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New Proposals Planned for Business
Combinations, Consolidations, and
Stock Compensation Plans
Paul Munter
ased on the Financial Accounting Standard Board’s (FASB’s) current plan,
1999 could shape up to be a very active year. The FASB currently has the
following technical projects on its active agenda: (1) business combinations, (2)
consolidations, (3) financial instruments, (4) impairment issues, (5) obligations
associated with retirement of long-lived assets, (6) not-for-profit issues, (7)
present-value-based measures, and (8) stock compensation issues. We will briefly
look at the status of each of these projects and the FASB’s current plans.
Paul Munter, Ph.D., CPA, is
KPMG Peat Marwick Professor of
Accounting at the University of
Miami. He is editor-in-chief of The
Journal of Corporate Accounting
& Finance.
The issue of business combinations has received and continues to receive a
significant amount of attention from standard setters and regulators around the
world. Indeed, the FASB added this project to its agenda largely at the urging of
the Securities and Exchange Commission (SEC). The concerns of the SEC and
others are really two-fold.
The first concern is that under the current rules for business combinations
(found, primarily in Accounting Principles Board APB Opinion No. 16, Business
Combinations), determination of whether a combination should be treated as a
pooling-of-interests or a purchase can be a difficult decision (since 12 criteria
specified in APB Opinion No. 16 must be met for the combination to be treated
as a pooling-of-interests). The result of this is that a significant amount of both
regulators’ and standard setters’ time is spent on business combinations issues.
For example, it has been estimated that more than 50 percent of the SEC staff’s
time is spent on business combinations issues. Additionally, a significant number
of the issues which the Emerging Issues Task Force (EITF) has addressed in recent
years have focused on business combinations issues.
In addition to the time spent enforcing the current rules, the second major
concern is that the U.S. standards on business combinations are out of step with
the rest of the world. For the most part, business combinations very rarely receive
CCC 1044-8136/99/1003159-06
© 1999 John Wiley & Sons, Inc.
Paul Munter
pooling treatment outside of the United States. Conversely, however, a substantial
number of recent combinations have been accounted for as poolings under the
U.S. literature.
In light of these problems, the FASB has been actively working on the
question of business combinations. To date, the FASB has issued a Special Report
to outline the issues (in 1997). Additionally, the FASB, in concert with G4+1 (the
coalition of standard setters from the U.S. (FASB), U.K., Australia, Canada, and
New Zealand, plus the International Accounting Standards Committee), the
FASB is currently preparing to release an Issues Paper that will serve as the
Invitation to Comment on the project.
In addition to the release of the Issues Paper in the very near future, the FASB
is actively carrying out its deliberations on the project. The FASB now plans to
release an exposure draft of a proposed standard on business combinations
sometime near the middle of 1999. Since deliberations are ongoing, it is difficult
to speculate as to timing of implementation and transition issues. However,
based on the FASB’s early conclusions about key aspects of the project, it appears
very likely that the FASB’s final standard will closely mirror standards in the
international community. This would mean a severe restriction on the use of
pooling-of-interests is the likely result.
Obviously, then, companies that are active in mergers and acquisitions will
need to closely monitor the timing of this project, since it will very likely create
a substantial change to the accounting landscape for business combinations.
As you may recall, in October 1995 the FASB issued an exposure draft that
addressed consolidation policies and procedures. That exposure draft proposed
sweeping changes to both consolidation policies and consolidation procedures.
As you know, the issue of consolidation policies addresses the question of which
investees should be consolidated, while the issue of consolidation procedures
addresses the question of how the consolidation process should be done.
The FASB’s exposure draft met with significant resistance from accounting
professionals—particularly those in industry who would be most affected by the
proposal. In response to the comment letters and other feedback, the FASB has
been redeliberating this topic. However, in its current deliberations, it is only
focusing on consolidation policies. Thus, for the moment, the FASB would leave
the process of consolidation unchanged from current practice.
In examining the question of consolidation policies, the FASB is focusing on
the question of control. In short, the FASB ultimately would like to issue a
standard that requires an entity to consolidate another investee when control is
achieved—whether or not control is obtained through ownership or other
means. While this might seem to be a radical concept, in fact, it can be argued that
this concept is consistent with the approach discussed in Accounting Research
Bulletin (ARB) No. 51, Consolidated Financial Statements. Regarding
consolidation policy, paragraph 1 of ARB No. 51 states that:
There is a presumption that consolidated statements are more meaningful
than separate statements and that they are usually necessary for a fair
presentation when one of the companies in the group directly or indirectly
has a controlling financial interest in the other companies (emphasis added).
The Journal of Corporate Accounting and Finance/Spring 1999
Paragraph 2 of ARB No. 51 (as amended by FAS No. 94, Consolidation of All
Majority-Owned Subsidiaries) noted that:
The usual condition for a controlling financial interest is ownership of
a majority voting interest, and, therefore, as a general rule ownership by
one company, directly or indirectly, of over fifty percent of the
outstanding voting shares of another company is a condition pointing
toward consolidation.
Importantly, ARB No. 51 does not say that majority ownership is the only
way to achieve controlling interest in another entity. However, prevailing
practice has been to use the ownership test as the basis for determining whether
or not an investee should be consolidated. The FASB’s current deliberations are
once again examining the issue of control. The FASB’s current working definition
of control is:
the ability to direct the ongoing policies and management that guide the
activities of another entity so as to increase the benefits or limit the losses
from directing those activities. The ability to increase benefits or limit
losses could be derived through ownership of an equity interest, initiating
actions that result in more effective use of the assets, or other indirect
benefits such as revenue enhancements or cost savings through synergies.
It is important to note that this definition of control is not tied to an
ownership model. As can be seen, ownership is one way to achieve control, but
not the only way that control can be achieved.
The FASB is currently hoping to issue an exposure draft addressing
consolidation policies in the first quarter of 1999. That exposure draft, if issued
as currently envisioned by the Board, would require entities to consolidate all
investees when control is present (whether or not a majority ownership interest
is present). Examples of investees that might be affected—causing investors to
change the accounting from the equity method to consolidation—include a sole
general partner’s interest in a limited partnership, holding a large minority
interest while the remainder of the shares are widely held, or holding a majority
position on the board of directors (even though the entity does not have a
majority equity interest in the investee). As can be seen, the project has the
potential to significantly affect the financial reporting practices of many entities—
whether publicly-held or private, whether for-profit or not-for-profit. As a
consequence, practitioners will need to be alert as the FASB moves forward on
this project.
The FASB leapt over a major hurdle when it issued FAS No. 133, Accounting
for Derivative Instruments and Hedging Activities, in June 1998. This document
had consumed a significant amount of the FASB’s time and resources over the
past decade and had been the primary focus of its deliberations on financial
instruments. With the completion of that project, the FASB has now begun
examining other aspects of financial instruments. In particular, two projects
under the financial instruments umbrella bear some consideration.
The Journal of Corporate Accounting and Finance/Spring 1999
Paul Munter
The first of these projects is called liabilities and equity. Since this project is
primarily a classification project, it has received relatively little attention. However,
for many entities, it has the potential to alter the reported classification of certain
financial instruments in corporate balance sheets. In essence, this project is asking
whether certain financial instruments should be classified as exclusively debt,
exclusively equity, or some of each. For example, the issuer of a convertible bond
currently reflects the entire amount as a liability in its balance sheet, rather than
attaching a separate value to the conversion feature and classifying that component
in equity. Conversely, there is diversity in practice as to the classification of preferred
stock that has a redemption feature. Some argue that the redemption feature makes
the preferred stock the equivalent to a debt instrument and should be included in the
liabilities section of the balance sheet. Indeed, in the absence of specific guidance
about some of these issues, companies have resorted to the use of “mezzanine”
capital or “temporary” equity classifications.
In this project, the FASB hopes to clarify the classification of these and other
instruments. Furthermore, it seem quite likely that the FASB will declare (quite
appropriately) that mezzanine capital or temporary equity are not appropriate
balance sheet headings. Ultimately, a balance sheet should have three major
categories: assets, liabilities, and equity. The timing of an exposure draft is
unclear at the present time; however, it is possible that we could see some more
definitive guidance from the FASB as we near the midpoint of this year.
The other major aspect of the financial instruments project is called measuring
at fair value. The question you might ask is: measuring what at fair value? The
ominous answer is: all financial instruments. Paragraph 3 of FAS No. 133 states
that fair value is the most relevant measure for financial instruments. Indeed,
FAS No. 133 states that it is the intention of the FASB to mandate that all financial
instruments (whether assets or liabilities) be measured at fair value (that is,
marked-to-market) once the FASB can resolve the conceptual and practical
issues associated with this approach.
Financial institutions, insurance companies, and similar entities have long
argued that such an approach is warranted because they try to match or balance their
financial assets and their financial liabilities. Under current accounting, many
financial assets (e.g., marketable securities and investments in debt instruments in
accordance with FAS No. 115, Accounting for Certain Investments in Debt and Equity
Securities) are marked-to-market, while the corresponding liabilities are not. Thus,
financial services entities have argued that there is a mismatch between the accounting
and the risk management strategies employed by the companies.
While the concept of marking all financial instruments to market may have
intuitive appeal for financial services companies, it is less enthusiastically endorsed
by commercial entities. For commercial entities, those financial liabilities are
supporting nonfinancial assets (e.g., inventories, depreciable assets, and so on).
As such, that same intuitive appeal that seems logical for financial services
entities lacks much of its appeal for commercial enterprises.
Nonetheless, the FASB has stated its intention to move to a mark-to-market
approach for all financial instruments at some point in the future. Presently, an
exact timetable has not been established by the FASB; however, this is a project
that could affect any company that is preparing financial statements based on
generally accepted accounting principles (GAAP). As a consequence, work on
this project should be closely monitored.
The Journal of Corporate Accounting and Finance/Spring 1999
As you know, the primary standard for determining whether a long-lived asset
is impaired is established in FAS No. 121, Accounting for the Impairment of LongLived Assets and for Long-Lived Assets to Be Disposed Of. However, other guidance
may be applicable to related issues such as discontinued operations or restructurings.
As we have discussed previously, there are several problems with the existing
literature including: (1) inconsistencies among the standards and (2) matters not
adequately addressed in the literature (such as the criteria that must exist before
long-lived assets can be evaluated for impairment as assets held for disposal).
Given these problems, as well as the scrutiny that the SEC is giving to these
items, it is not surprising that the FASB is attempting to move quickly on this
project. As a consequence, the FASB currently expects to have an exposure draft
available for public comment near the end of the first quarter of 1999.
This project has been on the FASB’s agenda for several years. Indeed,
originally, this project was to examine the accounting for the costs of
decommissioning nuclear power plants. Obviously, the scope of the project has
been broadened significantly since that time. In February 1996, the FASB issued
an exposure draft on this project that would have required the accrual of a
liability (with a resulting increase to the asset that would then be included in
subsequent depreciation computations) when a constructive liability existed for
the cost to retire long-lived assets.
Subsequent to the issuance of that exposure draft, there have been additional
questions about the definition of a constructive liability, as well as what costs
should be included in the liability. As a result, the FASB is currently working on
a revision to that previous exposure draft. Currently, it is uncertain when the
revised exposure draft will be released. However, it seems likely that the proposal
will be forthcoming as we near the midpoint of this year.
As we reported to you last year, the FASB issued an exposure draft on this subject.
The key question is, under what circumstances are not-for-profit organizations
deemed to be intermediaries when they receive funds that will be transferred to other
not-for-profit entities. This is a key determination because, in accordance with FAS
No. 116, Accounting for Contributions Received and Contributions Made, if the entity
is acting as an intermediary, the contribution is not reflected in that entity’s financial
statements. Conversely, if the entity is not deemed to be an intermediary, then it
must reflect the contribution as revenue and report the subsequent expense. Thus,
this determination can significantly affect the reported financial performance of a
not-for-profit entity that receives a significant amount of funds that will be disbursed
to other entities. At the current time, it seems likely that the FASB will finalize its
proposal in the near future.
We have reported on this project previously. As you know, the FASB issued
an exposure draft of a proposed Concepts Statement last year. In substance, the
The Journal of Corporate Accounting and Finance/Spring 1999
Paul Munter
FASB is proposing that in making many present-value-based measures, entities
should use probabilistic estimates of future cash flows, rather than using point
estimates as is currently done. While this topic may seem insignificant, there is
the potential for the FASB to alter other existing standards based on its conclusions
in this Concepts project.
We will be reporting to you shortly on the FASB’s exposure draft on stock
compensation issues that is expected to be released very soon. This project is not
a reexamination of the issues that led to the issuance of FAS No. 123, Accounting
for Stock-Based Compensation, in October 1995. Rather, at the time FAS No. 123
was issued, there were questions about certain practices in the context of APB
Opinion No. 25, Accounting for Stock Issued to Employees. The FASB did not
previously address these issues because it was the Board’s intention to supersede
APB Opinion No. 25.
As you know, the FASB’s proposal was highly controversial and the Board
concluded that, in light of that controversy, it was not politically feasible for it to
mandate the fair value method accounting that FAS No. 123 discusses. Rather,
the FASB recommends this accounting but allows entities to continue to use APB
Opinion No. 25—an approach almost universally adopted in practice.
As a result, the previous problems with the application of APB Opinion No.
25 still exist and must now be addressed by the FASB. There are several issues to
be addressed, but the most significant are:
Who is an employee?—this is important because under FAS No. 123,
only for grants to employees can companies use APB Opinion No. 25
accounting. For grants to nonemployees, companies must use the fair
value model of FAS No. 123 and reflect the value of those grants in
Accounting for plan modifications or plan cancellation and reissuances—
the issue here is at what point do such actions convert a fixed APB
Opinion No. 25 plan into a variable APB Opinion No. 25 plan. This is
important because variable plans generally result in compensation
under APB Opinion No. 25, while most fixed plans do not.
Accounting for employee stock purchase plans that contain a look-back
feature—the issue is whether the look-back feature converts a fixed
employee stock purchase plan (thus being noncompensatory) into a
variable plan (thus being compensatory).
As we noted, it appears likely that the FASB will be issuing an exposure draft
on many of these issues very soon. We will, of course, be updating you on each
of these projects as the FASB moves forward in its deliberations. ♦
The Journal of Corporate Accounting and Finance/Spring 1999
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