FASB Statements “Business Combinations” (SFAS 141R) and “Noncontrolling Interests and Consolidated Financial Statements” (SFAS 160) clearly embrace the fair-value concept in accounting for business combinations. The FASB stresses that consolidated statements should reflect the underlying economics that exist on the date a business is acquired.
To capture those economics, the fair value of the acquired firm, at the date control obtained is the basis for financial reporting for all business combinations. Fair value is considered the most relevant attribute for measuring, reporting, and assessing the financial effects of a business combination.
Consolidated Financial Reporting in the Presence of a Noncontrolling Interest:
Noncontrolling Interest Defined:
When a parent company acquires a controlling ownership interest with less than 100 percent of a subsidiary’s voting shares, it must account for the noncontrolling shareholders’ interest in its consolidated financial statements. The noncontrolling interest represents an additional set of owners who have legal claim to the subsidiary’s net assets and profits.
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Exhibit 4.1 provides a framework for introducing two fundamental valuation challenges in accounting and reporting for a noncontrolling interest. The issues focus on how the parent, in its consolidated financial statements, should-
i. Assign values to the noncontrolling interest’s share of the subsidiary’s assets and liabilities?
ii. Value and disclose the presence of the other owners?
The answer to both of these questions involves fair value. The acquisition method captures the subsidiary’s fair value as the relevant attribute for reporting the financial effects of a business combination. Fair values also provide for managerial accountability to investors and creditors for assessing the success or failure of the combination.
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Control and Accountability:
In acquiring a controlling interest, a parent company becomes responsible for managing all the subsidiary’s assets and liabilities even though it may own only a partial interest. If a parent can control the business activities of its subsidiary, it directly follows that the parent is accountable to its investors and creditors for all of the subsidiary’s assets, liabilities, and profits. To provide a complete picture of the acquired subsidiary requires fair-value measurements for both the subsidiary and the individual assets and liabilities.
Thus, for business combinations involving less- than-100 percent ownership, the acquirer recognizes and measures at the acquisition date the:
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i. Identifiable assets acquired and liabilities assumed at their full fair values.
ii. Noncontrolling interest at fair value.
iii. Goodwill or a gain from a bargain purchase.
In concluding that consolidated statements involving a noncontrolling interest should initially show all of the subsidiary’s assets and liabilities at their full fair values.
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Thus, even though a company acquires less than 100% of another firm, the acquiring company includes in their acquisition-date consolidated statements 100% of each of the assets acquired and each of the liabilities assumed at their full fair values. This requirement stands in marked contrast to the former purchase method which focused on cost accumulation and allocation. Under the former purchase method, the parent allocated the acquisition cost only to the percentage acquired of each subsidiary asset and liability.
Thus, prior to SFAS 141R, subsidiary assets and liabilities were measured partially at fair value and partially at the subsidiary’s carryover (book) value. The new requirements will help ensure that managements are accountable for the entire fair value of their acquisitions. However, compared to situations where 100 percent of a firm is acquired, measuring subsidiary fair value when accompanied by a noncontrolling interest presents some special challenges.
Subsidiary Acquisition-Date Fair Value in the Presence of a Noncontrolling Interest:
When a parent company acquires a less-than-100 percent controlling interest in another firm, the acquisition method requires a determination of the acquisition-date fair value of the acquired firm for consolidated financial reporting.
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The total acquired firm fair value in the presence of a partial acquisition is the sum of the following two components at the acquisition date:
i. The fair value of the controlling interest.
ii. The fair value of the noncontrolling interest.
The sum of these two components then serves as the starting point for the parent in valuing and recording the subsidiary acquisition. If the sum exceeds the collective fair values of the net identifiable assets acquired and liabilities assumed, then goodwill is recognized. Conversely, if the collective fair values of the net identifiable assets acquired and liabilities assumed exceeds the total fair value, the acquirer recognizes a “gain on bargain purchase.”
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Measurement of the controlling interest fair value remains straightforward in the vast majority of cases—the consideration transferred by the parent typically provides the best evidence of fair value of the acquirer’s interest. However, there is no parallel consideration transferred available to value the noncontrolling interest. Therefore, the parent must employ other valuation techniques to estimate the fair value of the noncontrolling interest at the acquisition date.
Usually, a parent can rely on readily available market trading activity to provide a fair valuation for its subsidiary’s noncontrolling interest. Market trading prices for the noncontrolling interest shares in the weeks before and after the acquisition provide an objective measure of their fair value. The fair value of these shares then becomes the initial basis for reporting the noncontrolling interest in consolidated financial statements.
Frequently, acquirers must pay a premium price per share to garner sufficient shares to ensure a controlling interest. A control premium typically is needed only to acquire sufficient shares to obtain a controlling interest. The remaining (noncontrolling interest) shares no longer provide the added benefit of transferring control to the new owner, and therefore, may sell at a price less than the shares that yielded control.
Such control premiums are properly included in the fair value of the controlling interest, but usually do not affect the fair values of the remaining subsidiary shares. Therefore, separate independent valuations for the controlling and noncontrolling interests are typically best for measuring the total fair value of the subsidiary.
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In absence of fair value evidence based on market trades, firms must turn to less objective measures of noncontrolling interest fair value. For example, comparable investments may be available to estimate fair value. Alternatively, valuation models based on subsidiary discounted cash flows or residual income projections can be employed to estimate the acquisition-date fair value of the noncontrolling interest.
Finally, if a control premium is unlikely, the consideration paid by the parent can be used to imply a fair value for the entire subsidiary. The non- controlling interest fair value is then simply measured as its percentage of this implied subsidiary fair value.
Noncontrolling Interest Fair Value as Evidenced by Market Trades:
In the majority of cases, direct evidence based on market activity in the outstanding subsidiary shares (not owned by the parent) will provide the best measure of acquisition-date fair value for the noncontrolling interest. For example, assume that Parker Corporation wished to acquire 9,000 of the 10,000 outstanding equity shares of Strong Company and projected substantial synergies from the proposed acquisition.
Parker estimated that a 100 percent acquisition was not needed to extract these synergies. Also, Parker projected that financing more than a 90 percent acquisition would be too costly.
Parker then offered all of Strong’s shareholders a premium price for up to 90 percent of the outstanding shares. To induce a sufficient number of shareholders to sell, Parker needed to offer $70 per share, even though the shares had been trading in the $59 to $61 range. During the weeks following the acquisition, the 10 percent noncontrolling interest in Strong Company continues to trade in the $59 to $61 range.
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In this case, the $70 per share price paid by Parker does not appear representative of the fair value of all the shares of Strong Company. The fact that the noncontrolling interest shares continue to trade around $60 per share indicates a $60,000 fair value for the 1,000 shares not owned by Parker. Therefore, the valuation of the noncontrolling interest is best evidenced by the traded fair value of Strong’s shares, not the price paid by Parker.
The $70 share price paid by Parker nonetheless represents a negotiated value for the 9,000 shares. In absence of any evidence to the contrary, Parker’s shares have a fair value of $630,000 incorporating the additional value Parker expects to extract from synergies with Strong.
Thus the fair value of Strong is measured as the sum of the respective fair values of the controlling and noncontrolling interests as follows:
At the acquisition date, Parker assessed the total fair value of Strong’s net identifiable assets at $600,000. Therefore, we compute goodwill as the excess of the total fair value of the firm over the sum of the fair values of the identifiable net assets as follows:
Allocating Acquired Goodwill to the Controlling and Noncontrolling Interests:
To provide a basis for potential future allocations of goodwill impairment charges, acquisition- date goodwill should be apportioned across the controlling and noncontrolling interests. The parent first allocates goodwill to its controlling interest for the excess of the fair value of the parent’s equity interest over its share of the fair value of the net identifiable assets. Any remaining goodwill is then attributed to the noncontrolling interest. As a result, goodwill allocated to the controlling and noncontrolling interests will not always be proportional to the percentages owned.
Continuing the Parker and Strong example, all of the acquisition goodwill is allocated to the controlling interest as follows:
In the unlikely event that the noncontrolling interest’s proportionate share of the subsidiary’s net asset fair values exceeds its total fair value, such an excess would serve to reduce the goodwill recognized by the parent. For example, if Strong’s 10 percent noncontrolling interest had a fair value of $55,000, Strong’s total fair value would equal $685,000, and goodwill (all allocated to the controlling interest) would decrease to $85,000.
Alternatively, if Strong’s 10 percent non- controlling interest had a fair value of $70,000, Strong’s total fair value would equal $700,000. In this case, goodwill would equal $100,000 with $90,000 allocated to the controlling interest and $10,000 allocated to the noncontrolling interest. Finally, if the total fair value of the acquired firm is less than the collective sum of its net identifiable assets, a bargain purchase occurs. In such rare combinations, the parent recognizes the entire gain on bargain purchase in current income. In no case is any amount of the gain allocated to the noncontrolling interest.
Noncontrolling Interest Fair Value Implied by Parent’s Consideration Transferred:
In a limited number of cases, especially when a large percentage of the acquirer’s voting stock is purchased, the consideration paid by the parent may be reflective of the acquirer’s total fair value. For example, again assume Parker pays $70 per share for 9,000 shares of Strong Company representing a 90 percent equity interest.
Also assume that the remaining 1,000 noncontrolling interest shares are not actively traded. If there was no compelling evidence that the $70 acquisition price was not representative of all of Strong’s 10,000 shares, then it appears reasonable to estimate the fair value of the 10 percent noncontrolling interest using the price paid by Parker.
In this case the total fair value of Strong Company is estimated at $700,000 and allocated as follows:
Note that in this case, because the price per share paid by the parent equals the noncontrolling interest per share fair value, goodwill is recognized proportionately across the two ownership groups.
Assuming again that the collective fair value of Strong’s net identifiable assets equals $600,000, goodwill is recognized and allocated as follows:
Allocating the Subsidiary’s Net Income to the Parent and Noncontrolling Interests:
Subsequent to acquisition, the subsidiary’s net income must be allocated to its owners—the parent company and the noncontrolling interest—to properly measure their respective equity in the consolidated entity. As SFAS 160 observes, the FASB “decided to require that net income and comprehensive income be attributed to the parent and the noncontrolling interest but not provide detailed guidance for making that attribution”.
Thus the board recognizes the possibility that certain acquired subsidiary assets may not benefit the parent and noncontrolling interest in a manner proportional to their interests. Nonetheless, we expect that such non-proportional benefits will be the exception rather than the rule.
Here we will assume in all cases that the relative ownership percentages of the parent and noncontrolling interest represent an appropriate basis for attributing all elements (including excess acquisition-date fair-value amortizations) of a subsidiary’s income across the ownership groups. Including the excess fair-value amortizations is based on the assumption that the noncontrolling interest represents equity in the subsidiary’s net assets as remeasured on the acquisition date.
To illustrate, again assume that Parker acquires 90 percent of Strong Company. Further assume that $30,000 of annual excess fair-value amortization results from increasing Strong’s acquisition-date book values to fair values.
If Strong reports revenues of $280,000 and expenses of $200,000 based on its internal book values, then the noncontrolling interest share of Strong’s income can be computed as follows:
As a procedural matter, the $5,000 noncontrolling interest in the subsidiary net income is then simply subtracted from the combined entity’s consolidated net income to derive the parent’s interest in consolidated net income. Note that the noncontrolling shareholders have a 10 percent interest in the subsidiary company, but no interest in the parent firm.
Revenue and Expense Reporting for Mid-Year Acquisitions:
In virtually all of our previous examples, the parent gains control of the subsidiary on the first day of the fiscal year. How is the consolidation process affected if an acquisition occurs on a mid-year (any other than the first day of the fiscal year) date?
When a company gains control at a mid-year date, a few obvious changes are needed. The new parent must compute the subsidiary’s book value as of that date to determine excess total fair value over book value allocations (e.g., intangibles). Excess amortization expenses as well as any equity accrual and dividend collections are recognized for a period of less than a year. Finally, because only income earned by the subsidiary after the acquisition date accrues to the new owners, it is appropriate to include only postacquisition revenues and expenses in consolidated totals.
Consolidating Postacquisition Subsidiary Revenue and Expenses:
Following a mid-year acquisition, a parent company excludes current year subsidiary revenue and expense amounts that have accrued prior to the acquisition date from its consolidated totals. For example, when Comcast acquired AT&T Broadband, its December 31 year-end income statement included AT&T Broadband revenues and expenses only subsequent to the acquisition date. Comcast reported $8.1 billion in revenues that year.
However, in a pro forma schedule, Comcast noted that had it included AT&T Broadband’s revenues from January 1, total revenue for the year would have been $16.8 billion. However, because the $8.7 billion additional revenue ($16.8 billion – $8.1 billion) was not earned by Comcast owners, Comcast excluded this preacquisition revenue from its consolidated total.
To further illustrate the complexities of accounting for a mid-year acquisition, assume that Tyler Company acquires 90 percent of Steven Company on July 1, 2009, for $900,000 and prepares the following fair-value allocation schedule:
The affiliates report the following 2009 income statement amounts from their own separate operations:
Assuming that all revenues and expenses occurred evenly throughout the year, the December 31, 2009, consolidated income statement appears as follows:
The consolidated income components are computed below:
i. Revenues = $600,000. Combined balances of $750,000 less $150,000 (½ of Steven’s revenues).
ii. Expenses = $425,000. Combined balances of $475,000 less $75,000 (½ of Steven’s expenses) plus $25,000 excess amortization ($200,000 ÷ 4 years × ½ year).
iii. Noncontrolling interest in Steven s income = $5,000. 10% × ($150,000 Steven’s income – $50,000 excess amortization) × ½ year.
In this example, preacquisition subsidiary revenue and expense accounts are simply eliminated from the consolidated totals. Note also that by excluding 100 percent of the preacquisition income accounts from consolidation, the noncontrolling interest is viewed as coming into being as of the parent’s acquisition date.
A mid-year acquisition requires additional adjustments when preparing consolidating worksheets. The balances the subsidiary submits for consolidation typically include results for its entire fiscal period. Thus, in the December 31 financial statements, the book value of the firm acquired on a mid-year date is reflected by a January 1 retained earnings balance plus revenues, expenses, and dividends paid from the beginning of the year to the acquisition date.
To effectively eliminate subsidiary book value as of the acquisition date, Consolidation Entry S includes these items in addition to the other usual elements of book value (i.e., stock accounts). To illustrate, assuming that both affiliates submit fiscal year financial statements for consolidation.
Tyler would make the following 2009 consolidation worksheet entry:
Consolidation Worksheet Entry S:
Through Entry S, preacquisition subsidiary revenues, expenses, and dividends are effectively:
i. Included as part of the subsidiary book value elimination in the year of acquisition.
ii. Included as components of the beginning value of the noncontrolling interest.
iii. Excluded from the consolidated income statement and statement of retained earnings.
Acquisition Following an Equity Method Investment:
In many cases, a parent company owns a noncontrolling equity interest in a firm prior to obtaining control. In such cases, as the preceding example demonstrates, the parent consolidates the postacquisition revenues and expenses of its new subsidiary. Because the parent owned an equity investment in the subsidiary prior to the control date, however, the parent reports on its income statement the “equity in earnings of the investee” that accrued up to the date control was obtained.
In this case, in the year of acquisition, the consolidated income statement reports both combined revenues and expenses (post-acquisition) of the subsidiary and equity method income (preacquisition).
In subsequent years, the need to separate pre- and postacquisition amounts is limited to ensuring that excess amortizations correctly reflect the mid-year acquisition date. Finally, if the parent employs the initial value method of accounting for the investment in subsidiary on its books, the conversion to the equity method must also reflect only postacquisition amounts.
SFAS 141 Purchase Method—Consolidated Financial Reporting with a Noncontrolling Interest:
SFAS 141R, “Business Combinations,” and SFAS 160, “Noncontrolling Interests in Consolidated Financial Statements,” represent a distinct departure from past consolidated reporting for subsidiary assets, liabilities, income, and noncontrolling interests. The new acquisition method, which focuses on acquisition-date fair values, replaces the previous purchase method and its emphasis on cost accumulation and allocation. However, the SFAS 141R and SFAS 160 provisions for 100 percent fair-value measurements for all acquisitions will be applied prospectively, leaving intact long-lasting financial statement effects from past applications of the purchase method to business combinations.
Under the purchase method, the parent recognized the fair values of acquired subsidiary assets and liabilities, but only to the extent of its percentage ownership interest. In the presence of a noncontrolling interest, subsidiary assets and liabilities were measured partially at fair value and partially at the subsidiary’s carryover (book) value. This dual valuation for subsidiary assets and liabilities was viewed as being consistent with the cost principle.
Because only the parent’s percentage was purchased in the combination, only that percentage was adjusted to fair value. Therefore, the valuation principle for the noncontrolling interest under the purchase method was simply its share of the subsidiary’s book value.
To illustrate the accounting for a business combination using the purchase method, assume that Ramsey Company purchased 80 percent of the outstanding shares of Santana Company for $1,435,000 cash on January 1, 2008. Exhibit 4.13 shows Santana’s acquisition date balance sheet and Ramsey’s cost allocation using the purchase method. Note that the parent allocates only its cost to the subsidiary’s assets based on their fair values.
Because the parent purchased only 80 percent of the subsidiary’s shares, only 80 percent of the subsidiary’s net assets are valued at the parent’s cost. The 20 percent held by the noncontrolling interest is not part of the exchange transaction, and therefore no new basis of accountability arises. Thus, 20 percent of the net assets remains at the subsidiary’s former book value (carryover basis), and 80 percent of the net assets is valued at cost to the parent.
For example, Santana’s land account will appear on Ramsey’s acquisition-date consolidated balance sheet at $603,000.
This amount can be computed in either of two mathematically equivalent ways as follows:
The subsidiary’s book value is consolidated in total whereas any cost in excess of book value is assumed to be a parent company expenditure appropriately allocated based on fair values. By comparison, the acquisition method recognizes 100 percent of the fair values of the subsidiary’s assets and liabilities regardless of the controlling interest’s ownership percentage. Thus the acquisition method would show a full $610,000 fair value for the land.
To complete the illustration of the purchase method, assume that Ramsey and Santana submit December 31, 2008, financial statements as shown in the first two columns of Exhibit 4.14. Ramsey then prepares the following worksheet entries.
Consolidation Entry S:
Consolidation Entry A:
Consolidation Entry I:
Consolidation Entry D:
Consolidation Entry E:
The noncontrolling interest in Santana balance totals $367,000 at the end of the year. This valuation represents 20 percent of the subsidiary’s year-end book value (common stock plus ending retained earnings) or 20% × ($1,000,000 + $835,000).
This $367,000 total can also be seen on the worksheet with supporting details as follows:
Note that the noncontrolling interest’s share of subsidiary income does not take into account any of the excess cost amortizations. This treatment is consistent with the noncontrolling interest valuation at subsidiary book value.
Criticisms of the Purchase Method in the Presence of a Noncontrolling Interest:
Several criticisms were leveled at past practice for consolidated financial reporting in the presence of a non-controlling interest.
These include:
i. Dual valuation of subsidiary balance sheet accounts.
ii. The “mezzanine” categorization of the noncontrolling interest in consolidated balance sheets.
iii. The valuation basis for the noncontrolling interest.
iv. Accounting for the parent’s transactions in the ownership shares of its subsidiary.
We briefly discuss each of these criticisms below:
As shown in the Ramsey and Santana example above, the purchase method employed a mixed-attribute model to consolidate subsidiary assets whenever a noncontrolling interest was present. By recognizing the fair value of subsidiary assets only to the extent of the parent’s ownership percentage, these assets were consolidated in part at fair value, and in part at the subsidiary’s book value.
Many considered this dual valuation in the presence of a noncontrolling interest as hindering the relevance of the resulting consolidated balances. Moreover, because book values tended to understate asset valuation, financial ratios such as return-on- assets were also overstated. The problem was compounded in step acquisitions when several purchase cost allocations were combined at various amounts through time.
Another criticism of past practice was the fact that most parent companies reported their noncontrolling interests between the liability and stockholder’s equity sections in an area referred to as the “mezzanine.”
SFAS 160 followed this recommendation and now requires that the noncontrolling interest be reported separately in the stockholders’ equity section of the consolidated balance sheet.
Under the purchase method, the noncontrolling interest was valued at its percentage of the subsidiary’s book value. To provide a consistent measurement attribute for the subsidiary, SFAS 141R now requires accounting for the noncontrolling interest at its acquisition-date fair value. Thus, the managers of the parent company are accountable for the entire fair values of their acquisitions.
Finally, past practice varied when the parent company sold or bought subsidiary shares while nonetheless maintaining control. In some cases, gains or losses were recognized on these transactions and in other cases they were treated as equity transactions. SFAS 160 now requires a consistent treatment for these economically similar events. Thus, all transactions by a parent in a subsidiary’s ownership shares will be accounted for as equity transactions, as long as the parent maintains control.