Consolidated Financial Statements
Major Changes Coming!

By Michael Davis and James A. Largay III

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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.

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