Understanding the FASB's new basis project: when should a reporting entity adopt a new basis of accounting for assets and liabilities?

Accountants hear with increasing frequency that the usefulness of financial statements prepared according to generally accepted accounting principles is declining. One reason for this may be reliance on the historical cost model and its requirement that the original purchase price (or the amount borrowed) be used to report most assets (liabilities). Recent Financial Accounting Standards Board requirements in Statement no. 107, Disclosures About Fair Value of Financial Instruments, may lead to an overhaul of some aspects of the historical cost model.

Another FASB initiative addresses potential departures from the original acquisition cost by entities experiencing a change in control, borrowing significant amounts of money or undergoing major capital structure modifications. In December 1991, the FASB addressed this initiative in a Discussion Memorandum, New Basis Accounting. As part of the FASB's project on consolidations and related matters, the DM examines the circumstances in which a reporting entity should adopt a new basis of accounting for assets and liabilities.

This article analyzes the new basis project. The specific issue the FASB faces is illustrated in exhibit 1, page 87, by the difference between NBP's stockholders' equity, currently carried at $1,000, and its fair value, $2,500, as shown in the condensed balance sheets. The new basis project will determine the circumstances calling for NBP's separate balance sheet to report the fair value amounts. The project also must determine the accounting treatment of the new basis revaluation-recognition of gain or loss in income or as a direct adjustment to stockholders' equity.

EXISTING NEW BASIS SCENARIOS

Existing scenarios in which an entity adopts a new basis in its financial statements are described in the sidebar on page 88. Except for business combinations, the new basis project includes reevaluations of each one of these scenarios.

CATEGORIES OF POTENTIAL

While grappling with situations that could give rise to a new basis of accounting, the FASB focused first on scenarios in which (1) a new reporting entity is created or (2) the existing entity's book values are irrelevant. The FASB later decided the four scenarios described below permit a better grasp of new basis issues.

A. Purchases of a majority of an entity's stock by outsiders. Although this category includes situations currently covered by push downs, the DM expands the potential transactions and asks: Should new basis (or push down) also apply to any majority acquisition? Should new basis amounts be reported on an acquired entity's separate balance sheet according to the same rules used for reporting new basis amounts in consolidated financial statements? If so, the conclusions the FASB reaches in its consolidation project will dictate the push down amounts.

Note: The FASB's Consolidation Policy and Procedures DM addresses whether assets and liabilities of a minority interest should be reported at the carryover basis or at the basis implied by the parent's acquisition cost. Reporting a minority interest at its implied fair value is accepted practice in some countries, but not in the United States.

Even if there is agreement new basis is appropriate for majority stock acquisitions, does a secondary offering, an initial offering or the exchange of a majority of an entity's stock in the market over a short time qualify? Must the change in majority ownership be accompanied by a new control group? Can a new control group arise when an existing shareholder group purchases a minority of the stock? These are difficult questions the FASB will need to answer.

B. Significant borrowing transactions. Underlying scenario A is the premise one or more stockholders are risking substantial resources on the entity's performance. Can that premise be extended to third-party lenders who put substantial resources at risk by granting credit to the entity or to others, based on the lenders' estimate of the entity's fair value?

When evaluating such a scenario, it's important to consider whether fair value estimates made by stockholders acquiring a residual interest are different from those made by lenders acquiring a contractual interest. In some cases, debt covenants give lenders effective control of the entity. Other lending arrangements, such as highly leveraged recapitalizations, blur the distinction between stockholders and creditors. Scenarios A and B tend to converge when creditors control the entity and the basis for distinguishing between A and B becomes less clear. If this convergence of stockholder and creditor rights exists in some lending arrangements, is then a new basis appropriate even though the capital risked by the lender is not issued to acquire the entity's equity?

C. Reorganization or restructuring of an entity's debt and equity. In this scenario, current stockholder and creditor groups estimate the entity's fair value and revise their rights and claims accordingly; these groups may remain unchanged after rights and claims are restructured. Thus, there may be no ownership or control change and no independent third-party valuation. While all participants may be insiders, their likely conflicting economic interests support the fair value estimates. Chapter 11 bankruptcy and quasi reorganizations are included here, as are unleveraged recapitalizations and subsidiary spinoffs.

In an unleveraged recapitalization, management negotiates with creditors on the stockholders' behalf to rearrange the entity's capital structure in pursuit of a specific objective, such as repelling a hostile takeover. Exchanges between debt and equity holders are influenced by the participants' fair value estimates. Are these estimates, accepted by those seeking to maintain or enhance their economic interests, sufficient to enable the recapitalized entity to adopt a new basis of accounting for assets and other liabilities?

Spinning off a subsidiary removes it from the parent company umbrella and gives parent company stockholders stock in the subsidiary. Although spinoffs are accounted for at existing carrying amounts under Accounting Principles Board Opinion no. 29, Accounting for Nonmonetary Transactions, the value of the subsidiary's stock to the new owners is the subsidiary's fair value. The new basis question is whether the spun-off subsidiary's new balance sheet should reflect an estimated fair value immediately, after shares traded with third parties take on a market-determined value or not at all.

D. Corporate joint ventures. In a corporate joint venture, two or more unrelated corporations establish a new business entity under joint control. The venturers' respective equity interests are negotiated based on the estimated fair values of contributed tangible and intangible net assets. Do these negotiations produce fair value estimates that are sufficiently credible to recognize a new basis in the joint venture's balance sheet?

CRITERIA INFLUENCING WHETHER A NEW BASIS IS WARRANTED

The FASB identified six factors that, together or separately, could determine when new basis recognition is appropriate. A series of cases, grouped according to the four potential new basis categories discussed above and including different combinations of the six factors, are presented in New Basis Accounting. The FASB asks DM readers to respond to these cases; those adapted for this discussion appear in exhibit 2, page 89.

Change in ownership and control. Situations in which a new investor or unified group of investors obtains control of an entity by acquiring more than 50% of the entity's stock may be viewed as creating new reporting entities. Examples range from a single investor acquiring 100% of a company's stock to a unified investor group acquiring 51%. Push down accounting is included here, although the Securities and Exchange Commission generally insists at least 80% of the entity's stock be acquired.

If the FASB affirms the validity of the push down concept, it also must specify the circumstances requiring push down treatment, including

* The minimum level of ownership change.

* The permissible level of other interests in the company's assets, such as debt holders.

NBP's book value balance sheet (exhibit 1) shows liabilities of about 71% of its capitalization. Are debt holders' or noncontrolling shareholders' information needs compromised if financial statements change when ownership and control change?

Change in ownership or control. Because majority ownership can change without a change in control and vice versa, new basis propriety must be evaluated in such situations, even if a new basis is appropriate when both ownership and control change. Has a new reporting entity arisen in examples I and 2 of exhibit 2? Given the class B shares, can the price paid for the class A shares in either example signify a new basis for NBP?

Entity participation. Accounting events occur when a transaction or other event affects an entity's financial position. Stock ownership changes occurring outside the entity-some covered by the push down concept-do not affect the entity's financial position and should not affect its financial statements. The principal difficulty is the extent to which a transaction's form versus its economic substance should influence recognition of accounting events. Entity participation may strengthen the case for an accounting event calling for a new basis; should a similar transaction outside the entity have the same weight?

After the stock issuance in example 3, exhibit 2, the new control group owns 80% of NBP's 500 outstanding shares. The same ownership interest results if the new control group purchased 80 of the 100 shares already outstanding from existing shareholders for $25 per share. How important is the fact the initial public offering changed the entity's capital structure, whereas acquisition of already existing shares left NBP's capital structure unchanged?

Creation of a new legal entity. Financial reporting focuses on the reporting entity, which may not be a legal entity. Consolidated statements provide the best example. The legal entity often is the starting point for identifying the reporting entity. Some new basis candidates, such as push downs, do not create a new entity. Others, such as corporate joint ventures, do create a new entity. Some LBOs are undertaken by a newly formed legal entity created solely for that purpose. Which circumstance should lead to new basis accounting?

The difficulty in answering this question is illustrated by example 4, exhibit 2. Although NEWCO is a new legal entity, it lacks prior economic substance and its continuing existence is managed easily. The LBO's substance, and presumably the case for a new basis, are unaffected by NEWCO's continued existence or by the surviving legal entity if NEWCO and NBP merge.

Changes in financial statement user group. This issue concerns whether new basis is appropriate when the needs of the user group relying on the entity's general purpose financial statements have not changed and whether new basis is appropriate because a new user group based a decision on the entity's estimated fair value.

* Former user group's needs unchanged. Those relying on an entity's general purpose financial statements, such as public debt holders and noncontrolling shareholders, may seek a time series of comparable financial information for that entity. Some argue those users' needs do not change when, for example, a new control group takes over. New basis adjustments to assets and liabilities distort interperiod comparisons. Since the new control group has unrestricted access to the entity's internal records, it can obtain needed information without the entity's general purpose financial statements.

Others argue the more up-to-date values reflected in the new control group's new basis also are relevant to external users. Reporting the new basis information makes public what otherwise might remain private, inside information.

* New user group has new needs. This situation can arise in significant borrowing transactions. Although private lenders need not rely on general purpose financial statements, public debt holders must. A significant flotation of new public debt or a leveraged recapitalization in which previous equity holders now possess a new package of debt and equity interests can produce new user groups. Such groups may prefer that general purpose financial statements report the fair values on which the debt issue or recapitalization was based.

Presence of monetary versus nonmonetary consideration. The presence of cash or other monetary assets in a potential new basis transaction supports the fair values assigned nonmonetary assets. Acquiring stock for cash provides that credibility when ownership or control changes. Formation of a corporate joint venture illustrates the monetary-nonmonetary issue because a joint venture involves shared ownership and control, not an exchange or relinquishment of ownership and control. Most agree formation of a joint venture results in a new reporting entity, a factor supporting new basis treatment for the venture's property. Nevertheless, contributing only nonmonetary property may cloud the valuation issue. Company B's cash contribution in example 5, exhibit 2, supports the fair value of the property contributed by company A. In example 6, the participants agree their equal property contributions are worth $5,000. Because their interests are equal, the venturers could assign any carrying values to their contributions as long as the respective economic values are equal. Thus, some argue the lack of monetary consideration makes new basis valuation inappropriate or at least suspect.

RECOGNITION AND MEASUREMENT

Recognition of the revaluation adjustment. Most agree when a new basis is coupled with a new reporting entity, the valuation adjustment flows directly into contributed capital. The DM refers to this as "fresh start" accounting. Disagreement exists, however, over how a revaluation adjustment by continuing entities should enter equity. A continuing entity adopting a new basis of accounting may create such fundamental change that the post-new basis entity substantively qualifies as a new reporting entity.

In other cases, the revaluation adjustment is considered a holding gain and could be entered directly into a separate component of equity-like certain foreign currency translation adjustments-or flow through earnings or comprehensive income into equity.

Measurement of the revaluation adjustment. Some of the measurement issues related to a revaluation adjustment are similar to those in accounting for business combinations, including

* Whether to impute a revaluation adjustment to minority shareholders.

* How to measure the adjustment in a step transaction.

The consolidation DM examines these two issues. Whether minority interests share in the valuation adjustment likely depends on the entity concept the FASB adopts for consolidated reporting. In a step transaction, the issue is whether to sum the pieces of the adjustment measured at each step or to base the entire adjustment on the values present when the final step producing control occurs.

DRAMATIC CHANGES ARE POSSIBLE

The FASB's new basis project could make dramatic changes in financial reporting, changes crucial to financial statements' usefulness. The FASB's challenge is to identify circumstances justifying financial statements reporting a "new basis," and the DM is designed to gather data pertinent to this challenge. However, determining those circumstances and providing a framework leading to more relevant information in financial statements will not be an easy task.

The deadline for comments on the new basis DM is July 15, 1992. Copies may be obtained by writing the FASB order department, 401 Merritt 7, P.O. Box 5116, Norwalk, Connecticut 06856-5116 or by calling [phone], ext. 555. [TABULAR DATA OMITTED]

EXECUTIVE SUMMARY

* MANY BELIEVE the usefulness of financial statements prepared according to generally accepted accounting principles is declining, perhaps because of their reliance on the historical cost model requirement to report assets at the original purchase price and liabilities at the amount borrowed.

* THE FASB HAS ISSUED a Discussion Memorandum, New Basis Accounting, to examine when a reporting entity should adopt a new basis of accounting for assets and liabilities.

* THE FASB FOCUSED on majority stock acquisitions, significant borrowings, reorganizations of capital structures and joint ventures.

* THE DM IDENTIFIES six factors that, together or separately, could determine when new basis recognition is appropriate. The DM includes case studies with different combinations of the six factors.

* THE NEW BASIS project has the potential to change dramatically financial reporting practices and improve financial statement usefulness.

* THE DEADLINE FOR practitioners to comment on the new basis DM is July 15, 1992.

EXHIBIT 2

Examples involving new basis criteria

Example 1: Change in majority ownership. No change in control. Suppose NBP's common stock consists of 60 class A shares (two votes each) and 40 single-vote class B shares, for 100 shares and 160 votes. All shares participate equally in NBP's residual interest. Company A owns all of NBP's class A shares and company B owns all the class B shares. Company A has a 60% ownership interest and 75% [(60 x 2) [divided by] 160] of the votes. If Company B buys 15 of company A's class A shares, then company B obtains a 55% [(40 + 15) [divided by] 100] ownership interest and company A retains control with 56% [2(60 - 15)][divided by] 160) of the votes.

Example 2: Change in control No change in majority ownership. Refer to example 1. Company A now owns only 20 of the class A shares and company B owns the rest. Company B now has an 80% [(40 + 40) [divided by] 100] ownership interest and controls 75% [40 + (40 x 2)] [divided by] 160) of the votes. If company A buys 25 of company B's class A shares, company A obtains control with 56% [2(20 + 25)][divided by] 160) of the votes; company B keeps a 55% [40 + (40 - 25)] [divided by] 100) ownership interest.

Example 3: Initial public offering (IPO) of voting stack by the entity. Assume NBP issues 400 new shares at an offering price of $25 per shore (book value, $10 per shore) to a new investor control group.

Example 4: Leveraged buyout of NBP by NEWCO. NEWCO is formed by investors, with $2,500 of borrowed cash, to acquire the stock of NBP. The investors guarantee the debt until NBP's stock is acquired and pledged as collateral for the debt. Example 5: Joint venture formation: One participant invests cash. Company A contributes property carried at $3,500 (fair value, $5,000) for a 50% interest in a corporate joint venture, and unrelated company B contributes $5,000 in cash for its interest.

Example 6: Joint venture formation: Neither participant invests cash. Companies A and B each contribute property with an estimated fair value of $5,000 for 50% interests in a corporate joint venture.