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6.2 Classification of NCI
Publication date: 30 Sep 2022
us Business combinations guide
As detailed in ASC 810-10-45-17, only securities that represent an ownership interest, and are classified as equity for financial reporting purposes, are presented as NCI.
6.2.1 Securities with characteristics of debt and equity
Entities may finance operations with securities that have characteristics of debt and equity, such as puttable stock, or stock with a fixed coupon. These securities, often referred to as equity-linked instruments, can be an attractive form of financing for issuers who benefit from a lower cash coupon or dividend. Investors also benefit, often through a minimum guaranteed return, more seniority, and potential appreciation of the stock. The inclusion of debt like characteristics, however, can mean the security must be classified as debt, precluding equity classification and NCI presentation. See FG 7.4.3.3 for discussion of preferred stock of a subsidiary accounted for as a liability.
Alternatively, if liability classification is not required, reporting entities may still be required to account for certain features (i.e., embedded derivatives), separate from the security. Finally, even if these securities qualify as NCI, they may require separate presentation as “mezzanine equity,” indicating that the reporting entity may need to settle them for cash or other assets. See BCG 6.2.1.4 for information on mezzanine equity.
Determining the appropriate balance sheet classification of equity-linked instruments can be difficult because various sections of accounting guidance must be considered in sequence. Figure BCG 6-1 provides a roadmap of the necessary steps.
Figure BCG 6-1
Roadmap to evaluating NCI with debt and equity features
Roadmap to evaluating NCI with debt and equity features
6.2.1.1 Unit of account for assessing NCI classification
NCI often contains additional features that can affect the cash flows. For example, common stock may be issued with a put feature, offering the holder a residual interest in the entity along with the option to receive the return specified in the put option. When NCI has additional features, a reporting entity must determine whether the feature is freestanding or embedded in the NCI, as this can impact classification and subsequent measurement, which is further explained in FG 5.3.
In an acquisition, the buyer may provide the NCI holder incremental rights, such as the ability to force the controlling interest to redeem the NCI (i.e., a put option). The reporting entity would need to consider whether the put option is a separate (i.e., freestanding) financial instrument. When applying the guidance in FG 5.3, a reporting entity would often conclude the underlying shares and the incremental feature is a single unit of account (i.e., embedded) because (1) the incremental feature is issued concurrent with the newly created NCI, and (2) the feature cannot be legally detached, and if exercised, would require forfeiture of the outstanding shares.
In contrast, when a put option is issued separate from the shares in the subsidiary, it will often constitute its own distinct unit of account (i.e., freestanding). In such cases, the freestanding put should be separately evaluated in accordance with FG 5.6 to determine how to account for it. If equity classification is appropriate, these freestanding instruments will still be presented as NCI even though they are not outstanding shares. See BCG 6.2.2.
Example BCG 6-1 illustrates the analysis of whether a put right should be separately recorded.
EXAMPLE BCG 6-1
Analysis of put right
Analysis of put right
Parent Company A acquires 80% of the common shares of Subsidiary from Company Z. Company Z retains the remaining common shares (20%) in Subsidiary.
As part of the acquisition, Parent Company A and Company Z enter into an agreement that allows Company Z to put its equity interest in Subsidiary, in its entirety, to Parent Company A at a fixed price on a specified date. The put option is non-transferrable and terminates if Company Z sells its Subsidiary shares to a third party.
Should the put right be separately recorded?
Analysis
The put option is embedded in the NCI recorded in Parent Company A’s financial statements because it does not meet either of the conditions of a freestanding financial instrument explained in FG 5.3:
- The put option was executed as part of the acquisition; therefore, it was not entered into separate and apart from the transaction that created the NCI.
- The put option is not legally detachable and separately exercisable, as it is non-transferrable and terminates if Company Z sells its shares.
6.2.1.2 Securities that require liability classification
If an entity determines that the incremental features should be considered together with the underlying shares, the reporting entity must next determine whether the combined instrument should be classified as a liability. See FG 5.5 and FG 7.3 for a discussion of which instruments must be classified as liabilities.
In practice, mandatorily redeemable shares frequently meet the criteria for liability classification because they require settlement for a fixed amount at a fixed date. Similarly, a forward contract embedded in the outstanding shares would achieve the same economic outcome. That is, it will require the exchange of shares for cash at a predetermined date and amount.
Instruments deemed liabilities under the guidance in FG 5.5 and FG 7.3.1 are measured at fair value, and changes in fair value are reflected in earnings.
Liability classification is also required when the reporting entity enters into a purchased call and written put with the NCI holders, and the put and call have the same fixed exercise price and exercise date. This is further addressed in ASC 480-10-55-59 through ASC 480-10-55-63. That guidance would not be appropriate, however, if the purchased call and written put have (a) different exercise prices, (b) floating exercise prices, or (c) different exercise dates. In such situations, the NCI, along with the embedded put and call, should be evaluated in accordance with guidance described in BCG 6.2.1.3 and BCG 6.2.1.4.
Furthermore, if the NCI is considered a share-based payment award, the guidance in ASC 718 should be followed. For example, shares of a consolidated subsidiary issued to employees may be puttable only upon completion of a defined service period. If the redemption price is based on a formula, the guidance in ASC 718-10-25-9(a) may result in treatment of the arrangement as a liability-classified award. See SC 3.3.3 for further discussion of repurchase features in stock-based compensation awards.
6.2.1.3 Embedded features in an NCI that require bifurcation
If the NCI is not a liability, a reporting entity must evaluate whether any features embedded in the instrument must be separately accounted for as a derivative, referred to as bifurcation. Features that commonly need to be considered include put and call options, conversion options, and required dividend payments.
Bifurcation is required if all the criteria detailed in ASC 815-15-25-1 are met, as described in FG 5.4. In practice, there are several reasons why bifurcation would not be required.
Bifurcation is only required if a feature meets the definition of a derivative in ASC 815-10-15-83, as described in FG 5.4.2 and DH 2. Puts and calls embedded in the NCI of a private company generally do not meet the definition of a derivative as they typically do not meet the “net settlement” requirement. This is because the shares are not readily convertible to cash as there is no public market for them. Consequently, they would not need to be separately accounted for.
Bifurcation would also only be required if the feature introduces economics that are different than those in the host contract (e.g., a fixed return embedded in an equity instrument). For this analysis, the economics of the host contract are considered, and whether the host is more akin to debt or equity. This is a highly judgmental analysis and is further explained in FG 5.4.1 and FG 7.3.2. If it is determined that both the feature and the host in question have similar economics, then bifurcation would not be required. An example of this might be a conversion option into common stock that is embedded in perpetual preferred stock when the preferred stock is deemed to have economics that most closely resemble that of an equity instrument.
Finally, an embedded feature that meets the definition of a derivative does not have to be separated if it qualifies for a scope exception from the derivative guidance. One such scope exception is for certain contracts involving a reporting entity’s own equity (see ASC 815-10-15-74(a)). Conversion options embedded in preferred shares may meet this exception, as further discussed in FG 5.4.3.
If bifurcation is required, the total proceeds should be allocated as described in BCG 6.3.1. A reporting entity would still need to consider whether the shares (i.e., the host contract) should be accounted for as permanent NCI or mezzanine NCI.
6.2.1.4 NCI that requires mezzanine classification
Even if an NCI is not classified as a liability, the reporting entity must still consider whether it should be presented as mezzanine or permanent equity, as described in ASC 480-10-S99-3A. Mezzanine equity is presented on the balance sheet after liabilities and before stockholders’ equity, informing the reader that the holder may demand cash or other assets for the shares at a future date. Mezzanine classification would only be appropriate if cash settlement is not certain or required, as explained in FG 7.3.4 in the context of preferred stock.
In determining whether mezzanine classification is appropriate, a reporting entity should also consider features that were bifurcated. For example, if the reporting entity determined that bifurcation was required for the put feature in puttable NCI, the reporting entity may still need to classify the NCI as mezzanine equity if the holder may tender the shares to the reporting entity and demand cash or other assets (i.e., gross settlement).
In addition to “plain-vanilla” put options embedded in the NCI that would cause the NCI to be mezzanine classified, we often see reporting entities issue shares that are contingently puttable if certain events occur, and therefore, require mezzanine classification. Examples include shares that are contingently puttable either upon a change of control, a violation of covenants, or in the event the reporting entity does not take certain actions by a specified date.
The requirements for mezzanine classification are included in ASC 480-10-S99-3A, which codifies guidance issued by the SEC. Accordingly, if the reporting entity is a private company, application of the guidance would not be required. Notwithstanding, as noted in FSP 5.6.3.1, mezzanine classification is strongly encouraged for private companies, especially in those circumstances when there is a strong likelihood that the reporting entity might settle the NCI for cash.
6.2.2 Equity-classified instruments that are not shares as NCI
Securities that qualify for equity classification, but are not shares, are still presented as NCI. Examples include written call options, warrants, and employee stock options. See further discussion in BCG 5.4.1 and BCG 5.4.2. FG 5.6 explains the process for determining whether these instruments qualify for equity classification.
6.2.3 Whether to include indirect interests in NCI
A reporting entity may be required to present interests it holds in a subsidiary indirectly as part of the reporting entity’s controlling interest and not NCI as noted in the definition of NCI.
Excerpt from ASC Master Glossary
Noncontrolling interest: The portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent. A noncontrolling interest is sometimes called a minority interest.
Interest held indirectly through a consolidated entity
A reporting entity may hold a controlling interest in a subsidiary directly and may also hold an interest in the same subsidiary indirectly through another consolidated entity. To determine the total controlling interest, the reporting entity should combine the entire interest held indirectly through the consolidated entity with the direct interest. This is illustrated in Figure BCG 6-2. To determine its controlling interest in Subsidiary X, Reporting Entity would combine the 20% indirect interest held through consolidated Entity Y with its 80% direct interest in Subsidiary X, for a total controlling interest of 100% in Subsidiary X. Reporting Entity would reflect the 40% interest held by third parties in Entity Y (which includes Entity Y’s 20% share of Subsidiary X) as noncontrolling interest in Reporting Entity’s consolidated financial statements. This will effectively reflect 8% (40% of 20%) of Subsidiary X as part of the overall NCI balance.
Figure BCG 6-2
Interest held indirectly through a consolidated entity
Interest held indirectly through a consolidated entity
Interest held indirectly through a substantive nonconsolidated entity
When an indirect interest is held through a substantive nonconsolidated entity, we believe it would be inappropriate to combine the indirect interest with the direct interest. The rationale is that the reporting entity does not control the indirectly held portion, and accordingly, that interest would behave more like a noncontrolling interest than an extension of the reporting entity. Accordingly, the indirectly held interest would be considered NCI.
Figure BCG 6-3 illustrates this scenario. Reporting Entity has an 80% direct interest in Subsidiary X. It also has an indirect interest in Subsidiary X through a substantive nonconsolidated entity, Entity Y. In determining its controlling interest, Reporting Entity includes only the 80% direct interest. The remaining 20% interest in Subsidiary X held by Entity Y would be viewed by Reporting Entity as NCI of Subsidiary X, and not included in the Reporting Entity’s controlling interest.
Figure BCG 6-3
Interest held indirectly through a substantive nonconsolidated entity
Interest held indirectly through a substantive nonconsolidated entity
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