Equity accounting – time to say goodbye?

The endless oddity of one of the long-standing aspects of financial reporting

On my old blog (now sadly wiped from cyberspace), I devoted several entries to the mechanics of equity accounting, not because I really wanted to, but because the topic generates so many head-scratching oddities (like the one I discussed last time). This is how I put it on one occasion:

  • I’ve always thought equity accounting is one of the stranger aspects of accounting literature. I mean, there’s nothing very principles-based about taking a bright line of owning 20% of an investee’s voting power (even if the presumptions attached to it are rebuttable) and using it to trigger such a radically different accounting approach. Even if you do have significant influence at 20%, what about that leads you logically to the equity method? The second edition of Skinner and Milburn’s Accounting Standards In Evolution summed up the issue this way:
  • “Authoritative accounting literature has been largely silent on the conceptual basis for equity accounting. A few accountants have challenged its conceptual validity…The basis for this challenge is that accrual (of the equity interest) does not meet the concept of an “asset”..If an investor does not control the investee, it does not have the power to have assets equal to its share of the investee’s earnings remitted to it, or alternatively, to direct their use in the investee enterprise. Thus, the theoretical credentials for equity accounting on the basis of significant influence are open to question.”
  • They go on to say that “some accountants defend the equity basis of accounting simply as a valuation, arguing that it results in a better measure of the value of the investment than does cost” (but then they were writing in 2001, before fair value accounting for financial instruments reached its later stage of evolution). Anyway, IAS 28 doesn’t do anything to clarify this – I can’ t see any trace of an underlying principle either in the standard itself or in the basis for conclusions. It just tells you what you have to do….”

And, largely because of that, the IASB keeps tweaking the mechanics of what you have to do, messing with IAS 28 for one reason or another on three separate occasions in 2014 alone. And by the way, I’ve encountered several occasions over the years where issuers have problems obtaining the necessary information from the investee to implement equity accounting, and they not unnaturally ask why this doesn’t demonstrate their lack of significant influence over it. Unfortunately, it’s not quite that simple – one might have the power to participate in an investee’s financial and operating policy decisions while still running into road blocks on what that participation actually accomplishes. But still, it’s hard not to sympathize with the argument.

Mary Dolson recently considered the issue on the PWC blog, seemingly with no more enthusiasm than I’ve expressed. Here’s part of what she had to say:

  • “Accounting technical types (like me) spend a lot of time talking about the ‘how to’ of applying equity accounting. This time spent seems disproportionate to any benefit that might result.  Questions range from ‘does the notional ppa include real goodwill such that associates need to be tested for impairment annually’ (no they don’t, the IASB has said) to accounting for cross holdings, eliminations of upstream and downstream profits, what happens when you’re diluted, etc.
  • Conceptually, we wonder about the ‘unit of account’ question; are we trying to do a ‘collapsed consolidation’ or is it a fair value proxy from an earlier era?
  • And for a standard that’s quite old it gets amended and generally tinkered with on a regular basis.
  • …. And 14 smart people spent time talking about (the most recent issue) at (the then most recent) IASB meeting. Not to mention the prep time, the staff time, the recording of the decision, the documenting of the due process steps. Surely, there are higher priorities for the international accounting standard setter.”

She concludes: “Smart people thought this up but I think its day has passed. Any suggestions for a better answer?”

The only commentator on her post to date says this: “Fair value or cost…..fair value wins on relevance grounds.” Well, if no one else has anything to say on it, that’s good enough for me. Perhaps (for the sake of argument) the IASB could continue to address an issuer’s generally greater strategic interest in investees over which it has significant influence by retaining the current requirements for disclosing summarized financial information of those investees. But that aside, I can’t see at all why fair value measurement would be any less relevant for these investees than for any others (possibly recognizing gains and losses in other comprehensive income or loss rather than in core profit and loss, since the division exists anyway, not that I’m a fan of that either). If nothing else, maybe the IASB should clearly reassert at some point in the near future why fair value measurement doesn’t make sense, if that’s its view. Although I know that getting even that much clarity would eat up much more prep time, staff time, and so on….

The opinions expressed are solely those of the author

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