Uncomfortable questions are surfacing about the purpose and the nature of the equity method of accounting. Graham Holt explains
First published in the May 2014 UK edition of Accounting and Business magazine.
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Equity accounting was originally used as a consolidation technique for subsidiaries at a time when acquisition accounting was considered inappropriate because it showed assets and liabilities not owned by the reporting entity.
The equity method evolved as a basis of reporting the performance of subsidiaries partly as it was seen as more appropriate than cost.
International consensus on the equity method eventually led to an amended EU directive to require the use of equity accounting for associates of an investor. Some European countries questioned this amendment on the basis that it did not use acquisition accounting principles to account for subsidiaries.
What's the point?
In short, equity accounting has a long history and is currently used to account for associates and joint ventures. However, IAS 28, Investments in Associates and Joint Ventures, does not state what equity accounting is trying to portray. Under the equity method, on initial recognition the investment in an associate or a joint venture is recognised at cost, and the carrying amount increased or decreased to recognise the investor’s share of the profit or loss of the investee after the date of acquisition.
Many of the principles applied in the equity method are similar to the consolidation procedures described in IFRS 10, Consolidated Financial Statements. For example, under equity accounting, profits are eliminated on intergroup transactions only to the extent of an investor’s interest. This reflects a proprietary perspective to consolidation, as opposed to the entity perspective of IFRS 10.
Although IAS 28 does not specifically state that IFRS 3, Business Combinations, should be applied to an acquisition of an investee, it does refer to the acquisition accounting principles in IFRS 3. For example, IAS 28 requires that goodwill relating to an associate or a joint venture is included in the carrying amount of the investment. Amortisation of goodwill is not permitted.
Equity accounting reflects a measurement approach as well as a consolidation approach. For example, losses in excess of carrying value are not recognised in most circumstances - after the investor or joint venturer’s interest is reduced to zero, a liability is recognised only to the extent that the investor or joint venturer has incurred legal or constructive obligations or made payments on behalf of the investee.
The basis for conclusions in IAS 28 refers to the equity method as a way to measure an investment in an associate and a joint venture. Thus, questions can be raised as to whether equity accounting is a type of financial instruments valuation accounting or a one-line consolidation.
There are a number of differences between consolidation and equity accounting that may give a different result, including acquisition costs and loss-making subsidiaries. In the consolidated financial statements, acquisition costs on a business combination are expensed in the period they are incurred, but included in the cost of investment for equity accounting. The consolidated financial statements include full recognition of losses of a subsidiary, but under equity accounting an entity discontinues recognising losses once its share of the losses equals or exceeds its interest.
Recent developments have helped preparers understand the thinking behind the equity method. In December 2012, the International Accounting Standards Board (IASB) published two exposure drafts for amending IAS 28 - IAS 28, Equity Method: Share of Other Net Asset Changes, and IAS 28, Sales or Contributions of Assets between an Investor and its Associate or Joint Venture. The first dealt with how an investor should recognise its share of changes in net assets of an investee not recognised in comprehensive income, while the second dealt with the inconsistency between IFRS 10 and IAS 28 dealing with the sale or contribution of assets between an investor and its investee.
There appears to be significant diversity in the way the equity method is applied in practice mainly because of the two different concepts of measurement and consolidation underpinning the method. The proposed amendments did not address this issue and were seen as a short-term measure. Respondents felt it was important for the IASB to establish a clear conceptual basis for the equity method.
Some jurisdictions require equity accounting to be used in the separate financial statements of the parent company for investments in associates, joint ventures and subsidiaries. IAS 27, Separate Financial Statements, does not currently permit this as the option was removed for investments in separate financial statements in 2003. The IASB has been asked to restore this option and issued an exposure draft in December 2013 entitled Equity Method in Separate Financial Statements (Proposed amendments to IAS 27). The draft also requires the change to be applied retrospectively if the entity elects to use the equity method.
Retrospective application for associates and joint ventures may not be a problem as the equity accounting used in an entity’s separate financial statements would be consistent with its consolidated financial statements. However, there may be a problem with investments in subsidiaries in areas such as impairment testing and foreign exchange.
There is some doubt about the objective of separate financial statements, as they are not required in International Financial Reporting Standards (IFRS). In general, they are required by local regulations or other financial statement users. IAS 27 points out that the focus of such statements is on the financial performance of the assets as investments.
IAS 27 does not mandate which entities must produce separate financial statements for public use. It applies when an entity prepares separate financial statements that comply with IFRS.
Currently, financial statements in which the equity method is applied are not separate financial statements. Similarly, the financial statements of an entity that does not have a subsidiary, associate or joint venturer’s interest in a joint venture are not separate financial statements.
When an entity prepares separate financial statements, investments in subsidiaries, associates and jointly controlled entities are accounted for at cost or in accordance with IFRS 9, Financial Instruments.
Investments accounted for at cost and classified as held for sale are accounted for in accordance with IFRS 5, Non-current Assets Held for Sale and Discontinued Operations.
If an entity elects, as permitted by IAS 28, to measure its investments in associates or joint ventures at fair value through profit or loss in accordance with IFRS 9, it has to account for them in the same way in its separate financial statements. At present, therefore, companies have to elect under IFRS to measure their investments in associates, joint ventures and subsidiaries either at cost or to treat the investment as a financial instrument. The proposed third option will lead to diversity in practice but perhaps more importantly, it raises the question about the nature and purpose of equity accounting.
Respondents to the IASB exposure drafts are generally not in favour of introducing accounting policy options in IFRS. The proposed change to IAS 27 will align the accounting principles across boundaries but some respondents feel that the use of the equity method in separate financial statements is inappropriate because the proposed amendment lacks a conceptual basis.
If the main objective of the proposals is to improve the relevance of information, then the IASB should first clarify what the equity method purports to achieve. The basis of the argument of respondents opposing the introduction of the equity method is that it simply reflects information already given in the consolidated financial statements and the introduction of additional accounting policy options reduces the comparability of financial information. Further it is felt that the IASB should investigate current practice in countries with experience in applying the equity method before approving the change.
The proposals could be seen as creating confusion about the purpose and nature of the separate financial statements. Apart from the single-line presentation, consolidation rules would apply, so additional questions are raised about the purpose and the nature of the equity method.
The IASB feels including this option in IAS 27 would not involve any additional procedures because the information can be obtained from the consolidated financial statements by applying IFRS 10 and IAS 28.
Under the present proposals in the exposure draft, an entity could account for its investments in subsidiaries using the equity method, its associates under IFRS 9 and its joint ventures at cost. The proposed amendment affects IAS 28, which makes it imperative to consider whether any consequential amendments reflect the intention of the amendment to IAS 27.
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School