Consolidated Financial Statements

CPA Journal, The, Feb 2008 by Davis, Michael, Largay, James A III

Major Changes Coming!

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 StandardsSFASs 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 costbased purchase accounting replaced by estimates of die 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 poolingof-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 diey 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.