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New accounting rules for minority interests will boost shareholder equity and lower leverage ratios at most companies.
Marie Leone, CFO.com | US
April 18, 2008
New rules that change the way companies account for minority interests in their financial statements will have a small — yet measurable — effect on reported income and debt ratios, says a new study. And some industries and individual companies will see significant changes, according to the report, issued by Georgia Tech's Financial Analysis Lab.
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.
The new rules — FAS 160 (Noncontrolling Interests in Consolidated Financial Statements) and FAS 141(R) (Business Combinations) — go into effect for fiscal years beginning after December 15, 2008. FAS 160 will require companies that currently record minority interests in the mezzanine section of the balance sheet (sort of limbo between liabilities and equity) to record them as stockholders' equity instead. Meanwhile, FAS 141(R) will require minority interests to be measured at fair value on the date of acquisition, instead of being carried at historical cost on the books of the buyer.
The practical effect of the fair-value change, according to study authors Charles Mulford and Erin Quinn, is that for most acquisitions, minority interest in equity will be represented by a larger value. In turn, that bumped-up value will drive up shareholders' equity. The report does not calculate the fair-value effect because the researchers used reported minority interest values from 2006 and 2007, and did not have the data necessary to revalue them at fair value.
However, the researchers did record the effects of FAS 160. Indeed, Mulford explains that by moving minority interests out of the mezzanine section, a company will get an immediate hike in equity, making measures of leverage look better. In other words, the increase in equity will make the balance sheet appear lighter — as if the company can afford to take on more debt because it has more equity and therefore more net worth, says the accounting professor.
The study examines the financial statements of 876 public companies, 506 of them listed on the New York Stock Exchange. The authors underscore four major findings, two related to the size of minority interest on the balance sheet and income statement, and the other two focused on changes to ratios that are likely to appear in debt covenants.
If FAS 160 had been in effect, shareholders' equity for the 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 shareholders' 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.
For a company like Owens-Illinois, the change in shareholders' equity would have been significant under FAS 160. If minority interest were included in equity instead of relegated to the mezzanine section Owens-Illinois would have seen a 58 percent increase in total shareholders' equity for 2006, on $207 million in minority interest and $357 million in shareholders' equity.
Coca-Cola Bottling is another company that saw a big swing once FAS 160 was applied to its 2006 financial statements. Minority interest was reported in the mezzanine section of the balance sheet as $46 million, with shareholders' equity of $94 million. By adding the two lines, the adjusted shareholders' equity would have shot up to $140 million — a 29 percent increase.
Regarding the leverage calculations, the study reveals that the liabilities to shareholders' equity ratio would have declined by 2 percent on average, with 10 percent of the companies noting a fall of more than 20 percent. Meanwhile, the interest coverage ratio would have inched up by 1 percent on average, with 9 percent of the companies experiencing a bump of more than 10 percent. The interest coverage ratio measures a company's ability to meet its debt obligations.
For companies that are close to violating debt-to-equity ratios in loan covenants because their balance sheet is overleveraged, such a boost to equity could help if the loan agreement does not require the company to remove minority interest equity before calculating the ratio.
The study points to W.R. Grace & Co., as an example of a company whose ratio jumped drastically. W.R. Grace reported $18.3 million of income in 2006 and a minority interest in consolidated entities of $34.4 million. Under the new disclosures, net income would have increased to $52.7 million, with the $34.4 million attributed to the minority interest (65 percent of total income) and the $18.3 million attributed to the parent company (35 percent of total income).
It's likely that creditors will be tracking the effects and required disclosures of FAS 160 as well, because the change will produce an artificial decline in leverage measures for most companies, says the study. For example, Inter Parfums Inc. would experience a 22 percent decrease in leverage as measured by total liabilities to total shareholder equity if minority interest were included in its 2006 financial statements. Total liabilities for that year were reported as $134 million, and total shareholders' equity was $155 million, with minority interest recorded in the mezzanine section as $44 million. Under FAS 160, however, leverage would decrease from 0.86 to 0.67.
Similarly, for 2006, Trump Entertainment Resorts reported $1.7 billion in long-term liabilities, shareholders' equity of $413 million, and minority interest in the mezzanine sector of $125 million, producing a ratio of total liabilities to total shareholders' equity of 4.17. Once FAS 160 is applied, however, the ratio drops by 23 percent.
Companies that stand out from the sample with respect to percentage change in interest coverage ratio include Loral Space & Communications and Goodyear Tire & Rubber Co. Loral's earnings before interest, taxes, depreciation, and amortization were $94 million for 2006, with interest expense of $26 million, giving it a ratio of 3.57. If the minority interest of $25 million were included in the EBITDA calculation, the coverage ratio would increase by 26 percent, to 4.50.
Looking at Goodyear's financial statements for 2006, its interest coverage ratio would increase by 12 percent, from 1.91 to 2.13, under FAS 160. That hike would have come on $949 million in EBITDA and $111 million in minority interest income. Interest expense for Goodyear in that year was reported at $498 million.