• FASB to Votes in Rule Changes That Impact Fair Value Accounting and Impairment Model
• SFAS 141(R) – Revised Accounting for Business Combinations
• SFAS 160 and the New Accounting for Minority Interests

FASB to Votes in Rule Changes That Impact Fair Value Accounting and
Impairment Model

The Financial Accounting Standards Board (FASB) voted in rule changes to ease mark-to-market rules for valuing assets, including changes that would lessen the need for banks to take a charge to earnings when the value of assets decrease.  Previously a charge to earnings was required when a decrease in value was such that the asset was "other than temporarily impaired".  In addition to negatively impacting the bottom line such a charge could put banks and other financial institutions below regulatory capital requirements.

Under one of the changes adopted FASB changed the definition of "other than temporarily impaired"    To avoid the designation management had to assert that it had the ability to hold on to the asset until its value recovered.  The new rule allows companies to avoid the classification by stating that they intend to hold on to the asset and that it is more likely than not that they will.

Some investor groups feel that the new rules would allow executives too much room to manipulate the truth and to cover up losses.  Bankers argued that the old mark-to-market rules of valuing assets at market prices don't work when the markets aren't functioning properly.  Business groups mostly commended FASB' moves, but are looking for even more changes.

There was criticism that FASB had succumbed to political pressure to make it easier for banks to limit losses, a charge the Board denied saying that they couldn't "ignore what's going on around us."

The Board decided the FSPs would be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009.

Below is a highlight of the Board’s deliberations for your information. The final FSPs are expected to be issued at a later date.

Inactive Markets and Distressed Transactions

• Guidance and additional factors would be provided for determining whether there has been a significant decrease in market activity for an asset when the market is not active.


• The proposed presumption that all transactions are distressed (not orderly) unless proven otherwise was eliminated. The FSP will instead require an entity to base its conclusion on the weight of the evidence.


• The FSP will include examples and additional explanation on estimating fair value when the market activity has declined significantly.


• The FSP will require disclosure on a change of valuation techniques and fair measurement inputs.

• The scope of the new OTTI model would be limited to debt securities.


• If management asserts (1) it does not have the intent to sell the security and (2) it is more-likely-than-not it will not have to sell the security before recovery of its cost basis, the security would not be considered other-than-temporarily impaired, unless there is credit loss associated with the security.


• The portion of impairment related to the credit loss would be recognized in earnings; and any remaining difference between fair value and the cost basis should be recorded in other comprehensive income.


• There will be additional guidance and requirements on the presentation and disclosures of the total other-than-temporary impairments.

SFAS 141(R) – Revised Accounting for Business Combinations

In December 2007, the Financial Accounting Standards Board (“FASB”) issued a revised statement on business combinations SFAS No. 141(R), Business Combinations, which is currently effective for acquisitions completed (if you’re a calendar-year company) on or after January 1, 2009. Early adoption is not permitted.  SFAS No. 141(R) does not apply to the formation of joint ventures, the acquisition of an asset or a group of assets that does not constitute a business, a combination between entities or businesses under common control, a combination between not-for-profit organizations, or the acquisition of a for-profit business by a not-for-profit organization.

As a result, many different facets of how to account for these transactions, and the subsequent treatment, have changed from SFAS No. 141, Business Combinations. In the following, we have summarized the differences in some of the key provisions between SFAS No. 141(R) and SFAS No. 141.

Revised definition of a Business

SFAS No. 141(R) modifies the prior definition of a business. Under the new standard, the activities and assets that compromise a business need only be “capable” of being conducted and managed as a business, as viewed by a market participant, whose purpose would be providing a return to investors or lower costs or other economic benefits and is not required to include outputs and acquired inputs and processes. This will likely result in more acquisitions being accounted for as a business under the new rules.

Companies in industries such as biotech, pharmaceuticals, technology, internet and retail will likely have more transactions qualifying as acquisitions and should consider the provisions of SFAS No. 141(R) as they structure new deals.

Recording of full acquisition at fair value

A significant change in the recording of a business combination occurs for those acquisitions which do not represent a purchase of 100% of an entity (partial or step acquisitions). Under the prior standards, only the interest in the entity acquired and the related goodwill were recorded at fair value. Under SFAS No. 141(R), the entire entity is recorded at fair value, including the fair value of equity interests not acquired, which will result in different amounts being recorded for goodwill. Equity interests not being acquired, previously referred as minority interests, are now termed non-controlling interests.

Acquisition date/Measurement date

SFAS No. 141 defined the acquisition date as the date the acquisition closed or was consummated, which is usually the date assets were received, liabilities were assumed and the consideration was tendered. Under SFAS No. 141(R), the acquisition date is considered the date control has been transferred, as defined or evidenced by a written agreement, and can occur before or after the closing date. Under SFAS No. 141, equity which was issued as part of the exchange was measured based on the market price for a reasonable period before and after the terms of the acquisition were agreed to and announced. Under SFAS No. 141(R), the acquisition date is the measurement date.

Measurement period

The measurement period under SFAS No. 141(R) is similar to the allocation period under SFAS No. 141. The measurement period is the period when all information, facts, and circumstances existing at the date of acquisition have been obtained or resolved.  Adjustments to preliminary values of assets acquired, liabilities assumed, and equity interests at the time of acquisition are allowed to be “pushed back” to the acquisition date. This period cannot exceed one year from the acquisition date

Acquisition-related costs

Direct costs of the acquisition previously were considered part of the basis of the acquisition price. SFAS No. 141(R), in keeping with the theories behind SFAS No. 157, Fair Value Measurements (“SFAS No. 157”), requires acquisition related costs to be expensed as incurred. For past acquisitions, such as the AOL Time Warner transaction where the acquisition costs were an estimated $300 million of the $147 billion total acquisition cost or 0.2%, this may not represent a significant percentage of the deal. On many deals however, such costs may have a significant impact on company income statements.

Contingent consideration

Contingent consideration represents future promises to deliver cash, additional equity interests or other assets to former owners after the acquisition date when certain conditions have been met or certain events have occurred. Previously, contingent consideration was recognized when the outcome of the contingency was determinable. Under SFAS No. 141(R), contingent consideration is recorded at its fair value as part of the purchase price at the acquisition date and is classified either as a liability or equity, based on other applicable accounting guidance. The assessment of fair value requires the use of valuation techniques and considers all factors that contribute to the determination of fair value. Any changes in fair value subsequent to the acquisition date, which results from additional information gathered during the measurement period, will result in changes to the assets and liabilities acquired, including goodwill, or the consideration given, and adjusted retrospectively.

Contingent assets and liabilities are required to be revalued each reporting period and changes in fair value that are not measurement period adjustments are recognized in the income statement.

Research and development assets

Acquired in-process research and development (“IPRD”) assets that had no alternative uses at the time of acquisition were previously expensed at the acquisition date. Under SFAS No. 141(R), IPRD is recorded at its fair value at the acquisition date and classified as an indefinite lived intangible asset under SFAS No. 142. Development costs incurred after the acquisition on acquired developmental projects are charged to expense as incurred. When development is completed, IPRD are considered amortizable finite-lived assets or are expensed. This will impact companies who prevalently purchase developmental assets, such as biotech, pharmaceutical, internet, and technology industries companies.

Please note that the FASB’s Emerging Issues Task Force is deliberating an issue regarding the purchase of IPRD in an asset acquisition which may also change the accounting for those transactions.

Assets not used for its intended use or at its best use

An acquirer may purchase an asset that will either be abandoned or will not be used to its best use. Prior to the adoption of SFAS No. 157, entity-specific assumptions were used to value these assets, which often resulted in minimal to no value assigned. Under SFAS No. 141(R), all assets acquired are measured at fair value at the acquisition date, from the market participant’s viewpoint, regardless of the acquirers intended use, which may result in more assets being recorded.

Summary

While the accounting should not drive the terms of a transaction, being aware of the potential effects could prevent surprises when the transaction is reflected in the financial statements. Awareness of the effects could also inform decisions about thresholds or milestones for various aspects of the transactions or future transactions.

SFAS 160 and the New Accounting for Minority Interests

In December of 2008, the Financial Accounting Standards Board (the “FASB”) took another giant leap towards global accounting convergence when it issued a new rule on how to account for minority interests. The new standard, SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS No. 160”), “represents the completion of FASB’s first major joint project with the International Accounting Standards Board,” noted FASB member G. Michael Crooch, and is a major departure from the historical cost accounting that many companies use now.

Overview

Under SFAS No. 160, noncontrolling interests are recorded as a separate line item under equity and not as a ‘mezzanine’ item as previously required. This change in presentation applies to all such interests, not just new acquisitions, so companies may need to look at debt covenants or other agreements which reference equity or other measures affected by the change in classification to equity for appropriate revisions. Equity presentation is consistent with the FASB’s view that a noncontrolling or minority interest in a subsidiary is considered an ownership interest for purposes of the consolidated financial statements. A minority interest is the portion of a controlled subsidiary that is owned by someone other than the parent company. Because the parent is deemed to control the subsidiary, it must consolidate the subsidiary’s financial statements into its own.

Example

A professional sports team (the “Team”) may own 90% of a minor league team (the “Farm Team”), with the other 10% owned by a group of investors. Previously, the Team would have carried the 10% claim as a liability (if it was redeemable), or in the mezzanine section of its balance sheet. Under SFAS No. 160, however, the 10% must be recorded as equity. If this adjustment is a departure from current practice, the Team will record an immediate increase to their equity, making debt-to-equity ratios look more favorable.

We recommend that companies assess the broader impact of SFAS No. 160 before entering into a business combination involving acquisitions of less than 100% of the target company as it could affect their strategy on potential transactions. In addition to the factors noted above, there will also be changes to the income statement.

Currently, to arrive at a parent company’s consolidated net income, the company subtracts the percentage of earnings that belongs to the minority interest from its own earnings (which include 100% of the income or loss from the minority interest). Essentially, the minority interest income is treated like an expense against the parent company earnings.

Example

Consider a scenario in which the aforementioned Team records $25 million in earnings, while the Farm Team records $1 million in earnings. Prior to the adoption of SFAS No. 160, the professional sports team would record $26 million in earnings, and subtract 10% of the farm team’s earnings, or $100,000. As such, the Team’s consolidated net income would have been $25.9 million.

Under SFAS No. 160, however, parent companies are not required to subtract minority-interest equity from earnings, which means the Team’s consolidated net income would be recorded at $26 million. However, the Team must include a disclosure identifying what portion of income is attributable to the Team and the Farm Team, and distribute the net income between parent equity and noncontrolling interests in the statement of changes in equity.  It is expected that companies will add a footnote to meet that requirement.

SFAS No. 28, “Earnings per Share”, has been amended by SFAS No. 160 to specify that earnings per share data only relates to amounts attributable to the controlling interests.

Another effect that SFAS No. 160 will have is on the income statement. Specifically, calculations that use net income, including EBITDA, may have to be modified so that only the parent’s share of net income is included in the calculation. In addition, as a result of noncontrolling interests being classified as equity of the entire reporting entity, transactions between the parent company and the noncontrolling interests will be treated as transactions between shareholders, provided that the transactions do not create a change in control. This means that no gains or losses will be recognized in earnings (as were previously recognized) for transactions between the parent company and the noncontrolling interests, unless control is achieved or lost.

Also, in those cases where the net losses exceeded the carrying value of the minority interest, the parent previously had to absorb losses as the minority interest could not generally be less than zero. Under SFAS No. 160, that will no longer be the case and the balance in equity for noncontrolling interests can be negative.