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— Industry Insight —
In an economic environment where many companies are buying and selling portions of businesses, the relatively new M&A standards -- known as FAS 141(R) related to business combinations and FAS 160, which applies to noncontrolling interests in consolidated financial statements -- will have an impact on how companies account for these types of transactions. At first glance, the fundamental concept of "control" that drives the accounting seems easy to understand. If a company gains control, the acquisition is a business combination. If a company loses control, it deconsolidates the subsidiary. If a company maintains control, the transaction is recorded in equity. However, several intricacies have arisen, demonstrating the challenges companies face when accounting for partial acquisitions and disposals. It may be helpful to provide a summary of how control impacts the accounting under the old and new guidance. The key determination -- as discussed in the following examples -- is whether there has been a change of control. Disposing of 60% of a business and losing control. The new M&A standards require a company to record a gain/loss on the 60% sold and revalue the remaining 40% to fair value (that is, recognize 100% of gain/loss). Under the old guidance, a company would have just recorded a gain/loss on the 60% sold.
p>Disposing of 40% of a business and maintaining control. The new M&A standards consider this an equity transaction with no gain or loss. Under the old guidance, the company would have recorded a gain or loss on the 40% sold.
Owning 25% and acquiring an additional 35% interest of a business and obtaining control. A more complicated scenario, the new M&A standards require a company to 1) fair value 100% of the assets/liabilities of the business and consolidate it; 2) record the 40% noncontrolling interest at fair value; and 3) record a gain/loss on revaluation of the pre-existing 25% investment to fair value. The old guidance would have required the company to 1) fair value the incremental 35% acquired and consolidate the business; 2) record the 40% minority interest at carryover basis; and 3) retain the original 25% interest at carryover basis. Owning 60% of a business and acquiring the remaining 40% interest. The new M&A standards treat this as an equity transaction with no step-up of basis. Under the old guidance, the company would have been required to fair value the additional 40% interest as a step acquisition. As demonstrated in these scenarios, a company that loses control of a business but retains an equity investment will now recognize 100% of the gain upon deconsolidation, while a company that disposes a partial interest but maintains control wouldn't even recognize a gain on the shares sold. A company that obtains control of one of its existing investments will generally recognize a gain, while a company that acquires an additional interest in an entity that it already controls will not. While the concept of control under the M&A standards may sound simple to apply, the accounting may conflict with other facets of the accounting literature. Let's explore a few of these conflicts. Real estate. Accounting for sales of real estate and potential gain recognition under the real estate industry guidance is complex. In some cases, recognition of a sale is precluded, and in others gain recognition may be reduced or deferred. If a company sells only a portion of a business that consists primarily of real estate and the criteria for both sale and gain recognition have been met, then the company could record a partial gain relating to the portion sold in accordance with the real estate industry accounting guidance. This treatment is unlike the all-or-nothing approach included in the M&A standards. Therefore, when a company sells a portion of a business that consists primarily of real estate, the question arises whether the company follows the industry guidance specific to real estate or the guidance included in the M&A standards. The Financial Accounting Standards Board has recently issued proposed guidance that a company should continue to apply the specific real estate industry accounting guidance to sales of interests that are, in substance, the sale of real estate and that the M&A standards do not apply to such transactions. The rationale is that the accounting guidance for real estate contains many nuances unique to these transactions. Therefore, companies should continue to apply the specific guidance that was intended to handle these types of transactions. Transfer of a business to an existing equity investment. A company may sell a business to an entity in which it has an existing equity method investment, causing the company to lose control in the former business. Following the old guidance, a company would generally recognize a gain only for the portion of the business that was effectively sold to a third party, unlike the all-or-nothing approach included in the M&A standards. So, again we are left with a conflict in the accounting literature. The FASB has recently proposed guidance that would apply the M&A standards to the sale of a business to an existing equity investee, resulting in 100% gain/loss on such transactions. Joint ventures. There is also a conflict between joint venture accounting guidance and the M&A standards. Historically, a company that contributed a business into a true JV would not recognize a gain. In certain circumstances, partial gain recognition was appropriate. In either case, it was not the all-or-nothing approach prescribed by the M&A standards. The FASB has recently proposed that when a company contributes a business to a JV and loses unilateral control over that business, the M&A standards should apply, similar to other transactions where there is a loss of control. Therefore, the company would recognize 100% of the gain. Valuation considerations may be more complex in these transactions, in light of the need to recognize pre-existing interests, retained interests and noncontrolling interests at fair value in many circumstances. In some cases, a company may need to apply the M&A standards even if there is no monetary consideration paid. For example, there may be a change of control because of a change in shareholder rights, such that one party obtains control over an entity that in the past it had not controlled. Under the M&A standards, the company that gains control would have a business combination and would need to fair value 100% of the assets, liabilities and noncontrolling interests and recognize a gain on its previously held equity interest without the benefit of any monetary consideration being exchanged. Even when there is monetary consideration, valuation complexities can arise. Consider a scenario where a company acquires a 60% interest of a business. Assume the company paid $60 million in cash for the 60% interest, from which one might infer that the fair value of the 40% is $40 million ([$60 million/60%] x 40%), right? Maybe not. For example, in an all-cash deal for a public company, the value of the purchase price for the 60% interest will be determined by market conditions at the date the buyer and seller agree to the deal price, while the value of the 40% will be determined as of the closing date. Market prices will likely change between the agreement date and closing date, so the 40% cannot simply be derived from the transaction price for the 60% interest. In other cases, there could be considerations of control premiums or minority discounts that impact the value of the 40%. It's wise to consult with a valuation expert in this highly judgmental area. At first glance, the accounting for partial acquisitions and disposals seems straight forward, but there are several complexities that make it difficult to implement in practice and explain in communications to shareholders. More of these complexities will surface in the future. Remember, when determining the appropriate accounting for partial acquisitions and disposals, it may not be so simple. Jay B. Seliber is a partner with PricewaterhouseCoopers and the business combinations implementation leader for the firm. Comments |
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