A European example of issues arising in interpreting the definition of an investment entity
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 20th edition:
- The issuer, a savings bank… held 48.3% of the shares in entity B, which was engaged in investing in regional businesses for capital appreciation. The majority of entity B’s investments were stakes in the investee’s equity of between 20%-50%….The issuer had significant influence over entity B.
- Entity B prepared stand-alone financial statements according to local GAAP, in which its investment portfolio was accounted for at the lower of cost and fair value. Entity B had in the last couple of years prepared and shared with its board of directors a semi-annual estimate of the overall fair value of its investment portfolio. This report specified the value per investment, however, from the report it was evident that for many investments, the acquisition cost had been used as a proxy for fair value. For some investments, the fair value had been estimated, but only to a limited degree, whenever the methods and assumptions were evident.
- The issuer concluded that entity B was an investment entity according to IFRS 10. It adjusted its share of the profit or loss of the associate to take into account the changes in estimates of the fair value of entity B’s investment portfolio. When estimating the fair value of entity B’s investment portfolio, the issuer used the estimate that entity B made available to its board of directors, but made additional high level adjustments.
The enforcer (as ESMA likes to term it) disagreed that entity B met the definition of an investment entity, for the following reasons:
- … According to paragraph 27(c) of IFRS 10, an investment entity is an entity that measures and evaluates the performance of substantially all its investments on a fair value basis. According to paragraph B85K of IFRS 10, this would be demonstrated if an entity provides investors with fair value information and measures substantially all of its investments at fair value in its financial statements whenever fair value is permitted. Furthermore, an investment entity would report fair value information internally to the entity’s key management personnel, who would use fair value as the primary measurement attribute to evaluate the performance of substantially all of its investments as well as to make investment decisions.
- The issuer shared the semi-annual estimate of the portfolio’s fair value only with the board of directors but not with the investors that were not represented in the board of directors. In addition, the enforcer’s investigations showed that periodical updates on operational and financial performance had been the primary measurement for management and the board of directors to evaluate performance rather than considering the investments’ fair values…
The enforcer concluded then that the issuer should have accounted for its interest in entity B by applying the equity method.
Some readers might think that the problems identified by ESMA shouldn’t be enough to send the analysis in a different direction – after all, it seems clear in general, plain-language terms that entity B is some kind of investment entity. But it’s necessary to remember that the primary purpose of defining an investment entity for purposes of IFRS is to provide a very limited exception from consolidation, on the basis that fair value measurement is most relevant to investors in those entities (because, most often, that’s how investors transact with the entities, for example through the ability to redeem their holdings at any time at their net asset value per share). If management of the entity – for whatever reason – doesn’t think it necessary to comprehensively develop fair value measurements for its own purposes in assessing performance and making decisions, it’s hard to argue (in the IASB’s view at least) that fair value measurement provides the best perspective for investors (presumably investors in this case don’t have the right to redeem their holdings in the entity at any time at fair value, if management doesn’t even bother to calculate one).
At the time it introduced the investment entity concept, the IASB noted that it didn’t inherently provide a reason for amending the mechanics of equity accounting – if the investor with significant influence over the entity isn’t itself an investment entity, then fair value won’t be the most relevant measurement basis for its investors, and if that’s the case, then that applies to how it measures its investment in the associate as much as to anything else. But some IASB members “raised concerns about the potentially significant practical difficulties or additional costs that may arise for an entity in unwinding the fair value through profit or loss measurement applied by an investment entity associate or joint venture for their interests in subsidiaries.” These concerns won the day, and so the Board allowed (without requiring) that a non-investment entity “may, when applying the equity method, retain the fair value measurement applied by that investment entity associate or joint venture to the (investment entity’s) interests in subsidiaries.” But again, if the investment entity isn’t measuring such interests at fair value anyway, there can’t be much practical difficulty or cost entailed in requiring that a significant-influence investor should follow the usual equity accounting procedures.
The irony, though, is that as we’ve addressed before, equity accounting doesn’t seem to carry much conceptual validity – how is an asset carrying value determined by equity accounting more meaningful or easier to relate to than its fair value? – making it hard to care in this kind of situation about protecting the integrity of it. Of course, if the fair value measurements applied by the investor weren’t reliable, as ESMA implies, then that’s a problem in itself. But if they were reliable, then wasn’t the issuer’s accounting policy basically better than what the enforcer imposed on it…?
The opinions expressed are solely those of the author