Citi’s Amazing Smith Barney Gain

Citi's recorded gain from the Morgan Stanley joint venture deal is more than double its cash outlay thanks to a new accounting rule.

Bob Willens 2

The Citigroup/Morgan Stanley “joint venture,” announced on January 13, will result in the combination of Citi’s Smith Barney unit with Morgan Stanley’s Global Wealth Management Group. Under the terms of the agreement, Citi will exchange 100 percent of Smith Barney for a 49 percent stake in the joint venture (of which Morgan Stanley will own the remaining 51 percent), and an upfront cash payment in the amount of $2.7 billion.

At the time of closing, Citi reported that it would recognize a pre-tax gain of approximately $9.5 billion, or about $5.8 billion on an after-tax basis. Moreover, some $6.5 billion of tangible common equity (and approximately $6.4 billion of Tier 1 capital) will be created in the transaction.

At first blush, it seems odd that such a large gain will be reported in light of the fact that the upfront cash payment is only a fraction of the gain amount? The answer appears to lie in the application of a new FASB pronouncement, FAS 160, Non-Controlling Interests in Consolidated Financial Statements.

FAS 160, issued in December, applies to entities, such as Citi, that “de-consolidate” a subsidiary. The new rule is effective for fiscal years, and interim periods within those fiscal years, which began on or after Dec. 15, 2008. FAS 160 amends portions of Accounting Research Bulletin 51, Consolidated Financial Statements, which says that a parent (Citi in this case) must de-consolidate a subsidiary as of the date on which the parent “ceases to have a controlling financial interest” in the subsidiary.

Citi will lose its controlling interest in Smith Barney when the joint venture deal closes. At that time, the rule will require that Citi to account for the de-consolidation of Smith Barney by recognizing a gain or loss in net income that is attributable to Citi. The gain or loss is measured as the difference between the aggregate of one of three items — (1) the fair value of any consideration received; (2) the fair value of any retained non-controlling investment in the former subsidiary at the date the subsidiary is de-consolidated; or (3) the carrying amount of any non-controlling interest in the former subsidiary at the date the subsidiary is de-consolidated – and the carrying amount of Smith Barney’s assets and liabilities.

Indeed, the principal reason why the pre-tax gain seems disproportionately large is because in calculating the gain, Citi is required to include in the “amount realized” the fair market value of its retained non-controlling investment in Smith Barney. That value can be extrapolated from the amount Morgan Stanley is “paying” in the transaction — for what amounts to a 51 percent stake in Smith Barney.

To be sure, Morgan Stanley is remitting, in addition to the $2.7 billion in cash, a 49 percent stake in its valuable Global Wealth Management business. The ability to include in the amount realized the fair value of the retained non-controlling investment was something that Financial Accounting Standards Board deliberated over for quite some time. At the end of the day, however, FASB chose to take this controversial step on the theory that “using the carrying amount (as opposed to the fair market value) would be inconsistent with the view that losing control of a subsidiary is a significant economic event that changes the nature of the investment.”

As a result, the gain that Citi will be reporting from the transaction can be attributed, in large part, to its ability to “remeasure” its retained stake in Smith Barney. It should be noted that the gain, which demonstrates the existence of appreciated asset value in excess of tax basis for Citi, will also have the effect of allowing Citi to contend that a valuation allowance is not necessary with respect to its deferred tax assets.

At last count, Citi’s deferred tax assets amounted to about $44 billion. Such appreciated asset value is considered “positive evidence,” for purposes of FAS No. 109, Accounting for Income Taxes, the presence of which can overcome “negative evidence” and in the process obviate the need for an earnings diminishing valuation allowance.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com

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