What Analysts Should Know about FAS No. 141R and FAS No. 160

FAS No. 141R, “Business Combinations,” and FAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements,” became effective for fiscal years beginning after 31 December 2008. Many quarterly and annual reports for 2009 incorporated the requirements of these standards. In this article, the author discusses changes resulting from the standards’ implementation. The dramatic events of the past two years have brought unprecedented levels of uncertainty and controversy to the challenging world of financial analysts. They include a global financial meltdown, collapsing real estate markets, record unemployment, a recession, depressed equity values, and struggling businesses in all industries. Cruising under the radar of many analysts, however, are a few new accounting standards that could yield even more confusion and chaos. Among them are Statement of Financial Accounting Standards (FAS) No. 141R, “Business Combinations,” and FAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements.” Both standards are effective for fiscal years beginning after 15 December 2008.As a result of these standards, the financial statements of many corporations have been modified, especially if they include less than wholly owned subsidiaries. For example, FAS No. 160 requires the term “noncontrolling interests” to replace “minority interests.” This change is consistent with recent efforts to base the consolidation decision on the merits of managerial control rather than majority stock ownership. Moreover, the positioning of noncontrolling interests on consolidated balance sheets is now standardized, and their position on consolidated income statements has been significantly altered to accommodate a new measure of consolidated net income (CNI). According to FAS No. 160, the interests of noncontrolling shareholders in the net assets of a consolidated subsidiary are now reported as a component of shareholders’ equity. The option no longer exists to report this amount among the liabilities or in the “mezzanine” area between liabilities and shareholders’ equity. This requirement will certainly lead to higher levels of reported shareholders’ equity for many companies, thereby lowering debt-to-equity and return-on-equity ratios.Just as significant is the fact that the interests of noncontrolling shareholders in subsidiary earnings are no longer a component in the calculation of CNI. Thus, CNI is higher for parent companies with profitable subsidiaries because the noncontrolling interests in subsidiaries’ earnings are no longer deducted when CNI is computed. The primary thrust of this change is to provide decision makers with a profit measure for the entire consolidated entity. To supplement this change and provide a measure of consistency with the past, consolidated income statements must allocate CNI between the amount associated with the noncontrolling interests and the amount associated with the parent company. This latter amount is similar to CNI of previous periods.FAS No. 141R, which is not applied retroactively, introduces the “acquisition method” as a replacement for the “purchase method” for new business combinations (i.e., those taking place in fiscal years beginning after 15 December 2008). Two major features of the acquisition method are that direct costs associated with a business combination are now expensed as incurred (previously, they were capitalized as part of a combination’s price) and purchased in-process R&D is now capitalized until projects become reclassified operating assets or are abandoned (previously, in-process R&D was expensed in the period of the purchase). For an acquisition of a less than wholly owned subsidiary, the related goodwill calculation has been changed. Rather than basing goodwill on the amount associated with the parent company’s less than 100 percent investment, the acquisition method determines goodwill for the entire subsidiary. Consequently, goodwill is now measured as the excess of the fair value of the consideration issued by the acquirer plus the fair value of the noncontrolling interests minus the fair values of the subsidiary’s individual net assets. This change is likely to yield higher reported amounts of goodwill from new acquisitions. Similarly, with emphasis on the whole consolidated entity, the individual assets and liabilities of an acquired subsidiary are first consolidated at their full fair values instead of their proportionate values, as in the past. To accommodate this increase in reported values, the noncontrolling interests in the subsidiary’s net assets become correspondingly higher. With higher consolidated assets, there will likely be higher related expenses in future periods, thereby producing lower CNI.Should a new business combination involve a bargain purchase, the resulting negative goodwill is immediately reported in CNI (previously, it was allocated as a reduction among the acquired company’s long-term assets).As a result of changes brought about by FAS No. 141R and FAS No. 160, analysts need to be cautious when analyzing consolidated financial information influenced by these new standards, when performing time-series analyses of reported variables and their related ratios, and when forecasting future amounts of important variables.