FASB Rule Spawns a Second Bottom Line

The new standard kicks minority-interest equity out of the mezzanine, changing what makes up net income.

Readers of financial statements will soon need to take a second look at corporate bottom lines to make sure the net income numbers they’re looking at are the right ones. The double-take will come courtesy the Financial Accounting Standards Board, which this week issued FAS 160, a new accounting rule concerning non-controlling interests, a.k.a minority interests.

The new rule, which is effective for fiscal years beginning after December 15, 2008, requires companies to record minority interests as stockholders’ equity, a change that will affect the balance sheet and income statement going forward. Currently, “a vast majority” of companies place minority interests in the mezzanine section of the balance sheet, that limbo between equity and liability, says Georgia Tech accounting professor Charles Mulford. “I think FASB hasn’t liked the mezzanine section for some time now,” he added.

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. For example, an ice cream producer may own 90 percent of a dairy farm, with the other 10 percent owned by a group of Wisconsin investors. Because current accounting rules are vague and there is little guidance available, the ice cream company has a choice of carrying the 10 percent claim in the equity, liabilities, or mezzanine section of its balance sheet.

Under FAS 160, however, the 10 percent must be booked as equity. If that’s a departure from current practice, a company will get an immediate bump in equity, making measures of leverage look better. In other words, the increase in equity will make the balance sheet appear lighter. “It will look like companies can afford more debt because they have more equity and therefore more net worth,” asserted Mulford.

What’s more, if companies are close to violating debt-to-equity ratios in loan covenants because their balance sheet is overleveraged, an equity boost from FAS 160 may help if the loan agreement does not require the company to remove minority interest equity before calculating the ratio.

The income statement will go through changes too, however, and could wind up with an additional bottom line. 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. Essentially, the minority interest income is treated like an expense against the parent company earnings.

Consider a scenario in which the ice cream company records $50 million in earnings, while the dairy subsidiary records $1 million in earnings. Under today’s rules, the ice cream company books $51 million in earnings, and subtracts from that total 10 percent of the dairy’s earnings, or $100,000. The parent’s consolidated net income is $50.9 million.

Under FAS 160, however, parent companies are not required to subtract minority-interest equity from earnings, which means the ice cream company’s consolidated net income would be recorded at $51 million. However, the parent must include a disclosure identifying what portion of income is attributable to the parent and the subsidiary. Mulford figures most companies will add a footnote to meet that requirement.

The practical effect of FAS 160 on the income statement, according to Mulford, is that calculations that use net income will have to be tweaked. “If you have EBITDA and want to add back depreciation, you will have to make it clear that you want to use the parent’s share of net income in the calculation,” Mulford surmised, referring to earnings before interest, taxes, depreciation, and amortization.

Furthermore, most software packages that analyze corporate financials will have to be reworked to calculate the correct net income number. Right now, most software “pretty much punts when it comes to minority interest,” he says, explaining that when it comes to calculating debt-to-equity ratios, “minority interest usually doesn’t turn up as either.”

However, the professor noted, the computer tagging-language known as XBRL (extensible business reporting language), that the Securities and Exchange Commission is pushing, will be unaffected by the FAS 160 changes. XBRL, said Mulford, uses a chart of accounts in its taxonomy, which records line-by-line information. So it will pick up the minority-interest line where ever it appears.

This isn’t the first time FASB has moved to eliminate the mezzanine section of financials. The group issued FAS 150 last year to change the way companies record mandatorily redeemable preferred stock, which has the characteristics of both assets and liabilities. FASB voted to require companies to book the instrument as a liability.

For FASB’s part, FAS 160 is just one more step in its hunt for greater transparency and more simplicity in financial reporting. “This statement improves comparability by eliminating that diversity,” noted FASB’s summary of the rule.

Indeed, it does that by installing a single method of accounting for minority interests, especially when there is a change in a parent’s ownership stake in the subsidiary. According to FASB, whether the parent increases or decreases its investment in the subsidiary, the result is an equity transaction as long as the parent retains a controlling financial interest in the subsidiary.

That’s a departure from current practice. For example, under current practice, decreases in the parent’s ownership stake could be booked as either an equity transaction, or a transaction with gain or loss to income. “Net income will change for everyone,” when FAS 160 goes into effect, posited Mulford. “It will just take time to settle what net income means.”

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