwise govern allocations of ABC’s income, loss, or OCI between M and DEF in a manner that differs from
their proportionate ownership interests.
At the end of 20X1, the translation of ABC’s assets, liabilities, and operations from the euro to the U.S. dollar
results in a CTA of $100 million. Of the $100 million, $40 million is allocated to the noncontrolling interest in M’s
consolidated financial statements.
6.7.3 Impact of Changes to OCI or AOCI Resulting From Transition Adjustments or Changes in Accounting Principle
ASC 220-10
45-5
Paragraph 810-10-50-1A(a) states that, if an entity has
an outstanding noncontrolling interest, amounts for both
net income and comprehensive income attributable to the
parent and net income and comprehensive income
attributable to the noncontrolling interest in a
less-than-wholly-owned subsidiary shall be reported in
the financial statement(s) in which net income and
comprehensive income are presented in addition to
presenting consolidated net income and comprehensive
income. . . .
ASC 250-10
45-5 An
entity shall report a change in accounting principle
through retrospective application of the new accounting
principle to all prior periods, unless it is
impracticable to do so. Retrospective application
requires all of the following:
-
The cumulative effect of the change to the new accounting principle on periods prior to those presented shall be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented.
-
An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period.
-
Financial statements for each individual prior period presented shall be adjusted to reflect the period-specific effects of applying the new accounting principle.
45-6 If
the cumulative effect of applying a change in accounting
principle to all prior periods can be determined, but it
is impracticable to determine the period-specific
effects of that change on all prior periods presented,
the cumulative effect of the change to the new
accounting principle shall be applied to the carrying
amounts of assets and liabilities as of the beginning of
the earliest period to which the new accounting
principle can be applied. An offsetting adjustment, if
any, shall be made to the opening balance of retained
earnings (or other appropriate components of equity or
net assets in the statement of financial position) for
that period.
45-7 If
it is impracticable to determine the cumulative effect
of applying a change in accounting principle to any
prior period, the new accounting principle shall be
applied as if the change was made prospectively as of
the earliest date practicable. See Example 1 (paragraphs
250-10-55-3 through 55-11) for an illustration of a
change from the first-in, first-out (FIFO) method of
inventory valuation to the last-in, first-out (LIFO)
method. That Example does not imply that such a change
would be considered preferable as required by paragraph
250-10-45-12.
45-8
Retrospective application shall include only the direct
effects of a change in accounting principle, including
any related income tax effects. Indirect effects that
would have been recognized if the newly adopted
accounting principle had been followed in prior periods
shall not be included in the retrospective application.
If indirect effects are actually incurred and
recognized, they shall be reported in the period in
which the accounting change is made.
ASC 810-10
45-16
The noncontrolling interest shall be reported in the
consolidated statement of financial position within
equity (net assets), separately from the parent’s equity
(or net assets). That amount shall be clearly identified
and labeled, for example, as noncontrolling interest in
subsidiaries (see paragraph 810-10-55-4I). An entity
with noncontrolling interests in more than one
subsidiary may present those interests in aggregate in
the consolidated financial statements. A not-for-profit
entity shall report the effects of any donor-imposed
restrictions, if any, in accordance with paragraph
958-810-45-1.
45-19
Revenues, expenses, gains, losses, net income or loss,
and other comprehensive income shall be reported in the
consolidated financial statements at the consolidated
amounts, which include the amounts attributable to the
owners of the parent and the noncontrolling
interest.
The guidance in ASC 250-10-45-5 through 45-8 prescribes how changes in an accounting principle
should be applied and often requires entities to record an offsetting adjustment to retained earnings (or
other appropriate components of equity) in the period of adoption.
In certain instances, an ASU may specify that the offsetting transition adjustment should be recorded
as a component of OCI. Similarly, an adjustment to OCI could arise from a reporting entity’s accounting
for a change in accounting principle. When a parent initially records its consolidating entries, it should
record 100 percent of the change to its subsidiary’s OCI within its own OCI in a manner consistent
with the guidance in ASC 810-10-45-19. Recognizing that the parent’s OCI should ultimately reflect its
activities as well as the timing and magnitude of its future cash flows, the parent should then record a
second entry to reclassify the noncontrolling interest holder’s portion of the OCI transition adjustment
to the noncontrolling interest account, which is presented as a separate component of stockholders’
equity in accordance with ASC 810-10-45-16.
We believe that a similar concept applies when a transition adjustment or change in accounting principle
requires the reporting entity to record an adjusting entry directly to the balance of AOCI. For example, ASU 2018-02 allows a reclassification from AOCI to retained earnings of “stranded” tax effects that arise
from the December 22, 2017, tax legislation commonly known as the Tax Cuts and Jobs Act (the “Act”).
Stranded tax effects arise from the tax effects of transactions that were initially recognized directly
in OCI at tax rates in existence before the Act. Before adoption of ASU 2018-02, when the underlying
transaction is reclassified out of AOCI in periods after enactment of the Act, amounts in AOCI related
to the income tax rate differential (i.e., the difference between tax rates in effect before and after
enactment of the Act) would be stranded in AOCI. When a parent initially records its consolidating
entries upon adoption of ASU 2018-02, it should record 100 percent of the change in its subsidiary’s
AOCI balance within its own AOCI and then record a second entry to reclassify the noncontrolling
interest holder’s portion of the AOCI adjustment to the noncontrolling interest account.
Example 6-12
Subsidiary Y is a consolidated subsidiary of Company X because X’s 90 percent ownership of Y gives X a controlling financial interest in Y.
On December 22, 2017, the Act is enacted, generally reducing the U.S. federal corporate income tax rate from 35 percent to 21 percent.
Before the enactment date of the Act, Y recognizes a $1,000 loss in OCI in connection with a derivative used in cash flow hedging activities. Because there is no tax basis in the derivative, Y also recognizes a $350 deferred tax asset (DTA) and records a corresponding entry to OCI. No other changes in the fair value of the hedge occur after its initial recognition, and the forecasted transaction would not occur until 2018.
On the enactment date, Y reflects the effect of the change to the tax rate by
reducing the DTA by $140 (equal to the temporary difference of $1,000
multiplied by the 14 percent rate reduction) and recognizing a corresponding
increase in income tax expense.
Before the issuance of X’s 2017 consolidated financial statements, X and Y adopt ASU 2018-02 (which, as noted above, allows a reclassification from AOCI to retained earnings of stranded tax effects related to the Act) and apply it to their respective 2017 financial statements.
The entries related to the transactional activity described above, as reflected in Y’s separate financial statements, are summarized in the table below.
Next, X evaluates what the impact will be on its consolidated financial statements. To reflect the change to Y’s AOCI balance upon adoption of ASU 2018-02 (highlighted in red in the table above), X performs the following steps:
- Step 1 — Record 100 percent of the $140 change to Y’s AOCI balance as a result of the adoption of ASU 2018-02.
- Step 2 — Reclassify the noncontrolling interest holder’s portion (i.e., 10 percent) of Y’s AOCI adjustment to the noncontrolling interest account.
To perform these steps, X records the following consolidating journal entries to its consolidated financial statements:
Step 1:
Step 2:
6.8 Presentation of Preferred Dividends of a Subsidiary
ASC 810-10
40-2
Section 480-10-25 does not require mandatorily redeemable
preferred stock to be accounted for as a liability under
certain conditions. If such conditions apply and the
mandatorily redeemable preferred stock is not accounted for
as a liability, then the entity’s acquisition of a
subsidiary’s mandatorily redeemable preferred stock shall be
accounted for as a capital stock transaction. Accordingly,
the consolidated entity would not recognize in its income
statement any gain or loss from the acquisition of the
subsidiary’s preferred stock. In the consolidated financial
statements, the dividends on a subsidiary’s preferred stock,
whether mandatorily redeemable or not, would be included in
noncontrolling interest as a charge against income.
While ASC 810-10-40-2 highlights that distributions to equity holders (including noncontrolling interest holders) acting in their capacity as owners should be excluded from the determination of the consolidated entity’s net income, ASC 810-10 does not specifically address whether dividends on a subsidiary’s preferred stock should be treated as an attribution of the subsidiary’s income to the noncontrolling interest or a direct adjustment to retained earnings. Further, the last sentence of ASC 810-10-40-2 has been subject to multiple interpretations because ASC 810-10 does not allow the parent to present noncontrolling interest expense as a deduction in arriving at consolidated net income.
On the basis of the ambiguities in ASC 810-10-40-2 and informal discussions with the FASB staff, we believe that the following two alternatives are acceptable for presenting preferred dividends of a subsidiary in a parent’s consolidated financial statements:
- Alternative 1 — The parent presents the subsidiary’s preferred dividends as a component of the attribution of net income (loss) to the noncontrolling interest on the face of the consolidated statement of income. The preferred dividends result in a decrease (increase) in consolidated net income (loss) attributable to the parent.We believe that Alternative 1 is acceptable in all situations and is the preferable approach.
- Alternative 2 — The preferred dividends do not affect the reported amount of consolidated net income (loss) attributable to the parent. However, the parent (if public) treats the subsidiary’s preferred dividends as a direct adjustment when calculating income available to common stockholders of the parent. This outcome is consistent with the accounting for dividends on preferred stock issued by the parent. It is also consistent with the discussion in ASC 480-10-S99-3A(22)(a) regarding the accounting in the consolidated financial statements of the parent for remeasurement adjustments arising from redeemable preferred stock issued by a consolidated subsidiary.Under certain facts and circumstances, Alternative 2 may yield a presentation that could be considered misleading. Preparers should consider consulting with professional accounting advisers if Alternative 2 is applied.We believe that when Alternative 2 is applied by an entity that does not report EPS, the entity should provide transparent disclosure of the preferred dividends’ impact on income available to common stockholders9 when that amount differs materially from net income attributable to the controlling interest because of dividends paid on the noncontrolling interest. Such supplemental disclosure may be made on the face of the income statement (e.g., by using the format in the “Alternative 2” column of the table in Example 6-13) or in the notes.
The parent should consistently apply either Alternative 1 or Alternative 2 and consider disclosing
its accounting policy in accordance with ASC 235-10-50. Further, if the subsidiary’s preferred stock
is a redeemable equity security subject to the accounting requirements of ASC 480-10-S99-3A, any
remeasurement adjustments are considered akin to dividends and should be presented in the manner
prescribed by either of those alternatives. See Chapter 9 for additional considerations related to
redeemable securities of a subsidiary.
Example 6-13
Assume the following facts:
- Company A owns 100 percent of the common equity securities of its subsidiary, B.
- Subsidiary B has issued preferred equity securities that are held by an unrelated third party, Entity C (the noncontrolling interest).
- The preferred equity securities are neither cumulative nor participating securities (i.e., they do not participate in undistributed earnings of B).
- For the year ended December 31, 20X9, A’s consolidated net income was $700,000 (including B’s net income), and B declared and paid dividends totaling $200,000 on the preferred equity securities.
Under each alternative, the dividends on the preferred stock of B would be included as follows in A’s
consolidated statement of income for the year ended December 31, 20X9:
6.8.1 Noncontrolling Interests Held by Preferred Shareholders
A reporting entity should consider how to attribute its subsidiary’s
net income or loss to the controlling and noncontrolling interests held in the
subsidiary when the subsidiary is funded with classes of equity that have different
rights and preferences (e.g., common equity and various classes of equity-classified
preferred shares). While the terms of preferred shares may vary significantly,
preferred shares commonly have a combination of some, or all, of the following
rights that the reporting entity may need to consider when attributing its
subsidiary’s net income or loss to the noncontrolling interests:
- Rights to the subsidiary’s assets and earnings that have priority over the rights of common shareholders.
- Entitlement to a share of the subsidiary’s earnings up to a stated dividend.
- Entitlement to a liquidation preference in the subsidiary.
- Stated dividend rights that are not affected by losses incurred by the subsidiary (i.e., the preferred shares receive dividends even if the subsidiary experiences losses).
We believe that depending on the terms of the share and the specific
facts and circumstances, when the net income or loss of a reporting entity’s
subsidiary is allocated between the controlling and noncontrolling interests held in
the subsidiary, the reporting entity should allocate earnings or losses in a manner
consistent with the three-step model described in Section 6.2 that reflects the substance of the
rights and preferences of the subsidiary’s share classes.
Example 6-14
Assume the following facts:
- Company C, Company H, and Company I form Entity CHI. The purpose and design of CHI is to buy and manage pizzerias.
- Company C contributes $100 million in exchange for 25 percent of the common shares of CHI, and H contributes $300 million in exchange for 75 percent of the common shares of CHI.
- Company H has a controlling financial interest in, and consolidates, CHI.
- Company I contributes $200 million to CHI in exchange for preferred shares in CHI that receive a 2 percent cumulative stated dividend per year; unpaid dividends are added to I’s liquidation preference, which is initially equal to its investment.
Further assume that H has no other activities other than its
investment in CHI. The results of operations for CHI for two
years are as follows (dollar amounts in millions):
Because I, the preferred shareholder, is entitled to a 2
percent stated dividend per year on its preferred shares, H
would attribute the net income (loss) of CHI to the
controlling and noncontrolling interest holders as follows
(dollar amounts in millions):
Footnotes
9
For entities that present EPS, the alternatives
will not affect income available to common stockholders, which
is the numerator in the calculation of EPS.
6.9 Noncontrolling Interests in Pass-Through Entities — Income Tax Financial Reporting Considerations
ASC 810-10
45-19
Revenues, expenses, gains, losses, net income or loss, and
other comprehensive income shall be reported in the
consolidated financial statements at the consolidated
amounts, which include the amounts attributable to the
owners of the parent and the noncontrolling interest.
ASC 810-10-45-19 requires reporting entities to report earnings attributed to noncontrolling interests as part of consolidated earnings and not as a separate component of income or expense. Thus, the income tax expense recognized by the consolidating entity will include the total income tax expense of the consolidated entity. When there is a noncontrolling interest in a subsidiary, the amount of income tax expense that is consolidated by the parent will depend on whether the subsidiary is a pass-through (e.g., a U.S. partnership) or taxable entity (e.g., a U.S. C corporation).
ASC 810-10 does not affect how entities determine income tax expense under ASC 740. Typically, no income tax expense is attributable to a pass-through entity; rather, such expense is attributable to its owners. Therefore, a parent with an interest in a subsidiary that is a pass-through entity should recognize income taxes on only its controlling interest in the pass-through entity’s pretax income. In the consolidated income tax expense, the parent should not include the income taxes on the pass-through entity’s pretax income attributed to the noncontrolling interest holders.
Example 6-15
Company X has a 90 percent controlling interest in Subsidiary Y (a limited liability corporation). Subsidiary Y is
a pass-through entity and is not subject to income taxes in any jurisdiction in which it operates. Company X’s
pretax income for 20X9 is $100,000. Subsidiary Y has pretax income of $50,000 for the same period. Company
X has a tax rate of 25 percent. For simplicity, this example assumes that there are no temporary differences.
Given the facts above, X would report the following in its consolidated income statement for 20X9:
In this example, ASC 810-10 does not affect how X determines income tax expense under ASC 740 since X
recognizes income tax expense for only its controlling interest in the income of Y. However, ASC 810-10 does
affect the effective tax rate (ETR) of X. Given the impact of ASC 810-10, X’s ETR is 24.2 percent ($36,250 ÷
150,000). If X is a public entity and the reconciling item is significant, X should disclose the tax effect of the
amount of income from Y attributed to the noncontrolling interest in its numerical reconciliation from expected
to actual income tax expense.
6.10 Calculation of Earnings per Share When There Is a Noncontrolling Interest
ASC 260-10
45-11A
For purposes of computing EPS in consolidated financial
statements (both basic and diluted), if one or more
less-than-wholly-owned subsidiaries are included in the
consolidated group, income from continuing operations and
net income shall exclude the income attributable to the
noncontrolling interest in subsidiaries. . . .
When calculating consolidated EPS, a reporting entity should exclude net income
attributable to noncontrolling interests. That is, as a starting point, the
numerator of the reporting entity’s EPS calculation should be based on net income
attributable to the parent’s shareholders, as determined in accordance with the
guidance discussed in Sections 6.2
through 6.9.
6.11 Adoption of a New Accounting Standard
If the adoption of a new accounting standard includes a transition
adjustment that affects the equity of a subsidiary that the reporting entity controls
but does not wholly own, the reporting entity should consider how the transition
adjustment would affect the noncontrolling interest in the subsidiary. ASC 810-10-45-19
indicates that revenues, expenses, gains, losses, net income or loss, and OCI of a
subsidiary not wholly owned by the parent should be attributed to both the parent and
the noncontrolling interest holders. Therefore, it would be appropriate to attribute the
transition adjustment to both the parent and the noncontrolling interest holders since
the transition adjustment may have affected net income in the prior periods.
The reporting entity should also consider whether and, if so, how the
adoption of a new accounting standard affects AOCI.
6.12 Acquisition Accounting Matters
We believe that if a difference exists on the initial acquisition date between
noncontrolling interests’ claims on net assets based on terms and conditions from
contractual arrangements and either their fair value (for noncontrolling interests
recognized in a business combination or an asset acquisition resulting from the
consolidation of a VIE) or their proportionate share of relative fair value (for
noncontrolling interests recognized in an asset acquisition resulting from the
consolidation of a subsidiary that is not a VIE), it would be inappropriate for the
reporting entity to recognize a gain or loss resulting from this difference when
attributing income and OCI to the parent and noncontrolling interests. However, it would
generally be acceptable to use the noncontrolling interests’ contractual claims on net
assets for the reporting entity’s attribution of income and comprehensive income. Such
an attribution approach should be consistent with contractual terms based on the claims
on net assets, which may or may not be proportionate to ownership interests. See
Sections 5.2.4 and 7.1.2 for additional considerations.