Exceptionally unreasonable, or: more issues in equity accounting

One hundred academics and non-academics recently met in Sydney, Australia, for the 2018 IASB Research Forum, to discuss some of the latest research into financial reporting matters.

The Forum is organized annually by the IASB in collaboration with an academic journal to create a platform for presentations and discussions of new accounting research of relevance to the IASB’s work. Here’s the abstract of one of the works presented and discussed:  Equity Financial Assets: A Tool for Earnings Management – A Case Study of the Youngor Group

  • With China’s adoption of principal-based international accounting standards, companies now have discretion in how to account for the initial measurement, sale, and subsequent reclassifications of financial assets, providing room for earnings management. We use Youngor as a case study to illustrate how earnings were managed to exploit this discretion. We document that the company re-classifies its available-for-sale (AFS) assets as long-term equity investments to decrease the volatility of the company’s apparent profits. We also make some predictions regarding how the company will handle its financial assets under the new standards. Our research contributes to the continuous improvement of China’s accounting standards and helps regulators better supervise and govern the capital market.

There’s a lot of meat in this paper, but for now I’ll just pick out two items:

  • On January 21, 2014, Youngor released a statement titled Announcement on Changing the Accounting Methods of Ningbo Bank Co., Ltd. According to the announcement, the company will adjust the accounting method for its investment in Bank of Ningbo Co., Ltd. (Ningbo Bank hereafter) beginning January 1, 2014, changing the original available-for-sale classification to long-term equity investments. The reason for this adjustment was that Youngor held a total of 10.10% of Ningbo Bank’s outstanding shares, being the third largest shareholder of Ningbo Bank. After Ningbo Bank changed its board of directors, Youngor’s president Hanqiong Li became one of Ningbo Bank’s eight directors. Youngor, therefore, is considered to have a significant influence over Ningbo Bank…
  • On April 8, 2016, Youngor issued an Announcement on Changes to the Accounting Methods of Ningbo Yak Technology Industrial Co., Ltd., stating that Youngor will adjust the accounting treatment of Ningbo Yak Technology Industrial Co., Ltd. (Ningbo Yak hereafter) beginning on March 17, 2016. The accounting treatment would change from long-term equity investment to available-for-sale financial assets. The reason for the adjustment is that Youngor’s shareholding ratio after Ningbo Yak had completed an asset restructuring was reduced from 30.08% to 13.18%, causing Youngor to drop from the first to the second largest shareholder. Additionally, the number of recommended Youngor directors decreased from two to one, and Ningbo Yak added two additional outside directors to form a nine-member board. Consequently, Youngor’s percentage of seats held at Ningbo Yak’s board decreased…
  • Compared to Ningbo Bank, Youngor’s proportion of board seats at Ningbo Yak is smaller, but the proportion of shareholding is larger. Therefore, Youngor’s decision to change the accounting treatment of Ningbo Bank from available-for-sale assets to long-term equity while changing the accounting treatment of Ningbo Yak from long-term equity to available-for sale assets seems exceptionally unreasonable…

Or rather amusingly brazen. Of course, we should acknowledge that the two things aren’t necessarily irreconcilable. IAS 28 states that if an entity holds less than 20 per cent of the voting power of the investee, it’s presumed that it doesn’t have significant influence unless such influence can be clearly demonstrated. It cites representation on the investee’s board of directors as one of the ways in which significant influence is usually evidenced, but doesn’t address what level of representation would be sufficient to evidence this; it also allows that circumstances exist where significant influence might exist in its absence (for example, perhaps, through other means of participating in policy-making processes). It follows that a stated level of shareholding might be sufficient to provide significant influence in particular circumstances, even where a higher level fails to do so in others. But of course, it also follows that an entity might play games for the purpose of managing earnings, or achieving some other desired effect.

What this really shows up is the weakness of equity accounting, a topic to which it’s fun to return every year or so (here for instance). Even if you think it’s useful to identify entities over which “significant influence” exists, I don’t believe the IASB has ever persuasively addressed why fair value wouldn’t still constitute a more relevant measurement basis for them (especially given the pile of finicky application questions that have to be addressed in making equity accounting “work”). 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 really, at this point, this part of the accounting model looks like a relic.

More to come on this research paper…

The opinions expressed are solely those of the author

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