The notion of applying what is now known as ‘equity method accounting’ to investment situations—where the investor is able to exercise significant influence developed in the early 1950s, as an application of the “substance over form” philosophy of financial reporting.
It was not actually made mandatory, until the late 1960s, in the US. Because the actual determination of the existence of significant influence was anticipated to be difficult, a somewhat arbitrary, refutable presumption of such influence was set at a 20% voting interest in the investee. This became the de facto standard for all later accounting requirements seeking to emulate the pioneering one set forth under US GAAP.
So what is equity method accounting and why is it required? This post answers the question. As well as equity method as it is prescribed by IAS 28 and when it is required. Furthermore, expanded and even more fully developed method—proportionate consolidation method (as a comparison), are also discussed. Read on…
Why Applying Equity Method Accounting
There is time when investor has essentially a passive position due to holding only a small minority ownership interest (or, in the case of debt, no actual ownership interest at all). In such situations, the investor is unable to control or materially influence decisions to be made by management of the investee. The use of fair value accounting has been deemed most appropriate in such circumstances.
In other situations an investor will have active control over the decisions taken by the management of the investee, or have joint control over those decisions, to be made in conjunction with its coinvestors. A third logical possibility is that the investor will have something less than control (or joint control), but will clearly also not be a mere passive investor. This last named circumstance is that where there is significant influence over an investee, and equity method maybe necessary.
The necessity of applying a method of accounting such as the equity method, when significant influence over the investee is held by the investor, can easily be understood when one considers how readily manipulation of the investor’s financial position and results of operations could be achieved in its absence.
If an investee has substantial income, but the investor, employing the cost method of accounting for the investment, uses its influence to defer the investee’s declaration of dividends, the result would be that the investor would not be reporting its share of the investee’s economic operating results—even though it had been in a position to cause a distribution of dividends, had it chosen to do so. This might be motivated, for example, by a desire to put aside future earnings to compensate for an expected, or feared, decline in the investor’s own operations.
Conversely, the investor could effect or encourage a dividend distribution even in the absence of earnings by the investee. This could be motivated by a need for reportable earnings, perhaps to offset disappointing performance in the investor’s own operations. In either case, the opportunity to manipulate reported results of operations would be of great concern.
More importantly, however, the use of the cost method would simply not reflect the economic reality of the investor’s interest in an entity whose operations were indicative, in part at least, of the reporting entity’s (i.e., the investor’s) management decisions and operational skills. Thus, the clearly demonstrable need to reflect substance, rather than mere form, made the development of the equity method highly desirable.
The pure equity method is not the only possible means of accomplishing the goal of reporting the economic performance of the investor. Other suggested solutions include the expanded equity method and proportionate consolidation. IASB and the various national standard-setting bodies have directed differing levels of attention to these alternatives over the years; the simple equity method has received the most universal support.
The equity method permits an entity (the investor) controlling a certain share of the voting interest in another entity (the investee) to incorporate its pro rata share of the investee’s operating results into its profit or loss. However, rather than include its share of each component of the investee’s revenues, expenses, assets and liabilities into its financial statements, the investor will only include its share of the investee’s net income as a separate line item in its income.
Similarly, only a single line in the investor’s balance is presented, but this reflects, to a degree, the investor’s share in each of the investee’s assets and liabilities. For this reason, the equity method has been referred to as “one-line consolidation.”
It is important to recognize that the bottom-line impact on the investor’s financial statements is identical whether the equity method or full consolidation is employed; only the amount of detail presented within the statements will differ. An understanding of this principle will be useful as the need to identify the “goodwill” component of the cost of the investment is explained below.
Expanded Equity Method
Less commonly presented than the pure equity method of accounting are the expanded equity method and the proportionate consolidation method. These alternative approaches effectively are successive points along a continuum ranging from a pure historical cost basis to full consolidation.
In contrast to the one-line consolidation approach of the simple equity method, the expanded equity method is an attempt to provide more meaningful detail about the various assets and liabilities, and revenues and expenses, in which the investor has an economic interest.
Thus, if using the expanded equity method, the investor’s interest in the investee’s aggregate current assets would be presented, as a single number, in the current asset section of the investor’s statement of financial position. Similarly, the investor’s share of the investee’s non-current assets, current liabilities, and noncurrent liabilities would be captioned separately in the corresponding section of the investor’s statement of financial position.
On the statement of comprehensive income, using this expanded equity method, the investor’s share of significant items of revenue, expense, gains, and losses would be set forth separately. This would not extend to every item of the statement of comprehensive income, but would highlight the major ones. Greater or lesser degrees of detail would be possible, depending on the investor’s preferences, since there are no definitive standards governing this method.
A major advantage of this method of reporting an investor’s interest in the investee is that the investor’s financial statements will provide a more meaningful insight into the true economic scope of its operations, including indications of the gross volume of business being transacted.
Furthermore, financial position will not be distorted by, for example, effectively merging the investee’s current assets with the investor’s noncurrent assets, which would be the result of placing equity in investee in the noncurrent asset section, as is required under common practice. As the amount of detail expands, the expanded equity method edges into proportionate consolidation, however.
The expanded equity method has not been endorsed, as such, although the equity method as defined by US GAAP (in APB Opinion 18) does incorporate elements of this approach. Specifically, APB 18 mandates one-line consolidation for the statement of financial position, but requires that certain components of the investee’s statement of comprehensive income (such as items related to discontinued operations) retain their character when incorporated into the investor’s statement of comprehensive income. Thus APB 18’s requirements do go beyond a strict application of the equity method.
Proportionate Consolidation (more fully developed)
This is a more fully developed variant of the expanded equity method, whereby the investor’s share of each element of the investee’s statement of financial position and statement of comprehensive income is reported in the investor’s statements.
Although there is nonauthoritative GAAP in the United States supporting this method of accounting for investments in joint ventures, and under IFRS this method is prescribed optionally for joint ventures, it has not been widely advocated for investments in which the investor does not exercise, at a minimum, joint control. Nonetheless, from a conceptual perspective, it does have appeal since it would convey the full scope of economic activities over which the reporting entity could be said to have either direct control or indirect yet significant impact.
Equity Method According to IAS 28
The equity method is generally not available to be used as a substitute for consolidation. Consolidation is required when a majority voting interest is held by the reporting entity (the parent) in another entity (the subsidiary). The equity method is intended for use where the reporting entity (the investor) has significant influence over the operations of the other entity (the investee), but lacks control.
In general, significant influence is inferred when the investor owns between 20% and 50% of the investee’s voting common stock. However, the 20% threshold stipulated in IAS 28 is not an absolute one.
Specific circumstances may suggest that significant influence exists even though the investor’s level of ownership is under 20%, in which case the equity method should be applied. In other instances, significant influence may be absent despite a level of ownership above 20%. Therefore, the existence of significant influence in the 20% to 50% ownership range should be treated as a refutable presumption. This 20% lower threshold is identical to that prescribed under US GAAP.
In considering whether significant influence exists, IAS 28 identifies the following factors as evidence that such influence is present:
(1) investor representation on the board of directors or its equivalent;
(2) participation in policy-making processes;
(3) material transactions between the investor and investee;
(4) interchange of managerial personnel, and
(5) provision of essential technical information.
There may be other factors present that suggest a lack of significant influence, such as organized opposition by the other shareholders, majority ownership by a small group of shareholders not inclusive of the investor, and inability to achieve representation on the board or to obtain information on the operations of the investee. Whether sufficient contrary evidence exists to negate the presumption of significant influence is a matter of judgment and requires a careful evaluation of all pertinent facts and circumstances, over an extended period of time in some cases.
When Equity Method Is Required
IAS 28 stipulates that the equity method should be employed by the investor for all investments in associates, unless the investment is acquired and held exclusively with a view to its disposal within twelve months from acquisition, or if it is in reorganization or in bankruptcy, or operates under severe long-term restrictions that would preclude making distributions to investors.
In the latter cases, the use of the equity method of accounting would not be deemed appropriate; rather, the investment would be carried at its historical cost.
The IASB’s Improvements Project made a number of changes to IAS 28 (effective 2005), among which is an exclusion from IAS 28’s requirements for investments in associates held by venture capital organizations, mutual funds, unit trusts, and similar entities that are measured at fair value in accordance with IAS 39, when such measurement is well-established practice in those industries.
When those investments are measured at fair value, changes in fair value are included in profit or loss in the period of the change.
When considering whether the investor has significant influence—and thus must apply the equity method of accounting—a number of factors must be taken into consideration. For example, beyond the mere 20% threshold of ownership, relevant indicia of significant influence would often include these factors:
(1) Representation on the board of directors or equivalent governing body of the investee;
(2) Participation in policy-making processes;
(3) Material transactions between the investor and the investee;
(4) Interchange of managerial personnel; or
(5) Provision of essential technical information.
Another complicating factor in ascertaining whether the reporting entity has significant influence over the investee is that the investor may own securities such as share warrants, share call options, or other debt or equity instruments that are convertible into common shares, or other similar instruments that have the potential, if exercised or converted, to give the entity additional voting power or reduce another party’s relative power over the financial and operating policies of another entity (i.e., potential voting rights).
The existence and effect of potential voting rights that are currently exercisable or currently convertible, including potential voting rights held by other entities, must be considered when assessing whether an entity has the power to have significant influence in the financial and operating policy decisions of the investee.
The standard does distinguish between the accounting for investments in associates in consolidated financials and that in separate financials of the investor. As amended by IAS 39, IAS 28 provides that in the separate financials of the investor the investment in the associate may be carried at either cost, by the equity method, or as an available-for-sale financial asset consistent with IAS 39’s provisions, if the investor also prepares consolidated financial statements. If the investor does not issue consolidated financial statements, the choices are expanded to include, if warranted by the facts, treating the investment as a trading security as well.
In practice, many parent-only financial statements apply equity method accounting to subsidiaries and significant influence investees alike. This probably does provide the most meaningful reporting, avoiding detailed inclusion of any assets, liabilities, revenues, or expenses other than the parent company’s own in its financial statements, while not distorting the bottom line measure of economic performance.
On the coming post, I am going to discuss the complications entities may face in applying the equity method accounting. So, do not miss it 🙂