by John Hughes
Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 15th edition:
- “Prior to the adoption of IFRS 11, the issuer presented in its income statement the line: ‘share in the profit or loss of associates and joint ventures accounted for using the equity method’ as part of its operating result. In presenting its income statement the issuer distinguishes between its operating and non-operating results. Following the publication of IFRS 11 and the elimination of proportionate consolidation, the issuer reviewed the presentation of its income statement. The presentation of the share in the profit or loss of operating associates and joint ventures accounted for using the equity method would not have changed, however, the issuer intended to present the result on non-operating associates and joint ventures separately.
- The issuer intended to adopt as its accounting policy that an investment accounted for using the equity method would be classified as ‘operating’ if it met the following conditions:
- – The activity of the entity is related to the operating activities of the group;
- – The elements in the income statement have primarily an operating nature: results that are primarily financial suggest that the nature of the entity is not operating;
- – In case of an industrial entity, the entity has started production.
- On the above basis, the issuer intended to change the presentation of the share in the profit or loss of a joint venture in its start-up phase as the assets of the joint venture consisted mainly of a factory under construction and the functional currency was different from the functional currency of the issuer. The issuer argued that the results of this start-up company were significantly different from the results of operating entities, since they contained important financial results that are not of an operating nature (e.g. the impact of changes in foreign exchange rate that are not regarded as an adjustment to interest costs according to paragraph 6(e)3 of IAS 23 – Borrowing Costs and other charges that cannot be capitalized as part of factory under construction). The issuer also argued that these results are different from the usual type of charges the issuer faces in its subsidiaries in a start-up/developing phase because the joint ventures are operating in other regions and have a different functional currency.
- The issuer considered that IFRS do not provide sufficient guidance on the presentation of this type of result. Paragraph 82 (c) of IAS 1 requires at least a separate line in the income statements for the share of the profit or loss of associates and joint ventures accounted for using the equity method. However, this paragraph does not indicate where this line should be presented nor does it prohibit using two lines.
- Overall, the issuer considered that this change in accounting policy would increase transparency and provide reliable and more relevant information.”
The enforcer (as ESMA likes to term it) disagreed, concluding that for the entity to present its share in a start-up phase joint venture’s profit or loss as part of its non-operating results wouldn’t provide more relevant information to the users of its financial statements. It cites the IASB’s comment in IAS 1.BC56, that if an entity chooses to disclose the results of operating activities, the amount disclosed should be representative of activities that would normally be regarded as ‘operating’. In this case: “The activities of the start-up subsidiary were of the same nature as some core activities of the issuer and were part of the normal business of the group in new regions….Considering a company to be in a start-up phase is not a valid reason to consider that its results are not of an operating nature because start-up companies are normally regarded as part of the normal business of a group.”
This general issue is highly familiar to Canadian entities – it was addressed in one of the OSC’s oldest staff accounting bulletins (now rescinded, but available here for historical interest) and continues to be a topic of interest for regulators, although the focus is more likely to be on expenses such as restructuring costs or inventory write-downs. ESMA’s example is somewhat more unusual. The enforcer’s conclusion seems supportable, primarily on the basis that the issuer’s distinction between operating and non-operating equity-accounted investees sounds inherently fuzzy, depending in large part on an assessment of the relative magnitude of their operating activities, rather than on the absence of any, and putting weight on other factors that don’t sound relevant at all. Still, this raises an interesting question: would such a distinction ever be valid, or is equity accounting a process that demands consistent presentation across all its applications?
Well, equity accounting isn’t the most conceptually sound notion on the books, but to the extent it means anything, it seems reasonable to suppose that if the “investor’s share” of the equity-accounted investee’s profit or loss consists entirely (say) of items of an financing nature, because that’s all there is in there, then it’s appropriate for the entity to categorize that item as non-operating, regardless of how it treats its share of the results of other investees. It’s interesting that there seem to be plenty of examples (including Canadian ones) of entities that simply exclude all profit or loss arising from equity accounting from their operating results, regardless of the underlying nature of those investees. At least one of the big firm’s texts seems to endorse this approach, saying “(an) acceptable alternative may be to exclude the results of all associates and joint ventures from operating profit,” without elaborating further. It’s not much of a stretch though to think that if this is an acceptable alternative as a matter of policy, regardless of the underlying nature of the investee’s activities (and maybe it shouldn’t be, but if it is), then it ought also to be acceptable to make a distinction between different kinds of investees, if it’s of a kind that can be relevantly expressed and reliably implemented.
Such a distinction might not always be possible of course. Still, all of that aside, equity-accounting is just a financial reporting mechanism that doesn’t in itself say anything about the nature of what’s being equity-accounted. So I don’t know that I’d take ESMA’s example as the last word on presenting profit or loss arising from such a mechanism…
The opinions expressed are solely those of the author