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Consolidated
Financial Statements
Major Changes Coming!
By
Michael Davis and James A. Largay III
FEBRUARY 2008
- The procedural aspects of consolidated financial statements have
gone practically unchanged for almost 50 years, with the exception
of accounting changes related to goodwill and the pooling-of-interests
method. The well-accepted methodology behind consolidated entities
will change dramatically when new FASB standards become effective
for periods beginning on or after December 15, 2008. The resulting
consolidated statements may look much the same, but the behind-the-scenes
mechanics and processes will be significantly different. Some reported
amounts—and their interpretation—will diverge from their
traditional meanings. CPAs
and financial executives should prepare themselves for major changes
in preparing consolidated financial statements. What finally emerged
from FASB’s redeliberation is complex, so an overview of
the concepts can help professionals quickly digest the changes
in the final standards.
New
Standards Based on Two Exposure Drafts
The new Statements
of Financial Accounting Standards—SFASs 141(R), Business
Combinations, and 160, Noncontrolling Interests in Consolidated
Financial Statements—emerged in December 2007 from
the extensive redeliberation of two FASB exposure drafts (ED)
issued in June 2005. As the first major joint project between
FASB and the International Accounting Standards Board (IASB),
the business combinations project sought to demonstrate that the
two standards-setting bodies can work together. Given the extent
of the changes, evaluating the success of those endeavors may
take time. In this case, International Financial Reporting Standard
(IFRS) 3 (revised in 2007), which is the IASB’s companion
statement on business combinations, reflects most of the changes
in SFAS 141(R).
In a nutshell,
the purchase method, now to be known as the acquisition
method, has been further modified such that, in many
mergers, it will no longer rely on historical costs. Combinations
involving either an acquisition of less than 100%, or control
that is achieved in steps, will see traditional cost-based purchase
accounting replaced by estimates of the acquired company’s
fair value. The estimated fair value of contingent consideration
agreements becomes part of the consideration that is recorded
at the acquisition date, with subsequent changes in its
fair value reported in current earnings, not as purchase-price
adjustments. Additional contingent assets and liabilities will
likely be recognized, and acquired in-process research and development
(R&D) will no longer be expensed as if it was internally
developed R&D, but instead it will be capitalized and initially
subjected to periodic impairment testing.
The major
changes incorporated in SFASs 141(R) and 160 can be divided into
six categories, which also include some lesser changes. When appropriate,
excerpts from respondent comments to the EDs are provided below.
Broader
Definition of a ‘Business’
SFAS 141(R)’s
broader definition of a business brings mutual entities within
its scope for the first time, according to the definitions in
para. 3. This means that mutual entities can no longer use pooling-of-interests
accounting when they merge. This seemingly innocuous change elicited
a majority of negative responses arguing that combinations of
mutual entities are true mergers—not acquisitions—with
no consideration exchanged. One respondent to the ED noted: “With
no consideration in a transaction, it is not practical to determine
an accurate fair value of the acquired company to the acquirer.
We are concerned … the results may be misleading …
primarily because they do not reflect the combination’s
true economics.”
Acquisitions
Recorded at Full Fair Value
“Full
fair value,” now referred to as the measurement principle
(first described in para. 20), is the most controversial issue
in the joint FASB-IASB business combinations project. Any “partial”
controlling acquisition (less than 100%) will be reported not
at the price paid, but at the acquirer’s estimated full
fair value for the company as a whole. For
example, an $8 billion acquisition of 80% of a company could be
reported at $9.5 billion if that is the entity’s estimated
fair value. Not only are all identifiable assets and liabilities
consolidated at their full fair values, SFAS 141(R) bases goodwill
on the excess of the total entity’s fair value over the
fair value of the identifiable net assets (para. 34). [FASB board
member Leslie Seidman’s wide-ranging dissent to SFASs 141(R)
and 160 cites her objection to attributing goodwill to the minority,
or noncontrolling, interest.]
Thus, the
noncontrolling interest will also be reported at its full fair
value upon acquisition. FASB is adopting the entity, or economic-unit,
theory of consolidations, and discarding the parent theory, with
its long history of focusing on the cost of the ownership percentage
purchased.
Consequences
of the full-fair-value approach. Most respondents
to the ED agreed with recording identifiable assets and liabilities
at fair value, but not goodwill; unlike identifiable assets, goodwill
cannot be measured directly. In addition, the acquiree’s
total fair value cannot be reliably measured when less than 100%
is purchased and a “control premium” exists.
Having control
of another entity is a valuable right with numerous benefits,
including the use of all the assets and the ability to declare
dividends. Because the value of this right is reflected in the
price necessary to obtain control, the premium theoretically no
longer needs to be paid once control is obtained. Therefore, estimating
the fair value of a “whole” entity based on the price
paid to acquire control with less than 100% ownership could significantly
overstate the entity’s true fair value. As one of the big
stumbling blocks in the suspended procedures element of FASB’s
1995 exposure draft on consolidations, the board had to address
this problem. It did so in SFAS 141(R) by requiring a valuation
model–based estimate of the entity’s total fair value,
not a “grossing up” of the purchase price for a partial
interest. One computational consequence of this approach is that
goodwill will generally not be allocated proportionately between
the controlling and noncontrolling interests.
Exhibit
1 uses an 80% acquisition with contingent consideration to
illustrate how different the results can be. Although SFAS 141(R)
promotes more comprehensive and consistent accounting across firms,
Exhibit
2 shows how financial ratios that use the new financial statement
data are not comparable to previous measures, and they will likely
be less reliable due to the concerns about estimation noted earlier.
Consistent with the full-fair-value approach to valuation, SFAS
160 redefines “consolidated net income” as “group
income” under current GAAP, before any subtraction for minority
interest (para. 29). Comparing
the redefined consolidated net income with current GAAP’s
“controlling interest’s share of the group income”
should be done with care.
Respondents’
comments and other issues. Respondents generally
opposed the proposal to record the fair value of contingent consideration
liabilities at the acquisition date, and to record subsequent
changes in their fair value in earnings [para. 65(b)]. One practical
reason for the opposition appeared in FASB’s “Comment
Letter Summary”:
Contingent
consideration cannot be measured reliably at the acquisition
date. Contingent consideration occurs because the buyer and
seller are not able to agree upon the fair value of the acquiree;
therefore, reliably estimating the fair value of the contingent
consideration is by definition impossible [emphasis added].
Another reason
for the opposition alludes to the possibility of manipulation;
respondents’ views were summarized as follows:
The proposal
might motivate acquirers to overestimate the acquisition-date
fair value of contingent consideration so that the reversal
of those liabilities results in income in future periods.
One hopes
that such manipulation using so-called cookie-jar reserves will
not proliferate. However, recent high-profile company financial
reporting frauds suggest that such manipulation will compound
the practical measurement concerns that make the reliability of
contingent consideration estimates inherently suspect. Two other
aspects of SFAS 141(R) that bear on the full-fair-value approach
to business combinations are as follows:
- Acquisition-date
(or pre-acquisition) contingencies have been recognized at fair
value for some time, generally in accordance with the “probable”
test in SFAS 5, Accounting for Contingencies. SFAS
141 (R) (para. 24), however, requires recognition of all contractual
rights and obligations, and of noncontractual contingencies
that more likely than not meet the definition of an asset or
liability under FASB Concepts Statement 6. Contingencies not
recognized at acquisition will be accounted for under other
applicable GAAP, such as SFAS 5. Thus, many more pre-acquisition
contingent liabilities and assets will be recognized up front,
primarily because “more likely than not” creates
a lower recognition threshold than “probable.”
- Planned
post-acquisition restructuring costs must be expensed, rather
than added to the cost of the investment or considered in the
carrying amounts assigned to identifiable assets and liabilities
(para. 13).
Step
Acquisitions
Two facets
of this issue stand out. First, when obtaining control in a series
of purchases or steps, SFAS 141(R) requires restating all previous
purchases to fair value as of the date control is achieved, and
reporting any gain or loss in income (para. 48). This approach
sharply contrasts with the current “cost accumulation”
or “purchase method” that accounts for each purchase
separately: Different prices paid for several blocks of stock
acquired result in reporting portions of the identifiable net
assets at different fair values, and produce layers of goodwill.
To illustrate
SFAS 141(R)’s accounting, suppose the acquirer carries its
40% share of the target’s stock at $120 million. When it
obtains control by purchasing another 20% for $75 million, the
acquirer revalues the previous 40% to $150 million and reports
a $30 million gain in income. Thus, the entire 60% position will
be carried at $225 million, compared with $195 million under current
GAAP. Most respondents to the exposure draft agreed with 141(R)’s
approach but favored reporting any gain or loss in other comprehensive
income, because of its similarity to unrealized gains or losses
on available-for-sale securities.
Second, when
changes in ownership interests occur after control is obtained,
perhaps by increasing ownership from 60% to 70% by purchase in
the open market or decreasing ownership from 70% to 60% by sale
in the open market, the difference between the amount paid (or
received) and the carrying value of that ownership interest is
reflected in additional paid-in capital. Such transactions will
now effectively be treated as treasury stock transactions. Current
GAAP records increases in ownership using the purchase method
approach described here. SFAS 160 augments the straight purchase
approach by comparing the price paid with the carrying value of
the noncontrolling interest acquired, and recording any gain or
loss in additional paid-in capital (para. 33). Exhibit
3 illustrates the differences. BDO Seidman captured the majority
view in its comment letter:
[T]his
particular part of the proposal is the most troublesome to us,
because it fails to hold management accountable for the costs
incurred in acquiring a business and requires part of the cost,
as well as part of the gain or loss on disposal, to permanently
bypass the income statement.
Any gain
or loss realized when ownership interest falls—whether by
sale or by subsidiary stock issuance [Staff Accounting Bulletin
(SAB) 51 transactions]—is also recorded as additional paid-in
capital, not income, as required under current GAAP. If such treasury
stock transactions eliminate additional paid-in capital, then
retained earnings absorb any further “losses.” But
when the ownership interest falls enough for the parent to lose
control of a subsidiary, SFAS 160 calls for the remaining interest
to be marked to fair value, with any gain or loss to be reported
in current income (para. 36).
Noncontrolling
(Minority) Interest Reported in Equity
One unresolved
display issue over the decades deals with noncontrolling interests.
Some companies report minority interest in noncurrent liabilities,
others in equity, and still others between the two in the mezzanine.
Most respondents disagreed with the 2005 consolidations ED’s
approach of reporting minority interest in equity, adopted in
SFAS 160 (para. 26). They argued that, although noncontrolling
interest doesn’t meet the definition of a liability, it
also does not meet the definition of equity. These respondents
reject the entity theory or economic-unit approach to this particular
issue, viewing the noncontrolling interests as nonowners. Such
respondents claim that the current practice of using the mezzanine
is “common, well understood, reflects the economics underlying
the entities, and therefore, should be retained.” However,
the authors believe that FASB is correct here—noncontrolling
shareholders are residual owners of the consolidated subsidiary’s
net assets—and that clear disclosure will remove any confusion.
A related
concern involves losses in excess of the noncontrolling interest’s
equity. SFAS 160 calls for the combined entity to share the income
or loss, even to the point of creating a deficit balance in noncontrolling
interest (para. 31), although the minority investors cannot report
negative investment account balances. Respondents to the ED argued
that if the noncontrolling interest has no obligation to fund
excess losses, then presenting a deficit for that interest—a
kind of “due from”—is contrary to the underlying
economics, and misleading.
Expensing
Acquisition Costs
SFAS 141(R)
requires the expensing of all acquisition costs (para. 59), contrary
to longstanding practice and, as noted by most respondents to
the ED, contrary to the treatment of transaction costs in other
settings. For example, just as companies capitalize transportation
or installation costs for new equipment, respondents argued that
acquisition transaction costs are an integral part of the purchase
price. Because, in the words of one respondent: “Every acquirer
considers transaction costs in determining what they are willing
to pay for an acquiree; they form part of the consideration transferred
and part of the fair value of the acquiree.” (Unchanged
under the new rules is the treatment of costs of registering and
issuing equity and debt securities in the business combination.)
Capitalization
of Purchased In-Process R&D
In a major
departure from the old SFAS 141 issued in 2001, which followed
SFAS 2 and FASB Interpretation (FIN) 4 rules that require the
expensing of all R&D expenditures, SFAS 141(R) requires capitalizing
purchased in-process R&D (IPRD) as an indefinite-life intangible
asset until completion or abandonment, although subsequent expenditures
will be expensed [para. 66 (a)]. The new rules specify that IPRD
be neither immediately written off nor amortized, but instead
be subject to annual impairment testing, similar to the treatment
of goodwill.
The support
for capitalizing is fairly straightforward—the acquirer
pays to obtain some amount of future benefit—whereas the
argument against capitalizing centers on the inability to reliably
measure IPRD or the benefit period. Unlike its internally generated
counterpart, though, an external purchase price lies behind the
capitalization of purchased IPRD. Even so, some argue that IPRD
does not meet the definition of an asset when its low likelihood
of success fails to signal probable future economic benefits.
Significance
of the Changes
The changes
discussed above are significant, represent major departures from
longstanding practice, and were the result of a lengthy redeliberation
process. Because this is FASB’s first truly joint project
with the IASB—and “final standards” were in
process for a long time due to coordinating with the IASB—the
authors believe that these significant changes to business combinations
and consolidation methodology signal growing cooperation between
the two boards. Given the move toward fair-value accounting, adoption
of the economic-unit concept was expected, at least to some degree.
Nevertheless,
estimating total goodwill in acquisitions of less than 100% may
become too problematic no matter how strongly FASB desires to
adopt the full economic-unit approach to consolidated statements.
But it rejected limiting goodwill to the amount purchased, a partial
economic-unit approach. Possibly more contentious, SFAS 141(R)’s
allowance of special treatment for purchased IPRD without addressing
the entire R&D question could create troublesome inconsistencies,
especially given the measurement difficulties.
Now that
the standards have been adopted, CPAs and businesses have several
months to prepare for the dramatic changes in accounting for controlled
entities. Not only are more fair values entering financial reporting,
new inconsistencies are being introduced into the mix, because
SFAS 141(R)’s treatment of acquisition costs and of purchased
in-process R&D represents a break from longstanding GAAP.
Reliability issues aside, users will need to carefully adjust
their interpretation of financial performance, especially when
comparing to prior periods.
Michael
Davis, PhD, CPA (inactive), is a professor and the director
of the accounting program at the University of Alaska–Fairbanks.
He can be reached at ffmld1@uaf.edu.
James A. Largay III, PhD, CPA (inactive), is a
professor of accounting and director of the MS in accounting program
at Lehigh University, Bethlehem, Pa. He can be reached at jal3@lehigh.edu.
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