Selling a portion of a business? A reduction in ownership interest may or may not result in a loss of control. PwC’s Christopher Chung discuss the accounting outcomes when control is maintained and when it is lost.
This video is part of The quarter close publication and video perspectives series.
Hi, I’m Christopher Chung.
As the economic landscape continues to change, one way we see companies responding is with dispositions of portions of their business. These transactions can extract value and create efficiencies, but can also result in complex accounting considerations depending on what is transferred and how control is impacted.
I want to identify the different ways a disposal can occur, explain why understanding control is important, and then describe the accounting for a partial disposal. At the end, I’ll walk through an example so you can see how the accounting works with some actual numbers.
Disposals occur through a reduction in ownership interest, which can happen in a variety of ways. The most common is when an owner simply sells a portion of its ownership interest, but can also occur when a subsidiary issues shares to its other owners, or if an owner transfers shares to another party. These are a few of the more common ways we see changes in ownership interest occur, but it’s not an all inclusive list.
Next, understanding control is important for these types of transactions. This is key because a reduction in ownership interest may or may not result in a loss of control. Control is generally present when the owner can direct substantive actions and financial interest of the subsidiary business, and typically exists when the owner has a majority voting interest.
There are other ways in which control can be lost, which are sometimes less obvious. The expiration of a contract, such as the end of a management or governance arrangement can impact control that was previously held. In addition, regulatory events, such as a ruling from a court, the impact of new legislation, or the outcome of arbitration, may cause a reporting entity to lose control.
When control is maintained, the transaction is generally treated as an equity transaction. This will typically result in amounts transferring between non-controlling interest and parent equity only. When control is lost, the owner should derecognize all the existing accounts and replace them with the recognition of new accounts. First, the owner should remove the carrying value of the assets and liabilities, including any noncontrolling interest. Next, the new investment is brought onto the balance sheet at fair value, as well as the fair value of the proceeds from the transaction. Additionally, the P&L will reflect any realization of OCI and any gain or loss on the disposal.
The gain is calculated as follows. First, you combine the fair value of consideration transferred, and the fair value of the new retained interest, and the former noncontrolling interest at carrying value. That amount, less the carrying amount of the net assets, including balances in AOCI, results in either a gain or a loss.
Now let’s walk through an example to see it in practice.
Assume the owner is a reporting entity which owns 90% of a controlled and consolidated subsidiary with a carrying value of $100 of net assets and $10 of noncontrolling interest. Suppose the owner sells a 70% controlling stake in the company for $210 in cash, retaining a 20% equity method interest. This assumes the total fair value of the business is $300 and the retained interest is worth $60.
Now, let’s go back to the model we talked about earlier. In this case, you would derecognize the net assets, and also the noncontrolling interest. So the whole original investment would be removed. Then you would record the proceeds, and the fair value of the remaining 20% interest. So that puts the retained investment back on the books at the new fair value. In our example, there is no AOCI. The gain or loss would be calculated as the remainder of all of these components, which in our example, would be a $180 gain recorded in the P&L.
In contrast, if the owner only sold a 10% stake of its original 90% investment and maintained control, the owner would continue to consolidate the subsidiary, and record an increase in NCI based on its proportionate interest in the carrying value of the subsidiary, record the fair value of the consideration received and any differences would be recorded in equity. No gain or loss would be recognized.
As you can see, partial disposals can be complex, especially when it results in a loss of control. Knowing the key points will help you apply the right accounting at the right time.
For more information on this topic, refer to Chapter 6 of the Business combinations and noncontrolling interests guide available on CFOdirect.com.