A Codification Exercise On The Reporting Of Discontinued Operations A Codification Exercise on the Reporting of Discontinued Operations
Read the following case study:
McNellis, C. J. (2018). Dynamic divestures: A codification exercise on the reporting of discontinued operations. Issues in Accounting Education, 33(1), 53–63.
During the first week of 20X8, Dynamic’s corporate controller, Anne Smith, prepares to initiate the closing activities for 20X7. The closing process at Dynamic is very extensive, as it includes routine activities for consolidating the activities of several subsidiary companies for the creation of the consolidated financial statements. Furthermore, Dynamic’s reporting personnel must also address the unique complications of each acquisition and divesture.
As Ms. Smith awaits the final financial statement numbers prepared by the reporting personnel at each subsidiary, she is anxious to determine the appropriate financial statement presentation of the three subsidiaries discussed above. Most specifically, she is curious as to whether the financial performance of each of the three subsidiaries qualifies for reporting under discontinued operations. Ms. Smith has asked you to review the intricacies of ZD Consulting, Hope Industries, and AM Mining Operations to determine which type of reporting (i.e., continuing operations versus discontinued operations) is appropriate for each subsidiary on Dynamic’s consolidated income statement.
To complete the case requirements, you should perform the following tasks:
Consider the facts presented for each company within the
Consult the FASB Accounting Standards Codification for guidance on the specific income statement presentation issue to which the controller has requested
Prepare a memo that clearly addresses the issue, discusses each company’s facts, and provides a clear conclusion regarding the appropriate presentation of each company’s financial information on Dynamic’s consolidated income
In constructing this memo, you should expect to incorporate Accounting Standards Codification references as required to support your conclusions.
Include any basic calculations used in your analysis from the data provided as part of your submission.
Assignment Paper Requirements:
Write a paper (memo) of a minimum of six double-spaced pages, not counting the title and reference pages (which you must include).
Copy and paste each one of the questions into your paper in bold type to ensure you have answered each of the assignment
Use terms, evidence, and concepts from class readings, including professional business language.
Cite at least three credible, academic, or professional sources for this assignment. The TAMUCT Library is a great place to find resources, as well as the FASB
Format your paper according to APA DRAFT – For Discussion Purposes Only
To: Energy Works, Inc. Accounting Files
From: Richard Smith, Accounting Policy team
Re: Accounting for proposed joint venture with Big Oil, Inc.
Sidebar: The type of transaction is described succinctly in the “Re” line
Energy Works, Inc. is a nonpublic oil and gas company that is forming a joint venture (JV) with Big Oil, Inc. for the extraction of proved oil reserves in the arctic. Both venturers wish to share in the risks and rewards of this venture, while benefiting from each other’s technical expertise and sharing of key assets. Energy Works will contribute a floating production storage and offloading facility (FPSO), valued at $100 million, along with $20 million in cash, to the venture in exchange for a 50% equity interest. Energy Works is not in the business of marketing its production facilities and equipment for sale; rather, it uses these facilities in its own oil and gas producing activities.
Big Oil will contribute its arctic drilling permit, also valued at $100 million, along with $20 million in cash, to the venture in exchange for a 50% equity interest. Assume that the cost basis of the contributed assets is the same as the fair values of these assets. Profits and losses of the venture will be shared based upon the equity interest held by each investor.
Operations of the joint venture will be overseen by its Board of Directors. Each venturer will receive 2 seats on the Board, for a total of 4 seats, and all significant decisions of the JV require the unanimous consent of the Board, with any disputes to be settled by an independent arbitrator (binding arbitration). The Board has appointed Energy Works to manage the day-to-day operations of the FPSO facility. Additionally, both venturers will provide employees and managerial personnel with technical expertise to perform day-to-day operations for the JV. Energy Works will not receive separate compensation for its role as manager. The joint venture will be legally organized as an LLC.
The following picture illustrates the relationships between the parties in this arrangement.
Energy Works must determine how to record its investment in the JV.
1. Is Energy Works required to consolidate the joint venture?
2. If consolidation is not required, what accounting method should Energy Works use to account for its investment in the JV?
3. How will Energy Works record the transfer of the FPSO facility to the JV?*
*This issue is not evaluated in full within this memo, however a discussion of key considerations is provided.
Sidebar: Notice that each issue is phrased in the form of a question.
Analysis – Issue 1: Is Energy Works required to consolidate the joint venture?
FASB Accounting Standards Codification (ASC) 810-10 (Consolidation) provides guidance for determining when consolidation of another entity is required. Two consolidation models are provided: the variable interest entity (VIE) model and the voting interest model. Arrangements should first be evaluated to determine whether they fall within the scope of the VIE model and, if not, shall apply the voting model. This requirement is described in par. 15-3 of ASC 810-10, as follows:
15-3 All reporting entities shall apply the guidance in the Consolidation Topic to determine whether and how to consolidate another entity and apply the applicable Subsection as follows:
a. If the reporting entity has an interest in an entity, it must determine whether that entity is within the scope of the Variable Interest Entities Subsections in accordance with paragraph 810-10-15-14. If that entity is within the scope of the Variable Interest Entities Subsections, the reporting entity should first apply the guidance in those Subsections. Paragraph 810-10-15-17 provides specific exceptions to applying the guidance in the Variable Interest Entities Subsections.
b. If the reporting entity has an interest in an entity that is not within the scope of the Variable Interest Entities Subsections and is not within the scope of the Subsections mentioned in paragraph810-10-15-3(c), the reporting entity should use only the guidance in the General Subsections to determine whether that interest constitutes a controlling financial interest.
Energy Works has an interest (an equity ownership share) in the joint venture and, accordingly, will begin by evaluating whether the VIE model applies.
Sidebar: Energy Works has not made an accounting policy election to apply proportionate consolidation to its investments in legal entities. (This is an accounting election available to companies in the extractive and construction industries, where an entity records its share of each asset, liability, revenue, and expense of the investee.) Rather, Energy Works will apply the consolidation accounting framework set forth in ASC 810, honoring the legal form of the transaction.
Consideration of Whether the VIE Model Applies
As noted in par. 15-3 above, the VIE model applies to entities that meet the definition of a VIE (par. 15-14) and which do not qualify for the scope exceptions provided in par. 15-17.
Energy Works believes that this arrangement may qualify for the so-called “business scope exception” in par. 15-17 of ASC 810-10, as follows:
15-17(d). A legal entity that is deemed to be a
need not be evaluated by a reporting entity to determine if the legal entity is a VIE under the requirements of the Variable Interest Entities Subsections unless any of the following conditions exist …:
1. The reporting entity… participated significantly in the design or redesign of the legal entity. However, this condition does not apply if the legal entity is an operating joint venture under joint control of the reporting entity and one or more independent parties or a franchisee.
2-4. [For the simplicity of this example, conditions 2-4 will not be evaluated in this memo, however in practice entities are required to evaluate these conditions.][endnoteRef:1] [1: Other exceptions to the business scope exception – omitted for simplicity of this example – include that substantially all of the JV’s activities cannot be performed on behalf of one investor, and that the reporting entity cannot have contributed over half of the fair value of the JV’s equity. We will assume for simplicity that neither of these exceptions apply to this case. ]
According to this guidance, a business is not required to be evaluated under the VIE model unless the reporting entity participated significantly in the design of the entity; however, this “design” exception does not apply to operating joint ventures under joint control of the venturers. As Energy Works participated in the design of the JV, the JV must meet the GAAP definition of a joint venture, under joint control, to qualify for this scope exception.
Therefore, Energy Works must evaluate whether the JV: 1) is a legal entity; 2) is considered a business; and 3) is an operating joint venture under joint control. If all of these conditions are met, Energy Works may apply the business scope exception.
First, we note that the JV is a legal entity. Legal entities are defined in ASC 810-10-20 as:
Any legal structure used to conduct activities or to hold assets. Some examples of such structures are corporations, partnerships, limited liability companies, grantor trusts, and other trusts.
As the joint venture will be organized as an LLC, it is considered a legal entity.
Next, ASC 810-10-20 defines a business as:
An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants…
Implementation guidance in par. 55-4 of ASC 805-10, Business Combinations, elaborates on this definition, stating: “A
consists of inputs and processes applied to those inputs that have the ability to create outputs.” Inputs are described as including long-lived assets (including intangible assets), and processes are described as including operational processes, documented or known by a skilled workforce.
In this case, the JV meets this definition, given that it has both inputs (an FPSO and drilling permit) and processes (the venturers have agreed to share their technological know-how for operating the facility as well as employees with technical expertise) that are capable of generating returns (outputs) for the venturers. Furthermore, the purpose of this JV is for the venturers to pool their resources to conduct operations, thus generating returns.
Sidebar: It’s worth noting that describing the JV as a business would be a higher hurdle if the JV were involved in the exploration, as opposed to the production, of oil. In this case, the Codification (as well as industry-specific nonauthoritative resources) make it clear that the JV meets the definition of a business. In fact, it could be argued that the assets being contributed by Big Oil alone (the permit and technical know-how embodied in its employees (i.e., processes)) would represent a business when viewed in isolation.
Notably, the FASB is currently revisiting the definition of business, in particular as it relates to groups of nonfinancial assets.
Operating Joint Venture under Joint Control
Finally, Energy Works must consider whether the JV meets the GAAP definition of a joint venture. The term corporate joint venture is defined in ASC 323-10-20 (Investments – Equity Method and Joint Ventures) as:
A corporation owned and operated by a small group of entities (the joint venturers) as a separate and specific business or project for the mutual benefit of the members of the group…The purpose of a corporate joint venture frequently is to share risks and rewards in developing a new market, product or technology; to combine complementary technological knowledge; or to pool resources in developing production or other facilities. A corporate joint venture also usually provides an arrangement under which each joint venturer may participate, directly or indirectly, in the overall management of the joint venture. Joint venturers thus have an interest or relationship other than as passive investors. An entity that is a subsidiary of one of the joint venturers is not a corporate joint venture. The ownership of a corporate joint venture seldom changes, and its stock is usually not traded publicly. A noncontrolling interest held by public ownership, however, does not preclude a corporation from being a corporate joint venture.
In this case, the JV will be owned by a small group of (in this case, two) entities for the benefit of the group. The purpose of the JV is indeed to share risks and rewards, as well as technology and key assets related to this project. Both venturers will participate actively in management of the venture through their required approval on all significant decisions. Therefore, this definition appears to be met.
In its guide book, Consolidation and the Variable Interest Model (2014), p.53, EY provides additional interpretive guidance related to this scope exception, as follows:
The actual term [joint venture] is narrowly defined for accounting purposes in ASC 323-10-20. The fundamental criteria for an entity to be a joint venture are (1) joint control over all key decisions, with (2) control through the owners’ equity interest. [Explanation added]
Therefore, Energy Works will also consider these fundamental criteria described by EY.
Sidebar: Sometimes, guidance in the Codification may seem straightforward, but interpretive guidance may point out additional factors that need to be considered to correctly apply the Codification. In this case, consideration of EY guidance offers two additional hurdles that we must clear in order to determine that the JV qualifies for this scope exception.
Joint control over key decisions
Regarding “joint control,” EY’s guide book Joint Ventures (2014) states:
We believe joint control exists when all of the venturers have, at a minimum, substantive veto or approval rights allowing them to effectively participate in all of the significant decisions of an entity. (For this reason, a joint venture would not be a consolidated subsidiary of any of the equity holders).
…decisions are significant when they relate to the significant financing, operating and investing activities expected to be undertaken by an entity in the normal course of business… To be jointly controlled, we believe each significant decision of the entity must require the consent of each of the venturers.[endnoteRef:2] [2: EY, Financial Reporting Developments: Joint Ventures. June 2014. Page 10.]
As stated in the Facts of this memo, the venturers will share control of all significant decisions related to the entity, with no one venturer having more weight than the other. Regarding Energy Works’ day-to-day management of the JV, EY’s guide states:
The existence of a contract or other agreement with one of the venturers …to perform the day-to-day management of the entity does not automatically prevent the entity from meeting the definition of a joint venture…As long as the contract does not convey decision-making authority over significant decisions to the venturer or the third-party, the entity could meet the definition of a joint venture…[endnoteRef:3] [3: EY (Joint Ventures). Page 19.]
While this decision requires significant judgment, we will assume in this case that the manager does not have authority to make significant decisions for the JV without the other venturer’s consent. A thorough reading of all contracts related to joint venture formation and management is needed to confirm this.
Sidebar: Establishing joint control is a key judgment. You must be able to argue – all the way down to the last detail – that the entities have equal voting power. For example, in the event the parties cannot agree on a matter, a common feature in a joint control arrangement is that the parties agree to seek a third-party arbitrator.
Control through owners’ equity interest
Finally, the venturers must be able to exercise this joint control as a right of their equity ownership. By contrast, per EY:
If a venturer exercises its decision-making authority through a means other than an equity interest (e.g., through a management services contract) or if an interest holder other than one of the venturers has voting or substantive veto rights (e.g., via a debt instrument), we do not believe the entity is a joint venture.
In this case, the venturers (as equity holders) will each have 2 seats on the Board as a right of their equity ownership, and these Board seats give them the authority to approve key decisions of the joint venture and to oversee the management of the venture. Energy Works was appointed by the Board to manage the FPSO facility but: 1) must act as directed by the Board, in a manner that serves the Board’s interests; 2) is not operating under a separate management services contract; and 3) is not receiving separate compensation for this service.
As the equity holders have both: 1) joint control, and 2) control through their equity interests, the JV meets the GAAP definition of an operating joint venture under joint control. Therefore, the business scope exception applies. Next, Energy Works will evaluate the JV under the voting interest model.
Sidebar: As a style point, notice how nonauthoritative sources are also presented in guidance sandwiches, following consideration of authoritative guidance.
Application of the Voting Model
The voting model in ASC 810-10 applies differently to limited partnerships (and similar entities), versus other legal entity structures (such as corporations). ASC 810-10 indicates that LLCs can fall within either model, depending on how they are structured. Based on a careful review of contract terms, Energy Works has determined that this particular LLC functions more like a corporation than a partnership.
Sidebar: The determination of applying the voting model using the limited partnership approach versus other entity approach involves judgment. Entities should consider, for example, whether the LLC maintains a specific ownership account for each investor (as in a partnership), and whether the venturers’ roles are akin to a general partner/limited partner relationship (as in a partnership).
ASC 810-10 provides the following consolidation guidance for entities other than limited partnerships:
other than limited partnerships, consolidation is appropriate if a reporting entity has a controlling financial interest in another entity and a specific scope exception does not apply (see Section 810-10-15). The usual condition for a controlling financial interest is ownership of a majority voting interest, but in some circumstances control does not rest with the majority owner.
Said another way, equity holders with greater than 50% equity are presumed to consolidate, but in certain cases would not consolidate if partners with a lesser ownership percentage have rights that block the majority owner’s control.
In this case, neither of the venturers has a controlling financial interest in the JV because neither venturer owns a majority (of greater than 50%) of the JV’s equity. Additionally, both parties have equal participating rights to establish key decisions for the JV – that is, neither venturer controls the decision making of the entity.
Accordingly, neither venturer will consolidate the JV.
Conclusion – Issue 1
Energy Works has evaluated its investment in the JV for potential consolidation, and has concluded that it is not required to consolidate the JV. Under ASC 810, companies must first consider whether an investment is within the scope of the VIE model then, if not, apply the voting model. Energy Works determined that this arrangement qualifies for the so-called business scope exception to the VIE model. That is, the JV meets the GAAP definition of a business, as well as the definition of a corporate joint venture, where the owners have joint control. A key judgment in applying these definitions is that the venturers share control, with no one partner having unilateral decision-making authority, as a right of their equity interests. Next, Energy Works applied the voting model and concluded that consolidation is not required because it does not have a controlling interest in the JV.
Sidebar: In practice, it’s a high hurdle to qualify for the business scope exception and, once applied, a reporting entity must continually evaluate (e.g., each reporting period) whether the entity continues to be eligible for this exception.
Analysis – Issue 2: If consolidation is not required, what accounting method should Energy Works use to account for its investment in the JV?
Energy Works considered whether the fair value, equity, or cost method is most appropriate for accounting for its investment. First, Energy Works considered whether the fair value method (ASC 320-10) applies, but concluded that it does not, as this investment does not have a readily determinable fair value. The company has also not historically elected to apply the fair value option to its investments.
Sidebar: Investments in the stock of entities – other than subsidiaries – can be accounted for using one of three methods: the fair value, equity, or cost method.
Regarding the cost method, very little scope guidance is available. Per ASC 325-20 (Cost Method Investments):
05-3 While practice varies to some extent, the cost method is generally followed for most investments in noncontrolled corporations, in some corporate joint ventures, and to a lesser extent in unconsolidated subsidiaries, particularly foreign.
While this investment appears to fall within the scope of this guidance, it’s important to consider whether the equity method is more appropriate. Instruments within the scope of ASC 323-10 (Investments – Equity Method and Joint Ventures) are described as follows:
15-3 The guidance in the Investments—Equity Method and Joint Ventures Topic applies to investments in
in-substance common stock
… including investments in common stock of
corporate joint ventures
… Subsequent references in this Subtopic to common stock refer to both common stock and in-substance common stock that give the
the ability to exercise
(see paragraph 323-10-15-6) over operating and financial policies of an
even though the investor holds 50% or less of the common stock or in-substance common stock (or both common stock and in-substance common stock).
In other words, investments in common stock that give an investor significant influence are within the scope of this topic. ASC 323-10 includes a rebuttable presumption that investments of greater than 20% indicate significant influence:
15-8 An investment (direct or indirect) of 20 percent or more of the voting stock of an investee shall lead to a presumption that in the absence of predominant evidence to the contrary an investor has the ability to exercise significant influence over an investee.
Based on this par. 8 guidance, it appears that Energy Works would be presumed – based on its 50% ownership – to have significant influence, and that application of ASC 323 (Equity Method) is appropriate. Additionally, par. 15-6 offers the following indicators of significant influence:
15-6 Ability to exercise significant influence over operating and financial policies of an investee may be indicated in several ways, including the following:
a. Representation on the board of directors
b. Participation in policy-making processes
c. Material intra-entity transactions
d. Interchange of managerial personnel
e. Technological dependency
f. Extent of ownership by an investor in relation to the concentration of other shareholdings (but substantial or majority ownership of the voting stock of an investee by another investor does not necessarily preclude the ability to exercise significant influence by the investor).
Energy Works has representation on the board, will participate in policy-making related to the entity, will provide employees and managerial personnel to the JV, and the JV will rely upon technological expertise of Energy Works. As several indicators of significant influence are present, and given Energy Works’ 50% equity ownership interest, Energy Works has concluded that it has significant influence over the JV. Accordingly, application of the equity method is appropriate.
Conclusion – Issue 2
Having determined that it is not required to consolidate the JV, Energy Works considered whether its investment should be accounted for under the fair value, cost, or equity method. Energy Works has concluded that the fair value method should not be applied, given that the joint venture will not have a readily determinable fair value. Use of the cost method is generally most appropriate for investments where the investor does not have significant influence.
In this case, based on its 50% equity ownership (which well exceeds the 20% rebuttable presumption that equity method applies), and its substantial participation in all aspects of the joint venture (from policy-making, to governance, to day-to-day management, to technology sharing), Energy Works has the ability to exercise significant influence over the joint venture. Accordingly, Energy Works has concluded that use of the equity method is appropriate.
Analysis – Issue 3: How will Energy Works record the transfer of the FPSO facility to the JV?
Next, Energy Works would need to consider how to record the transfer of its FPSO facility to the JV, in exchange for an equity method interest in the JV. This is a complex issue and is not evaluated in detail in this memo. Instead, rather than perform the complex scope evaluations involved in this issue, let’s briefly walk through how you’d go about this analysis. Energy Works would consider (and document):
· First, whether industry-specific guidance from ASC 932 (Oil and Gas Activities) applies.
· Next, whether the FPSO being transferred is integral equipment (i.e., in-substance real estate), which should be evaluated under ASC 360 (Property, Plant, and Equipment).
· If the above two topics do not apply, next Energy Works would consider whether the assets it is transferring (the FPSO facility and related employees and processes) are considered a business. If Energy Works is contributing a business, it should apply deconsolidation accounting guidance (ASC 810, Consolidation).
· If the assets contributed are not a business, Energy Works would evaluate whether this transaction is considered a nonmonetary exchange (of nonfinancial assets for an equity method investment) under ASC 845 (Nonmonetary Transactions).
· If the transfer is not subject to nonmonetary transactions guidance, Energy Works would apply standard equity method investment guidance (ASC 323).
The case studies included at the end of this chapter will give you the opportunity to consider and document these alternatives.
Sidebar: In practice, it’s common to have basis differences between the carrying amount of assets contributed and their fair values. These basis differences can give rise to some highly complex accounting judgments, both at the venturer and JV level. These judgments are particularly complex when considering equity investments issued in exchange for nonmonetary assets, as is the case here.
Note that the FASB has recently proposed changes intended to simplify the equity method of accounting by removing the requirement that entities track and account for basis differences.
Financial Statement and Disclosure Impacts
Energy Works will record its investment in the joint venture, and its contribution to the JV of the FPSO facility, as follows:
Dr. Investment in JV $120M
Cr. FPSO facility $100M
Cr. Cash $20M
ASC 323-10-50-3 sets forth required disclosures for equity method investments. As stated in par. 50-2, the extent of these disclosures shall depend on the significance of the investment to the investor.
Energy Works must disclose the following in the notes to its financial statements, related to this investment:
1. The name of the investee and percentage of ownership of common stock.
2. Energy Works’ accounting policies with respect to investments in common stock.
3. Any differences between the carrying amount of its investment and the amount of underlying equity in net assets, and how such differences are accounted for.
Also, for equity method investments in corporate joint ventures that are material to the investor, summarized financial information about the investee (assets, liabilities, and results of operations) “may be necessary.” Energy Works will therefore monitor the significance of this investment and will provide such disclosure in accordance with its existing accounting policies.
Sidebar: It can be helpful to support this disclosure section with excerpts from the guidance. However, in the interest of brevity, this example does not include such excerpts. Also, had Energy Works been a publicly-traded company, the company would need to consider whether incremental SEC disclosure requirements apply.
My heartfelt thanks to Nicholas Stell for his contributions to this memo.