In December 2007, FASB adopted two new business combination standards: Statement no. 141(R), Business Combinations, and Statement no. 160, Noncontrolling Interests in Consolidated Financial Statements. Both culminated years of work directed at improving reporting for consolidated entities.
An article in the June 2008 issue of the JofA (“A New Day for Business Combinations,” page 34) described nine major changes created by Statement no. 141(R). This article summarizes the most important changes created by Statement no. 160, which is effective for fiscal years beginning after Dec. 15, 2008.
Although developed in tandem with Statement no. 141(R), Statement no. 160 was issued as a separate standard because the original Statement no. 141 did not formally address how to account for what used to be called “minority interests.” Statement no. 160 provides improved terminology and conceptually consistent resolution to several reporting and measurement issues. The result will be more informative financial statements that reflect how the existence of and changes in noncontrolling interests (NCI) can affect cash flow potential for the consolidated entity and its shareholders.
The most visible innovation in Statement no. 160 is the name change from “minority interest” to “noncontrolling interest.” The problem with the old terminology was that it did not encompass the full range of combination scenarios. Some majority ownership positions don’t lead to consolidation, such as when a subsidiary is in bankruptcy. Conversely, under Interpretation no. 46(R), Consolidation of Variable Interest Entities, a parent with a minority holding in another entity may have sufficient control to require consolidation if it is deemed to be the primary beneficiary of the subsidiary’s activities. On Sept. 15, FASB issued an exposure draft proposing revisions to Interpretation no. 46(R). Among other things, the proposal requires performing new qualitative analysis when determining if a financial interest in a VIE is to be consolidated.
The shift to the term “noncontrolling interest” will emphasize a parent’s substantive control over a subsidiary rather than a simple ownership percentage and will more usefully reflect the underlying economic and accounting concepts.
There is much more to the standard than just this name change. Years of experience under the old purchase accounting standard showed the need for profound improvements in accounting for the NCI. Specifically, its treatment has varied considerably because of the haphazard processes that created previous consolidation standards.
The result, in FASB’s own words, was that “GAAP had no clear accounting and reporting guidance for the noncontrolling interest in a subsidiary” (Statement no. 160, paragraph B6). This lack of guidance led to an unclear and inconsistent concept of NCI that, in turn, created diverse and unproductive reporting. The following sections describe some of these problems and the related provisions in the new standard that are intended to overcome them.
Balance sheet. Minority interest has been presented on some balance sheets as a liability, as equity or, most commonly, as a fuzzy mezzanine item somewhere in between. The new statement will eliminate these options by specifically requiring the NCI to be displayed as a separate line item within the equity section of the consolidated balance sheet. (A set of illustrative financial statements is provided
in Exhibit 1.)
Income and comprehensive income. Consolidated income statements will present net income for the entire enterprise as well as the allocations to the parent and NCI. Reported earnings per share will be based only on the income attributable to the parent. The consolidated total of accumulated other comprehensive income (AOCI), whether due to available-for-sale securities, pension adjustments, derivatives or other sources, will also be allocated between the controlling and noncontrolling interests.
A major change affecting income reporting concerns the treatment of the earnings related to midyear acquisitions. Currently, consolidated revenue and expenses are often reported under the hypothetical assumption that the parent controlled the subsidiary from the beginning of the year, which is acceptable as long as a subsidiary’s pre-acquisition earnings are backed out at the bottom of the income statement. Since the current treatment allows nondescript measures of top-line performance, the new standard will eliminate this option. Under Statement no. 160, subsidiary revenues and expenses arising only after the date of combination will be reported on the consolidated income statement.
Cash flow statement and statement of changes in equity. The cash flow and equity statements will report the outcome of the period’s events for the entire consolidated enterprise. This display will allow users to see cash flows and other equity changes flowing from all assets and liabilities under the parent management’s control. In addition, equity statements will now include a new column explaining the changes between the beginning and ending NCI balances.
In addition to the inconsistent placement of the NCI on consolidated balance sheets, existing GAAP permits diverse measurement practices, diminishing comparability. Specifically, the NCI’s portions of a subsidiary’s assets and liabilities often are included on the consolidated balance sheet at their book values as of the acquisition date. Because the parent’s portions of those same assets and liabilities are reported at fair value, the consolidated assets and liabilities are presented in the statements as an indecipherable mixture of old book and new fair values. This outcome is likely to confound users’ efforts to comprehend the situation.
To overcome this defect, Statement no. 141(R) will require a subsidiary’s assets (including goodwill) and liabilities to be recorded at fair value as of the acquisition date. When a subsidiary is partially owned, Statement no. 160 will require the NCI’s proportional claim to the difference between the fair values of the subsidiary’s assets and liabilities to be reported within consolidated equity. The result of applying both new standards will be a larger amount of total recorded goodwill and a correspondingly larger NCI equity item. Exhibit 2 illustrates NCI accounting for a basic combination scenario.
Going forward from the acquisition date, the NCI balance will increase or decrease based on its proportionate share of the subsidiary’s profits and losses. It will be reduced by its share of dividends paid by the subsidiary. Currently, the NCI’s share of losses is constrained to avoid showing a debit NCI balance. Under Statement no. 160, the sharing of income or losses will not be constrained, even if it means reporting a deficit balance for the NCI.
These modifications reflect an application of the entity accounting theory that will cause financial statements to reflect all shareholder interests, including those of the parent and subsidiary’s noncontrolling shareholders. Existing accounting for the NCI is a slapdash mix of practices that is not aligned with any particular concept and certainly does not produce information useful for rational decisions. This explicit adoption of the entity theory also is consistent with FASB’s Concepts Statement no. 6 classification of the NCI as a residual equity interest.
Statement no. 160 will stipulate new requirements for transactions and other events that change a parent’s ownership percentage in a subsidiary. Depending on the particular facts, the percentage may change because the parent buys or sells subsidiary shares or because the subsidiary engages in its own stock transactions without involving the parent. Some of these events leave the parent in control while others may cause the parent to lose control. The most common of these transactions are described in Exhibit 3.
Statement no. 160 will not allow recognition of gains or losses on the consolidated income statement when the parent retains control after changes in its ownership percentage. The rationale is that these transactions are capital in nature. By making this requirement explicit, the new statement will bring uniformity to an area of practice where diversity reigned because of the compromised guidance provided in Staff Accounting Bulletin no. 51, Accounting for Sales of Stock by a Subsidiary. This SAB inconsistently allowed gains and losses to be recognized in some but not all situations, with arbitrary distinctions between them.
When transactions alter the parent’s ownership percentage, Statement no. 160 will require the parent to proportionally adjust its investment account (in its accounting system, not in the consolidated statements). Any difference between the adjustment and the consideration given up or received will be added to or subtracted from the parent’s unconsolidated additional paid in capital, and will not be reported as a gain or loss on the income statement. In turn, no adjustments will be made to the carrying values in the subsidiary’s accounting records for its assets (including goodwill) and liabilities, apart from recognizing any consideration given up or received by the subsidiary from its stock transactions. In the consolidation process, the decrease or increase in the parent’s investment account will pass through to the NCI as an increase or decrease, respectively. These illustrations provide examples of the effects of changes in ownership.
These procedures will also be applied to situations when a subsidiary’s equity includes AOCI. The change in the parent’s ownership percentage will affect the allocation of the subsidiary’s total AOCI between the parent’s and the NCI’s portions. Specifically, the consolidated AOCI must be reallocated with an increase or decrease in the NCI and a corresponding decrease or increase in the parent’s additional paid in capital account.
When a parent loses control of a subsidiary because of its own transactions or those affecting only the noncontrolling shareholders, the underlying economics are more faithfully represented if the previously consolidated assets and liabilities are “deconsolidated.” Upon losing control, the parent’s own accounting system must accommodate its new status as the holder of an investment that has become a noncontrolling interest in the subsidiary that it used to control. How that adjustment is accomplished depends on the circumstances. If the parent still has influence, it will apply the equity method; if not, it will account for the investment as trading or available-for-sale.
Under existing GAAP, the parent’s records after deconsolidation include a new noncontrolling investment account with a balance equal to the carrying value of the retained shares in the former subsidiary, measured as of the date control was lost. This practice is deficient because that GAAP-based book value doesn’t reliably describe the future cash flow potential inherent in those shares.
Deconsolidation under Statement no. 160 will establish the parent’s new noncontrolling investment account with an initial balance equal to the fair value of the parent’s retained shares in the former subsidiary as of the date control is lost. The difference between the book and fair values for this investment will be reported as a gain or loss on the income statement and will be combined with the realized gain or loss on any shares sold as part of the deconsolidation transaction. The parent’s income statement will also be affected in two ways. Going forward, investment income will replace the previously consolidated operating revenues and expenses, and the earnings per share calculation will no longer allocate earnings between the parent and the NCI.
To summarize the underlying concept, a change in the ownership percentage resulting in a loss of control has a real economic impact on the financial interests of both the parent and the noncontrolling shareholders. This impact is not fully revealed under existing GAAP.
When a noncontrolling interest is retained in a formerly controlled entity, the new investment currently rolls forward at the basis of the kept shares. Statement no. 160 will more usefully describe how the former parent-subsidiary relationship transforms to a new investor-investee relationship by requiring fair value measurement at the time of deconsolidation.
Statement no. 160 will require new supplemental disclosures about the controlling and noncontrolling interests to help users understand how they affect the overall reporting entity and the future cash flow potential for the parent’s shareholders. Previously, no disclosures about NCI were required. Going forward, Statement no. 160 specifies that a footnote must reconcile the beginning and ending balances of both the parent and NCI equity amounts, including net income and owner contributions attributable to each of them. Additional disclosures will describe changes in the parent’s percentage ownership of its subsidiaries, including any circumstances leading to loss of control and deconsolidation of a previously consolidated subsidiary. The new disclosures will shine a light into areas where users have not had much illumination in the past.
Statement no. 141(R) and Statement no. 160 are integrally linked to work together to apply the new acquisition method to consolidated financial statements and reports and thus bring more useful information to the capital markets. With its more extensive and consistent fair value measurements, Statement no. 141(R) will help users assess the future cash flows of the consolidated enterprise. And with its consistent application of entity reporting concepts, Statement no. 160 will help them comprehend the relationship between the controlling and noncontrolling interests. As a result, users can perform more complete and reliable assessments of the prospective future cash flows available to the parent and its shareholders.
“A New Day for Business Combinations” June 08, page 34
“Extraordinary Items Share Exclusive Company,” May 07, page 80
What You Need to Know About Accounting for Business Combinations, a CPE self-study course (#182000)
Current Accounting Issues and Risks 2008—Strengthening Financial Management and Reporting (#029208)