As companies move to boost liquidity by selling off assets, some executives will be surprised to find that the transactions may be subject to a new merger rule. The reason: The relatively new accounting rule known as FAS 141(R) expands the definition of a business.
As a result, more asset sales will be considered a sale of a business for accounting purposes, and therefore will require an allocation of goodwill to the business sold, affecting the gain or loss on the sale. Goodwill is an intangible asset that represents the premium over book value that a buyer pays for a target company.
For example, all things being equal, if an asset group is carried on a company’s books at $600,000, and is then sold for $1 million, the company would record a pretax gain of $400,000. However, if the same assets now constitute a business under the new definition, their sell-off would require an allocation of goodwill to be added to their carrying value. Say that that the goodwill allocated is $100,000. Then the pretax gain on the sale would be reduced to $300,000. Further, the sell-off of assets may require a company to test its remaining goodwill for impairment.
What’s more, in certain situations, “there can be an significant amount of judgment” required by management and auditors to determine what is — and is not — a business for accounting purposes, says John Formica, a partner in the national technical office of PricewaterhouseCoopers.
Another area to watch, notes Formica, is how the income statement is affected by reductions in valuation allowances linked to deferred tax assets, as well as adjustments to tax reserves. Deferred tax assets stem from future tax deductions, like net operating losses. If a corporation with losses is uncertain about its ability to generate future taxable income, it is required to establish a valuation allowance, which is a current charge for a possible future tax benefit.
With regard to FAS 141(R), companies can take up to one year to make the final accounting adjustments for the transaction. Under the new rule, adjustments made outside of the one-year measurement period flow through the income statement and into earnings. That’s a departure from the old rules in that adjustments made to tax reserves and reductions in value allowances from acquisitions were generally recorded as a change to goodwill on the balance sheet, regardless if the adjustment was made outside of the one-year period.
This is the only provision within FAS 141(R) that applies to old deals, according to Formica. All other provisions relate to deals that close after Jan. 1, 2009.
The expanded definition of a business in FAS 141(R) may also increase the number of reporting units that are tested for goodwill impairment. Consider this, for example: When a company closes an acquisition, it must allocate goodwill to its reporting units — goodwill that is a segment or one level below, known as a component, says a PwC advisory. A component is considered a reporting unit if, among other things, it meets the definition of a business. The new broadened definition of a business may have the affect of classifying more components as reporting units to which goodwill must be ascribed and tested.
Indeed, during the first quarter of 2009, if a company has a change in its reporting units based on the new standard, it must reallocate goodwill to the new reporting units. To do that, a company must first figure out if any of the newly-defined components should be aggregated with existing units — because they handle similar products or customers — or should stand on their own. Once the reporting units are established, then goodwill must be reallocated, an activity that also will trigger a goodwill impairment test. Without a triggering event, goodwill is tested annually. But the good news about this change is that it will likely be less prevalent than some of the other provisions of the new standard, reckons Formica.
Companies that sell off assets also may find that another merger-related rule, FAS 160, applies to their transaction. FAS 160 is the rule that deals with minority interests, and changes the way the financial results of partially owned subsidiaries are consolidated by the parent company. That change will force affected companies to make adjustments to their balance sheets, as well as to their income statements, including net income.
Traditionally, minority interests were consolidated on the financial statements of the parent company in a section between liabilities and equity called the mezzanine. FAS 160, however, requires parent companies to consolidate minority interests in the stockholder’s equity section of financial statements.
That adjustment affects the balance sheet by increasing equity, which may make it look like a company can take on more debt. This, in turn, could affect debt-to-equity ratios and lender covenants. Further, the new reporting of minority interests will also change net income. If the subsidiary is profitable, net income will increase; if the subsidiary records a loss, that too will show up in the determination of net income.
The financial-statement effects of FAS 160 were examined in a study done last April by Georgia Tech’s Financial Analysis Lab. The study examines the financial statements of 876 public companies, 506 of them listed on the New York Stock Exchange. The authors, Charles Mulford and Erin Quinn, found that if FAS 160 had been in effect in 2006 and 2007, equity for the study group would have increased 2 percent on average, though 10 percent of the companies would have seen an increase of more than 25 percent. Income from continuing operations would have been increased by 3 percent overall, with 12 percent of the companies experiencing, again, more than a 25 percent increase.
The industry most affected by the inclusion of minority interest in equity is the financial-services sector: Of the 228 companies in that sector, 35 reported an increase of more than 25 percent. The energy sector was the next-most affected, with 18 of the 68 companies covered registering a bump of more than 25 percent.
Interestingly, FAS 160 does not require companies to change the way they calculate earnings-per-share. The reasoning, says Formica, is to keep historical EPS assessments an “apples-to-apples comparison.”
Nevertheless, Formica points out that in addition to balance sheets and net income changes, FAS 160 could affect contracts that a company may have based on EBITDA (earnings before interest, tax, depreciation and amortization) or equity, “which, for example, may require a company to modify its debt covenants,” says Formica.