March 10, 2017
When the Financial Accounting Standards Board (FASB) adopted its project to update the definition of a business, it determined that not only did the definition of a business need revision, but that clarification was also needed on the accounting for transfers of nonfinancial assets. The FASB has released the second phase of its definition of a business project addressing the accounting for transfers of nonfinancial assets. In January, the FASB released the first phase of this project when it redefined what constitutes a business.
The accounting for transfers of nonfinancial assets has long been a challenging and confusing area of accounting that can often result in outcomes that are different for seemingly similar transactions. For instance, under existing accounting standards, if an entity transfers control of a business, but retains partial ownership, it recognizes the retained interest in the business at fair value resulting in a gain or loss, but if an entity transfers rental real estate but retains partial ownership, it would not recognize the partial ownership at fair value and it would not recognize a gain.
New accounting guidance for revenue recognition issued in 2014 eliminated industry specific guidance on the accounting for transactions and created new guidance on how to account for transfers of nonfinancial assets that are not in the scope of revenue from contracts with customers. The elimination of industry guidance included accounting rules related to the partial sale of real estate, but the newly created ASC 610-20 Transfers of nonfinancial assets that was intended to replace the previous guidance left certain questions unanswered. For instance what qualifies as a nonfinancial asset? And what is the appropriate accounting when a partial interest is retained in a transferred nonfinancial asset?
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 clarifies these issues and simplifies the accounting for transactions involving real estate and joint ventures.
What is In Scope of Subtopic ASC 610-20?
To clarify the scope of the guidance the term "in substance nonfinancial asset" was defined. An in substance nonfinancial asset is a financial asset, such as cash or receivables, that is included in a contract to transfer assets where the combined fair value of all the assets is substantially all nonfinancial assets, such as real estate, equipment or intellectual property. An in substance nonfinancial asset may also include the transfer of ownership of a legal entity. When control of a legal entity that is not a business is transferred, an entity will look through the equity interests to the assets of the legal entity to conclude whether substantially all of those assets are nonfinancial. If they are, the entire transaction is accounted for as a transfer of a nonfinancial asset.
Through the creation of in substance nonfinancial assets the FASB simplifies the accounting for transactions that include nonfinancial assets and small amounts of financial assets. Transactions that involve the transfer to a party that is not a customer and assets that are substantially all nonfinancial assets and do not meet the definition of a business, the guidance of ASC 610-20 will be applied. Without the definition of in substance nonfinancial asset, the accounting for the financial assets included in these transactions would have required the application of U.S. generally accepted accounting principles (GAAP) related to each type of financial asset transferred, which would have significantly increased the complexity of the transaction despite the financial assets being minor to the contract.
Excluded from the guidance are businesses and not-for-profit activities. Derecognition of these activities (except for oil and gas related activities) should be addressed under ASC Subtopic 810-10, Consolidation—Overall.
How to Derecognize Nonfinancial Assets
Entities will derecognize nonfinancial assets when the noncustomer in the contract obtains control of the asset. When there are multiple distinct nonfinancial or in substance nonfinancial assets included in a single transaction, consideration will be allocated to each distinct asset using the allocation of transaction price to performance obligations guidance defined in the revenue recognition guidance.
Under current U.S. GAAP, when real estate is sold but the seller retains a partial interest in the real estate, no gain is recognized on the retained interest. In contrast, when a business is sold but an interest is retained by the seller, a gain or loss is recognized on the retained interest. The guidance for partial sales of real estate also applies to transfers of business when the business is "in substance real estate." Under this concept, some businesses are deemed to be in substance real estate meaning that they consist of substantially all real estate and related assets. The concept of in substance real estate results in a difference in accounting between the sale of a business and the sale of a business that is in substance real estate. The concept of in substance real estate and the difference in the accounting for partial sales is eliminated when the new standard is adopted.
Under the updated guidance, entities would derecognize a distinct nonfinancial asset in a partial sale when:
- The entity does not have (or ceases to have) controlling financial interest in the legal entity that holds the asset in accordance to the Consolidation guidance; and
- The entity transfer control of the asset in accordance to the revenue recognition guidance.
Once an entity transfers control, it is required to measure any noncontrolling interest it retains or receives at fair value. If any entity retains a controlling interest in the nonfinancial asset, then it does not derecognize the nonfinancial asset. Instead, it would account for the transfer as an equity transaction.
The guidance on noncontrolling and controlling interests brings the accounting for nonfinancial assets in line with the treatment of noncontrolling and controlling interests in assets that qualify as businesses.
The accounting for transfers of assets to joint ventures has been a challenging area of U.S. GAAP. There has been limited guidance, and practice has been evolving over time. In some instances, entities have determined they are able to recognize gains from the transfer to a joint venture and in other instances they have not.
ASU 2017-05 clarifies that when it comes to the transfer of nonfinancial assets to any nonconsolidated investee, including a joint venture, the guidance in ASC 610-20 applies. As a result, once adopted the guidance for partial sales of nonfinancial assets will require a gain or loss to be recognized on the noncontrolling interest retained by the transferring entity.
Expected Impact of ASU 2017-05
Real estate companies will likely feel the largest impact from ASU 2017-05 because the guidance clarifies that entities will not have to consider whether a business is in substance real estate.
The clarification of partial sales accounting will also be particularly important for real estate companies. Many in the commercial real estate sector conduct partial sales transactions where the seller retains an interest in the entity that owns the assets or obtains an equity interest in the buyer. Other industries that frequently conduct partial sales of nonfinancial assets or that frequently enter into joint ventures may also see benefits from the clarified accounting. These industries include utilities, life sciences and distribution companies.
Effective Date & Transition
Because the initial guidance for ASC Subtopic 620-10 aligned with the revenue recognition standard, adoption of the ASU 2017-05 will follow a reporting entity's revenue recognition implementation schedule. For public entities, the amendments will be effective for annual reporting periods and interim periods after Dec. 15, 2017. All other entities will adopt for annual reporting periods after Dec. 15, 2018, and interim periods after Dec. 15, 2019. All entities may early adopt for fiscal years and interim financial periods after Dec. 15, 2016.
As with the revenue recognition standard, transitioncan either be done under the retrospective or modified retrospective method. Under the modified retrospective method, a cumulative catch-up to retained earnings is applied at the beginning of the year of adoption. The selection of a transition method is independent of the selection of the transition method for the revenue recognition standard.
For More Information
For more information on how to get started with revenue recognition adoption, please contact Mark Winiarski of MHM's Professional Standards Group. Mark can be reached at email@example.com or 816.945.5614.