Less than zero – oddities of the equity method

I’ll return another day to the basic question of why we’re stuck with equity accounting, a practice that doesn’t really make much conceptual sense. But for as long as we’re stuck with it, it generates plenty of head-scratching opportunities. Take for example the situation where an investor’s share of losses in the associate or joint venture exceeds the carrying value of its interest: after reducing the carrying value to zero, the investor only provides for additional losses, and only recognizes a liability, to the extent it’s incurred legal or constructive obligations or made payments on the investee’s behalf. Subsequently, if the investee starts to report profits again, the investor resumes recognizing its share of those profits only after its share equals the share of losses not recognized. All right then. But now let’s go back to the issue I wrote about here, of eliminating unrealized profits on transactions between an investor and an associate. In a downstream transaction, where for example an investor makes sales to the investee, and a portion of the items sold remain in the investee’s inventory at the end of the period, the investor typically reduces its reported net income to eliminate the profits recognized on those items, with the balancing entry reducing the investment in the investee. But what if there isn’t any investment in the investee, because it’s been drawn down to zero? What happens then?

IAS 28 doesn’t address this issue, so a preparer in this situation needs to figure out what approach best reflects the “principles” of IAS 28. Unfortunately though, those principles only consist in this instance of a weird bunch of things you’re told you have to do. So what might make sense? Well, you might say that if there’s no investment left to eliminate, you can only remove those unrealized profits from the income statement by recognizing some kind of balancing liability on the balance sheet. But if the investor hasn’t incurred legal or constructive obligations or made payments on the associate’s behalf, this seems inappropriate given the guidance cited above. You might conclude then that since you can’t recognize a liability, you can’t eliminate those unrealized profits either, and therefore the investor recognizes greater profits on the transaction than it would have done if its accounting for the associate hadn’t reached this stage.

This only shows up the arbitrariness of the whole thing of course. The fact of the investment’s carrying value being below zero doesn’t in any way make those profits any more or less “unrealized” than they would have been otherwise – if you assume the elimination makes sense in the first place, it’s surely inappropriate to throw that out of the window because of some mathematical oddity. For this reason you might conclude the lesser evil is to recognize some kind of liability after all, perhaps characterizing it as deferred income or something like that, to be drawn down when the unrealized profits become realized by the associate. This doesn’t make much sense either – if an entity reports a portion of income from its transactions as being deferred, it should be a consistent result of the nature of the transaction, not as a side effect of something that doesn’t “work” elsewhere. But at least, under this way of proceeding, you’ve taken a consistent approach to reporting your performance.

IFRIC considered this issue a couple of years ago, coming to the conclusion that an entity should eliminate the gain to the extent of related investors’ interest in the associate or joint venture, even if the gain to be eliminated exceeds the investment’s carrying amount, and that the remaining gain in excess of the carrying amount of the entity’s investment in the associate or joint venture should be deferred. It tentatively recommended that the IASB amend IAS accordingly, and the IASB subsequently directed staff to prepare an exposure draft along those lines. This brief flurry of activity didn’t go anywhere however; staff is currently looking at the equity method in more detail, with the discussion to be picked up later in the year.

In the meantime then, at least one of the big firms says in its literature that both approaches are acceptable, going on: “The treatment chosen is based on the investor’s accounting policy choice for dealing with other situations where IAS 28 is unclear, reflecting whether the investor considers the equity method of accounting to be primarily a method of consolidation or a method of valuing an investment. The investor should apply a consistent accounting policy to such situations.” It’s probably the best answer there is, but really just amounts to shrugging and walking away. Once the investment’s carrying value falls below zero, the equity method departs radically from consolidation methods (which continue to recognize losses in full, including attributing to non-controlling interests their full share of those losses) while having no relevance at all as a valuation method (the investment’s fair value might be far above zero). You might intuitively “consider” equity accounting to be more like one of these things than the other, but only in the sense that if I forced you to choose who most resembles Brad Pitt, me or my dog, you’d probably push yourself to come up with an answer…

The opinions expressed are solely those of the author

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s