Advice for Reporting Non-Controlling Interests

As first-quarter earnings reports begin hitting the market, companies with minority interests in subsidiary operations will have some explaining to do when it comes to the balance sheet and the income statement.

Those earnings reports will reflect a new way of accounting for the financial results of subsidiaries where the parent company doesn’t have complete or even majority control—and some are concerned it may confuse the casual reader of financial statements.

The bite comes from Financial Accounting Standard No. 160, Noncontrolling Interests in Consolidated Financial Statements. FAS 160 was adopted in December 2007 along with FAS 141R, Business Combinations, to become effective for calendar-year companies with the beginning of the 2009 reporting year.

When the two standards were adopted, FAS 141R stole the limelight with a number of differences in how to account for business mergers, most notably its new uses of fair value and its requirement to expense (rather than capitalize) the up-front costs associated with mergers and acquisitions. FAS 160, however, ushered in new thinking about how the financial results of subsidiaries should be reflected in the parent company’s financial statements when the parent company holds a minority, or “non-controlling,” interest.

Wright

FAS 160 calls for a new presentation in both the balance sheet and the income statement, says Chris Wright, managing director at the consulting firm Protiviti. In the income statement, companies must reflect results from non-controlling interests using gross rather than net figures in the profit-and-loss calculations; the net figures are moved to footnotes. “The analyst community needs to retool a little what they do to remember to look in the footnote,” Wright says.

As for the balance sheet, FAS 160 moves equity related to non-controlling interests from the “mezzanine” section between equity and liability and places it entirely into equity, Wright says. The changes will be significant for companies that have significant ownership in subsidiary operations.

Formica

John Formica, a partner with PricewaterhouseCoopers, says the new approach under FAS 160 employs a different premise for reporting consolidated financial results. While consolidated financial statements have always been prepared for the parent company shareholders, FAS 160 views all shareholders—even those with a minority stake in a partially owned subsidiary—as equity holders in the consolidated financial statements of the parent company.

“For the most part, there’s a lot of repackaging going on. The same information will be there as before.”

— Jeff Ellis,

Managing Director,

Huron Consulting Group

As such, balance sheets and income statements generally will look healthier for companies with the implementation of FAS 160, Formica says. “You're saying those shareholders are part of this consolidated economic entity, and therefore should be part of equity, so the balance sheet will look better by having less leverage,” he says.

Similarly, FAS 160 holds that the income statement should reflect the results of operations relevant to all shareholders. That means net income will include earnings attributable to both the parent company and the minority shareholders, Formica adds.

A study by the Georgia Tech Financial Analysis Lab looked at the likely effect of implementing FAS 160 and found that on average shareholder equity will increase by 2 percent, liabilities will decline by 2 percent, and income from continuing operations will increase by 3 percent. At the extreme, a small number of companies will see increases in equity of more than 25 percent and declines in liability of more than 20 percent, according to the analysis. The income swing for those outlier companies could be as big as 25 percent, Georgia Tech says.

Living With FAS 160

Soranno

Charles Soranno, also a managing director for Protiviti, says companies and analysts need to take the equity move into account when considering leverage ratios and debt covenants. Previously, accounting executives and analysts could treat it as debt or equity as they deemed appropriate. By moving equity related to non-controlling interests fully into the parent company’s equity, “it will appear to give companies a lighter balance sheet, and it will artificially improve equity-to-debt ratios,” Soranno says. “Financial analytical models will need to change to make sure they account for that.”

GEORGIA TECH FINDINGS

The following study from Georgia Tech shows how FAS 160 and FAS 141R impact companies and shareholders:

The recently enacted FASB Statements 160 and 141(R) bring changes to accounting for

non-controlling interests (formerly known as minority interests) for companies with fiscal years beginning after December 15, 2008. In particular, SFAS No. 160 will change the presentation of minority interests on the financial statements. The minority interests in shareholders' equity will be required to be reported as a component of total shareholders’ equity. In addition, consolidated net income as presented on the income statement will include minority interests in income. For clarity, companies are instructed in both cases to break out the portions of equity or income attributed to the minority interest, but the “bottom line number” will change with the enactment of these statements.

Some of the accounting changes included in these statements may appear to be cosmetic rather than substantial. For example, non-controlling interest in equity will now be included as a part of total shareholders' equity instead of appearing in the mezzanine

section of the balance sheet. Also, consolidated net income will include the minority

interest in income on the face of the income statement instead of showing it as an expense

in arriving at net income. However, these changes will require financial statement users

to be more aware of the elements that make up total shareholders' equity and bottom line

net income. In addition, creditors will want to reexamine some financial ratios that may

be a part of debt covenants such as leverage and times interest earned.

This study examines four ways in which SFAS No. 160 will affect financial analysis.

The first two calculations give an idea of the size of minority interest on the balance sheet

and on the income statement: (1) the change in total shareholders' equity due to the

inclusion of minority interest in equity and (2) the size of minority interest in income as a

percentage of total income from continuing operations. The last two calculations

examine changes to ratios that are likely to appear in debt covenants: (1) the percent

change in the leverage ratio of total liabilities to total shareholders' equity and (2) the

percent change in debt coverage measured by the times interest earned ratio.

This report examines the consequences of these changes for companies reporting minority

interests. In particular, we find that (1) shareholders’ equity will increase by 2 percent, though 10 percent of the companies will see increases of over 25 percent; (2) income from continuing operations will increase by 3 percent, though 12 percent of the companies will see increases of over 25 percent; (3) liabilities to shareholders’ equity will decline by 2 percent, though 10 percent of the companies will see declines of over 20 percent; and (4) times interest earned will increase by 1 percent, though 9 percent of the companies will see increases of over 10 percent. Investors, analysts and other users of financial statements will want to be prepared to take these upcoming accounting changes into account.

Source

Georgia Tech Study on FAS 160 (April 2008).

The change in presentation also means that first-quarter net income figures for 2009 don’t directly correlate to 2008 first-quarter numbers for companies reporting non-controlling interests, Formica says. To address that, FAS 160 requires companies to present changes in the financial statements retrospectively for all periods presented, he notes.

The good news: The earnings-per-share calculation is not affected by FAS 160. EPS calculations will be based on net income attributable to the parent company shareholders, Formica says. “So when you see the EPS, the calculation will be very comparable to what it was previous to FAS 160.”

Ellis

Jeff Ellis, managing director at Huron Consulting Group, says FAS 160 also changes how the parent company must treat any losses suffered by subsidiaries. Before FAS 160, the parent would allocate losses between the parent company and the minority interest, he explains. If the losses exceeded the balance in minority interest, the parent would stop allocating losses at zero.

But FAS 160 “says you can end up with a debit balance in a non-controlling interest account,” he says. “It's an equity account. If there are losses, the parent will end up absorbing those losses.”

Robertson

Donald Robertson, a senior accounting analyst at Moody’s Investors Service, says he sees the change as a difference in presentation. “There's no cash outflow or inflow derived from this, so it shouldn’t impact the results of our analysis,” he says. “Typically the earnings measures we use exclude minority interest, and those measures would not change under the new rule.”

As companies begin rolling out their first-quarter results, Steve Quinlivan, an M&A lawyer with the law firm Leonard, Street and Deinard, says financial reporting executives must call attention to the new treatment of non-controlling interest under FAS 160—but do so carefully.

Old accounting is no longer considered U.S. Generally Accepted Accounting Principles, so companies have to be cautious about non-GAAP disclosures under Regulation G as they file their 10-Q quarterly reports, he says.

“The numbers in the 10-Q are not going to be comparable if you’re looking at a report from a prior year,” he says. “This is where the CFO, the CEO and the investor relations staff have to put a premium on getting it right in the earnings announcement.”

Ellis says he doesn’t expect the change to be difficult to comprehend. “For the most part, there’s a lot of repackaging going on,” he says. “The same information will be there as before.”