On February 22, 2017, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2017-05, Other Income Gains and Losses from the Derecognition of Nonfinancial Assets (Subtopic 610-20), Clarifying the Scope of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets. Current industry-specific guidance in Accounting Standards Codification (ASC) 360-20, Property, Plant, and Equipment Real Estate Sales, is being superseded by the new revenue recognition standard, ASU 2014-09, Revenue from Contracts with Customers (Topic 606). ASU 2014-09 created ASC 610-20, which provided some guidance for recognition and measurement for nonfinancial asset transfers with noncustomers, but the narrow scope and lack of guidance for partial sale transactions caused confusion for financial statement preparers. ASU 2017-05 amends ASC 610-20 s scope and specifies the accounting treatment for partial sales of nonfinancial assets, most commonly occurring in real estate, utilities, energy and shipping. The new guidance affects any entity with a contract to transfer a nonfinancial asset, a group of nonfinancial assets or an ownership interest in a consolidated subsidiary that does not meet the definition of a business or nonprofit activity. FASB intended for a broad interpretation of the term transfer, including both sales and situations in which a parent transfers ownership (or variable) interests in a consolidated subsidiary. Other derecognition changes include the loss of control due to expiration or termination of an existing contractual arrangement, a dilution event, government action, default of a subsidiary s nonrecourse debt or by contributing assets to a joint venture or other noncontrolled investee. While the ASU will change current accounting practice for real estate entities, these amendments will reduce complexity for all entities that sell or transfer nonfinancial assets by decreasing the number of derecognition models. Changes include: Specific scope exclusion in ASC 610-20 for businesses and nonprofit activities. Entities would no longer have to consider if a business also is an in substance nonfinancial asset. (Derecognition of businesses and nonprofit activities generally would be accounted for under ASC 810, Consolidation.) Codified definition of an in substance nonfinancial asset will improve consistency in applying the appropriate guidance. Updating ASC 845, Nonmonetary Transactions, to exclude exchanges of a nonfinancial asset for a noncontrolling ownership interest. Those transactions will now be accounted for under ASC 610-20. An equity method investment would no longer meet the definition of an in substance nonfinancial asset, eliminating the need for a scope exception for transfers of equity method investments in real estate entities deemed to be in substance nonfinancial assets in ASC 860, Transfers and Servicing. Contributions of nonfinancial assets to joint ventures are covered by ASC 610-20. Sales and partial sales of real estate assets will now have the same derecognition model as all other nonfinancial and in substance nonfinancial assets. FASB felt derecognition of nonfinancial assets should be the same regardless of whether the assets are transferred in the form of assets or a legal entity. ASU 2017-05 simplifies generally accepted accounting principles (GAAP) by reducing certain accounting differences between transactions involving assets and businesses, including: A change in ownership interest of a subsidiary while the parent retains control would be accounted for as an equity transaction and no gain or loss would be recognized. An entity generally would derecognize a nonfinancial asset in a partial sale transaction when it no longer has a controlling financial interest and control has transferred under guidance in ASC 606.
Any retained noncontrolling ownership interest in derecognized nonfinancial assets would be measured at fair value. Transfers to equity method investees would result in full gain recognition. This is the second phase of a larger project. In the first phase, FASB redefined a business so entities can better distinguish a business from a bundle of assets for accounting purposes. As a result, more transactions will likely be treated as dispositions of nonfinancial assets (rather than dispositions of a business), which will increase the number of transactions subject to this guidance. The third phase will focus on further alignment of measurement and recognition guidance for assets versus business. Scope ASU 2017-05 amends ASC 610-20 s scope. Entities generally would apply ASC 610-20 to derecognition of nonfinancial assets and in substance nonfinancial assets unless other guidance applies. Nonfinancial assets included under ASC 610-20 include intangible assets, land, buildings or materials and supplies and may have a zero carrying value. All transactions in which an entity retains a controlling interest or receives an interest in the buyer including joint ventures would be covered by ASC 610-20. Exclusions FASB expanded the list of ASC 610-20 s scope exclusions, generally items covered in other guidance: A transfer of a nonfinancial asset or in substance nonfinancial asset in a contract with a customer; covered by ASC 606 A transfer of a subsidiary or group of assets that constitutes a business or nonprofit activity; covered by ASC 810 A real estate or nonreal estate sale-leaseback transaction within the scope of ASC 360-20, Property, Plant, and Equipment Real Estate Sales, or ASC 840-40, Leases Sale-Leaseback Transactions A conveyance of oil and gas mineral rights; covered by ASC 932-360, Extractive Activities Oil and Gas A transaction that is entirely accounted for in accordance with ASC 860, Transfers and Servicing, which covers transfers of investments accounted for under: ASC 320, Investments Debt and Equity Securities ASC 323, Investments Equity Method and Joint Ventures ASC 325, Investments Other ASC 815, Derivatives and Hedging ASC 825, Financial Instruments A transfer of nonfinancial assets that is part of the consideration in a business combination within the scope of ASC 805, Business Combinations A nonmonetary transaction within the scope of ASC 845, Nonmonetary Transactions A lease contract within the scope of ASC 840, Leases An exchange of takeoff and landing slots within the scope of ASC 908-350, Airlines-Intangibles A contribution of cash and other assets including a promise to give within the scope of ASC 720-25, Other Expenses Contributions Made, or ASC 958-605, Not-for-Profit Entities Revenue Recognition A transfer of an investment in a venture that is proportionally consolidated under ASC 810-10 2
A transfer of nonfinancial assets or in substance nonfinancial assets solely between entities or persons under common control, such as a parent and its subsidiaries or two subsidiaries of the same parent (See Appendix A.) In Substance Nonfinancial Assets A contract may involve the transfer of both nonfinancial and financial assets. The superseded real estate guidance replaced by ASC 610-20 included a concept of in substance real estate, e.g., which treated the sale of an equity interest in an entity whose sole asset is real estate as a sale of the underlying property. Many real estate transactions meeting the current definition of a business are considered in substance real estate and accounted for in accordance with ASC 360-20 rather than ASC 810. Diversity currently exists in how an entity determines if a transaction includes in substance real estate. Some entities consider quantitative factors while others make a qualitative assessment. Entities using a quantitative approach in determining whether substantially all of the assets transferred are real estate differ on using fair value or carrying value of the assets transferred. ASU 2014-09 replaced the term in substance real estate with in substance nonfinancial asset, but failed to define the new term. ASU 2017-05 s definition addresses two situations so the accounting outcome is the same regardless of whether the assets are in the form of assets or a legal entity: The asset is part of a contract in which substantially all the fair value of the counterparty s promised assets fair value recognized and unrecognized is concentrated in nonfinancial assets, or A consolidated subsidiary, which is not considered a business, in which substantially all of the fair value of the subsidiary s assets is concentrated in nonfinancial assets ASU 2017-05 addresses the current diversity in practice of identifying in substance real estate. In analyzing the concentration of fair value, an entity should exclude cash or cash equivalents promised to the counterparty and any liabilities assumed or relieved by the counterparty. This prevents structuring an entity would be unable to achieve a particular accounting outcome by contributing cash to a counterparty and increasing the consideration it receives by the same amount. Determining whether a transaction involves an in substance nonfinancial asset will be a new concept to entities outside the real estate industry. Distinct Nonfinancial Assets ASU 2017-05 specifies that each distinct nonfinancial or in substance nonfinancial asset would be the unit of account for applying derecognition guidance, not the entire group of assets transferred. The issue arises when control transfers at different points in time, e.g., existence of a repurchase agreement. ASC 606 guidance would be applied at contract inception to identify distinct performance obligations and allocate consideration to each distinct nonfinancial or in substance nonfinancial asset in the group. FASB observed that when an entity derecognizes in substance nonfinancial assets in a subsidiary, control of each asset typically will be transferred at the same time. Therefore, in practice, an entity often may not need to separate and allocate consideration to each distinct nonfinancial asset in the transaction. 3
Partial Sales Partial sales are common in the real estate industry and include transactions in which the seller retains an interest in the property or has an equity interest in the buyer. Currently, ASC 610-20 does not address partial sales of nonfinancial assets. Under ASU 2017-05, a company would recognize a gain from the partial sale of a nonfinancial asset only if the legal entity is not consolidated and other criteria in revenue accounting are met. Current guidance generally prohibits full gain recognition; ASU 2017-05 will permit full gain or loss recognition upon the sale of the nonfinancial or in substance nonfinancial asset. An entity would first evaluate if it has a controlling financial interest 1 in the legal entity that holds the nonfinancial or in substance nonfinancial assets. If the legal entity is still consolidated, no gain or loss would be recognized; the decrease in the ownership interest would be recorded as an equity transaction. If there is no longer a controlling financial interest, entities would look to the new revenue rules for further evaluation. Transactions must first meet the criteria for a contract under the new revenue rules: Approval and commitment of all parties this can be written, verbal or implied by an entity s customary business practices Identifiable rights, obligations and payment terms for each party to the contract Contract has commercial substance, defined as the expectation the entity s future cash flows will change as a result of the contract Collectible, i.e., probable the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer Once these criteria are met, derecognition would occur when control is transferred under the new revenue guidance. This ensures consistency in transfer of control between customer and noncustomer transactions. If a noncontrolling interest is held, control is transferred when the legal entity can direct the use of and obtain substantially all of the benefits from each distinct nonfinancial or in substance nonfinancial asset within it. When the derecognition criteria are met, an entity would recognize a gain or loss for the difference between the consideration allocated to each distinct asset and that asset s carrying amount. The contract s promised consideration for calculating a gain or loss includes both the transaction price and carrying amount of liabilities assumed or relieved by a counterparty. (See Appendix B.) 1 ASC 360-20 used the term ownership interest. FASB has replaced this with the broader term controlling financial interest, which also would include transactions arising from a variable interest, e.g., a license, that is not an equity ownership interest. 4
Energy companies also enter into transactions that lead to the partial sale of equity interests in power plant entities while retaining a financial interest in the entities. Under current guidance, most power plants are considered integral equipment and treated as real estate, even though they are operating businesses. Currently, the sale of a noncontrolling equity interest in a power plant entity is subject to accounting rules governing real estate sales. Under ASU 2017-05, these transactions will see a significant accounting change. Generally, transactions involving an operating business will no longer be considered in substance nonfinancial assets and would instead be accounted for as an equity transaction under ASC 810. Unit of Account For partial sales structured as the sale of an ownership interest in a consolidated subsidiary, ASU 2017-05 clarifies an entity should evaluate whether it transfers control of the distinct underlying asset and not the ownership interest. Although the form of some partial sales transactions may be different, the substance of the transactions is the same and should be accounted for in a similar manner. Having the same unit of account for all transactions within Subtopic 610-20 s scope reduces complexity. ASU 2017-05 provides these examples: Case A Control Transfers Under ASC 810 and 606 Entity A owns 100 percent of Entity B, a consolidated subsidiary. Entity B holds title to land with a carrying amount of $5 million. Entity A concludes the land is not an output of its ordinary activities within the scope of Topic 606 and that Entity B does not meet the definition of a business within the scope of Topic 810. Entity A enters into a contract to transfer 60 percent of Entity B to Entity X for $6 million cash due at contract inception. At contract inception, the fair value of the 40 percent interest retained by Entity A is $4 million. Because all of the assets (the land) promised to Entity X in the contract are nonfinancial assets, Entity A concludes it should derecognize the land in accordance with ASC 610-20. Entity A first considers the guidance in Topic 810 and concludes it no longer has a controlling financial interest in Entity B or Entity X (the buyer). Using the guidance in ASC 606, Entity A determines the contract meets the criteria for a contract and control of the land has been transferred. Because Entity A continues to have a noncontrolling interest in Entity B, it evaluates the point in time at which Entity B, its former subsidiary, has control of the distinct nonfinancial asset. Entity A concludes it has transferred control of the distinct nonfinancial asset because Entity B controls the distinct nonfinancial asset based on the following: a. It has the present right to payment. b. Entity B has legal title to the land. c. It does not have physical possession of the asset because it cannot restrict or prevent other entities from accessing the land. d. Entity B has the significant risks and rewards of ownership. e. There is no acceptance clause (assumption). Entity A derecognizes the land and calculates the gain or loss as the difference between the consideration paid and the land s carrying amount. The amount of the consideration is $10 million, which includes $6 million in cash plus $4 million for the fair value of the noncontrolling interest in Entity B. Entity A recognizes a gain of $5 million ($10 million consideration $5 million carrying amount of the assets). Entity A records the noncontrolling interest in Entity B at $4 million. 5
Case B Control Transfers Under ASC 810 but Not Under ASC 606 Assume the same facts as in Case A, except that Entity A has the right but not the obligation to repurchase the 60 percent ownership interest in Entity B that it transferred to Entity X, i.e., Entity A has a call option. The call option gives Entity A the right to repurchase the 60 percent ownership interest in two years for $7 million. Entity A concludes that although the call option represents a variable interest in Entity B, it does not have a controlling financial interest in Entity B under ASC 810. However, when evaluating whether control of the land has been transferred in accordance with the ASC 606 guidance, Entity A considers the repurchase feature and concludes it does not transfer control of the land. In addition, because the exercise price on the call option is greater than the original selling price, the transaction is considered a financing agreement under ASC 606. Entity A does not derecognize the land and records a financial liability of $6 million in accordance with the guidance in paragraph 606-10-55-70. Entity A does not recognize an investment for its retained 40 percent ownership interest until it derecognizes the land. Transfers of Investments Equity Method Investments Under current GAAP, an entity is required to apply ASC 860 to a transfer of an equity method investment unless the equity method investment is considered in substance real estate, in which case ASC 360-20 would apply. ASU 2017-05 removes the scope exception in Topic 860 for in substance nonfinancial assets so an entity will no longer evaluate the underlying assets and liabilities of equity method investments to determine which derecognition guidance to apply to those investments. A contract that transfers an equity method investment along with other nonfinancial assets may be covered by ASC 610-20. Nonmonetary Exchanges For tax purposes, certain transactions are structured as a nonmonetary exchange of real estate. The transfer of nonfinancial assets in exchange for a noncontrolling ownership interest is currently addressed in ASC 845. ASU 2017-05 supersedes that guidance and those transactions will now be covered by ASC 610-20 and accounted for as a sale of the real estate asset for noncash consideration. FASB viewed such transactions to be similar to a partial sale of a nonfinancial asset and should be accounted for in a similar manner. Joint Ventures Conforming amendments have been made to ASC 970, Real Estate General, that require the derecognition guidance in ASC 610-20 be applied to contributions of an asset to a joint venture and other investees if the contribution is not considered a business or nonprofit activity. Transition Entities may use either transition method offered under ASU 2014-09 a retrospective or modified retrospective approach. Entities are allowed to apply a different transition method to transactions with customers, i.e., transactions within ASC 606, than to transactions with noncustomers, i.e., transactions within ASC 610-20. 6
Previous Disposals of a Business FASB has provided special transition guidance for previous disposals of a business. ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business, updated the business definition and could have resulted in an entity applying different definitions of a business to transactions in different fiscal periods, which would be costly and complex (see related BKD Thoughtware article). Regardless of the transition method elected for contracts with noncustomers, an entity is required to use the new business definition in ASU 2017-01. In addition, if a transaction that was considered the disposal of a business is now considered the disposal of an asset, an entity should not reinstate goodwill when adopting ASU 2017-05 for asset derecognition. Effective Date This ASU must be applied at the same time as adoption of ASU 2014-09; for public business entities, not-for-profit conduit bond obligors and employee benefit plans that file with the U.S. Securities and Exchange Commission, the amendments are effective for annual reporting periods beginning after December 15, 2017, including interim reporting periods. Early application is permitted only as of annual reporting periods beginning after December 15, 2016. For all other entities, this ASU is effective for annual reporting periods beginning after December 15, 2018, and interim reporting periods beginning after December 15, 2019. Early adoption is permitted for annual reporting periods beginning after December 15, 2016. For additional information, contact your BKD advisor. Contributor Anne Coughlan Director 317.383.4000 acoughlan@bkd.com 7
Appendix A Scope Decision Tree 8
Appendix B Derecognition Decision Tree 9