The underlying rationale and conceptual basis for the equity method of accounting for investments in associates is unclear. Equity accounting can be regarded as either the cost-based measurement of an investment or as a quasi (one-line) form of consolidation – but neither is particularly helpful for investors.
We explain the limitations of the equity method and advocate measuring all investments in associates at fair value, consistent with other minority equity holdings. This results in a more relevant basis for investors to include investments in associates in their analysis and valuation.
Last year we commented on the impairment of investments in associates under IFRS, and how French media company Vivendi reported their investment in Telecom Italia in their 2021 financial statements. Vivendi applied equity accounting to its investment and wrote down (impaired) the balance sheet value because the ‘recoverable amount’ was assessed to be less than the amount reported under equity accounting. Under IFRS, this write-down is to the higher of value-in-use and fair value.
In our article ‘Associate impairments may not reflect underlying economics’ we argued that the value-in-use measure (which, it seems, is invariably higher than fair value in practice) does not provide investors with relevant information. The chart below is taken from that earlier article and shows the evolution of the carrying value of the investment in Telecom Italia. The 2022 data is from the interim half-year report.
Vivendi investment in Telecom Italia
Vivendi financial statements 2015-22 and The Footnotes Analyst
Vivendi continued to apply equity accounting for the investment in Telecom Italia during the second half of 2022. However, on 31 December that year they reclassified the holding as an equity investment reported at fair value, with the carrying value written down to €787m, and an additional ‘reclassification’ loss (the change in carrying value due to the change in measurement basis) of €1,078m being recognised.
Vivendi previously classified its investment in Telecom Italia as an associate because it believed it had ‘significant influence’ over the company, the classification basis specified in IAS 28 (US GAAP is the same). Significant influence is presumed when the shareholding represents at least 20% of the voting equity of the investee. Vivendi’s holding was (and still is) an ownership interest of 17.0%, but a voting interest of 23.8% which, combined with two Vivendi representatives on Telecom Italia’s board of directors, meant that Vivendi considered (and the auditors agreed) that the significant influence threshold was met.
However, at 31 December 2022 both of these nominee directors resigned, which resulted in the reassessment of the investment, and its reclassification in the financial statements to an investment is reported at fair value.
Vivendi has elected to report these fair value changes in Other Comprehensive Income (OCI), as permitted under IFRS 9, rather than the default profit and loss. We do not support the FVOCI approach and believe it lacks transparency compared with the alternative of recognising fair value changes in profit and loss. Interestingly, under US GAAP the use of FVOCI for equity investments is not permitted.
The accounting by Vivendi, and the changes reported in 2022, prompted us to consider some interesting financial reporting questions and how these issues affect investors:
- What exactly does equity accounting seek to represent and what is the conceptual basis for this accounting method?
- Is equity accounting useful as an accounting method applied to a subset of minority equity investments? Does this provide investors more relevant information compared with reporting all (non-consolidated) equity investments at fair value?
- Does the change in the level of influence due to, for example, cessation of board representation really justify such a big change in accounting from the equity method to fair value? The concept of significant influence is, at best, somewhat vague. Notwithstanding the presumptive 20% threshold, we wonder how comparable the classification of equity investments as associates is in practice.
The equity method of accounting for investments classified as associates and joint ventures1Our focus in this article is primarily on associates. is a confusing form of financial reporting. It seems to us that some investors appear to struggle with the recognition, measurement and presentation of investments in associates in financial statements.
On the face of it, equity accounting seems straightforward; the investment is initially reported at the purchase price, which is subsequently increased by the investor’s share of changes in equity, primarily the share of retained earnings. The income statement of the investor includes the share of earnings of the associate with the cash dividends received captured in the cash flow statement.
However, in practice, equity accounting can be complex, with many unresolved application questions and some diversity in practice. The IASB is presently reviewing many of these issues and plans to propose amendments to IFRS as a result – we discuss some below. We think that many of these problems stem from the uncertain conceptual basis for equity accounting. The approach can either be regarded as a type of measurement basis for an equity investment or as a form of quasi (one-line) consolidation. Neither US GAAP or IFRS clearly states which applies, and from that stems the confusion for accountants as well as investors.
Although we appreciate that resolving practical issues in applying equity accounting will improve comparability (and hopefully the relevance) of financial statement data, we think that there needs to be a more fundamental review of this accounting method and whether it remains fit for purpose.
Equity accounting has been around in accounting standards in its current form since 19712In 1971 the UK issued SSAP 1 and the US issued APB 18, both of which were influential in the subsequent development of similar requirements in other jurisdictions, including IFRS and EU legislation. Since then, the fundamentals of equity accounting have not significantly changed. The use of equity accounting actually goes back much further and even predates full consolidation in some jurisdictions. However, it was 1971 that saw the introduction of the 20% significant influence test that forms the basis for the application of equity accounting today. For an excellent analysis of the global history of equity accounting we recommend the paper ‘An Analysis of the International Development of the Equity Method’ by Chris Nobes., a time that pre-dates many important developments in financial reporting, particularly the more widespread use of fair value to measure financial instruments. Perhaps it is time for a re-think?
Equity accounting viewed as a cost-based measurement for an investment
Equity accounting is applied to investments in the equity of other companies that do not represent subsidiaries, but for which the investor either has significant influence over the investee (called an associate) or the investor is a party to a joint venture. The common link is the influence over the strategic and operational decision making at the investee – in other words it is invariably more than just a passive investment.
Sometimes the influence is simply due to the size of the holding; there is a presumption that holding more than 20% of the voting equity gives significant influence. Sometimes other factors result in significant influence, such as contractual links or representation on the board of directors, even though the 20% threshold is not met. In the case of joint ventures, the joint venture agreement will provide for joint decision making.
However, the equity holding for which equity accounting is applied is still just an investment, it is not part of the group of companies under the control of the ultimate parent. Associates are not part of the group ‘single economic entity’, even where there may be a close relationship between the investor and the associate.
Since the balance sheet value of an associate is updated each period, you may think that it is some form of current value. This is not the case. At initial recognition the investment is reported at cost (the purchase price). This is split into the share of the underlying net assets of the associate plus a balancing notional goodwill figure (a split explained by the ‘one-line’ consolidation view we consider below), but the total is simply the purchase price.
In subsequent periods the original cost is increased to reflect the investor’s share of profit retained by the associate and the share of other movements in equity, such as gains or losses reported in OCI. However, this increase (or reduction) can be regarded as, in substance, the cost of a further investment made in the associate, which simply adds to the original price paid. If the associate distributes only part of the profit earned (and the balance sheet value rises) this is economically the same as fully distributing all earnings, with the investor reinvesting part of that dividend into the associate.
The ‘theoretical dividend plus reinvestment adjustment to cost’ is not the usual way in which the cost of equity investments is regarded, but it makes sense economically. Updating cost to reflect profit retained may make that cost slightly more relevant than not doing so, but fundamentally the measurement basis is still a form of historical cost and definitely not a current value.
Under equity accounting the carrying value of the investment is written down if it is assessed to have been impaired. This means that, when viewed as a measurement basis, equity accounting is actually the lower of cost and the estimated recoverable amount.
The problem for investors is that measuring equity investments at cost is not very useful for those seeking to understand the contribution of associates to the overall value of the investor company. Value changes for equity investments are frequent and can be substantial; cost-based measurement will therefore often quickly become out of date. While the cost of associates is updated on the downside due to impairments, this is often limited and lacks transparency. Furthermore, recognising negative value changes are not much help if there is no updating (or even disclosure in many cases) on the upside.
It seems odd to us that investments in associates are measured (essentially) at cost, whereas smaller minority equity investments are reported at fair value. We think that investors require up-to-date and relevant measurement of all equity investments, including associates – in other words, fair value. We do not think that the somewhat nebulous concept of ‘significant influence’ justifies such a very different approach to measurement.
But maybe the application of equity accounting can be explained by the alternative view of the method – as a form of quasi one-line consolidation. Perhaps the additional information obtained from this perspective overrides the disadvantage of measurement (effectively) at cost.
Equity accounting viewed as one-line consolidation
The alternative view of equity accounting is that it represents a modified form of consolidation that, in many respects, is the same as the accounting applied to subsidiaries. The key difference is that under equity accounting the balance sheet and income statement effects are summarised in one line instead of the line-by-line full consolidation. Nevertheless, the carrying value of the associate in the balance sheet and the income reported in profit and loss are effectively the same as the net (after non-controlling interests) contribution to shareholders’ equity and earnings attributable to the parent company shareholders if full consolidation were applied.
Equity accounting however, is more complex than simply recognising the share of net assets and earnings. For example, the method also includes the same adjustments that are applied to consolidated subsidiaries, such as fair value adjustments at the time of acquisition and the elimination of unrealised profits.
Fair value adjustments for associates
When a business is acquired, and control first obtained, the assets and liabilities of the new subsidiary are measured at fair value for inclusion in the consolidated balance sheet and to measure the residual ‘goodwill’ amount. The reason for this purchase price allocation process is that, from the perspective of the group, the individual assets and liabilities are ‘acquired’ at this point, and fair value represents their purchase price3For more about the calculation of goodwill, and how goodwill is accounted for, see our article ‘Goodwill accounting – Investors need something different’..
The same fair value adjustments are applied in equity accounting, except that they are not as obvious because the assets and liabilities that are adjusted do not separately appear in the consolidated balance sheet of the investor. The main impact is on the share of profit recognised in the income statement. For example, the fair value exercise for associates may include the (notional) recognition of intangible assets that are not part of the associate’s own balance sheet. This would result in a change in amortisation and a difference between the income reported under equity accounting by the investor company compared with the share of profit actually reported by the investee in its own financial statements.
The highlighted text in the note below shows that an amortisation adjustment of €60m was applied by Vivendi to its share of net earnings of Telecom Italia when applying equity accounting.4The disclosure we highlight is from 2021 – we think the same adjustment would have been applied in 2022 but could not find any disclosure. This may be because the equity method ceased to apply at the end of that year or because the other equity accounting adjustments (notably the write-down to fair value when the investment was reclassified) were large and rendered this amortisation adjustment immaterial to the overall assessment of group performance. In this case the adjustment turned a share of Telecom Italia profit into a loss.
Vivendi equity method disclosures and Telecom Italia amortisation adjustment
Extracts from note 14.2 of Vivendi 2021 financial statements
Unrealised profit elimination for associates
Under full consolidation, the parent and subsidiary are regarded as a single economic entity. This means that a transaction between the separate legal entities are merely internal transfers from the group perspective. Such transactions, and any related profit reported in the separate financial statements, are eliminated in the consolidated financial statements.
Similar adjustments to eliminate ‘unrealised’ profits are made in respect of a sale of assets between a group and its associates. The adjustment is for that portion of the profit that relates to the investors’ interest in the associate. For example, if a sale of assets is made by a group company to a 30% associate, then 30% of the profit is eliminated from the consolidated financial statements until such time as the asset in question is sold (or consumed) by the associate, at which time the effect is reversed and the (deferred) profit recognised.
Does one-line consolidation make sense?
The problem with equity accounting viewed as one-line consolidation is that the investor does not control the underlying business, does not have access to underlying assets and liabilities, and does not have access to any profit earned or cash flow generated, unless the investee chooses to pay a dividend. While the investor may have influence, it controls nothing.
Both the fair value adjustments when an acquired business is first consolidated, and the subsequent adjustments in respect of intra-group transactions, make a lot of sense for controlled subsidiaries. But do they make sense for associates?
The individual assets and liabilities of an associate and the goodwill difference between the purchase price and the value of the underlying individual items are not presented separately under equity accounting; so what is the purpose of these fair value adjustments? In our view, they add complexity to financial reporting and are of little benefit to financial statement users. Furthermore, because the associate is not part of the single economic entity, profits arising from transactions between the group and associates are, in effect, realised. Why, in that case, eliminate these gains?
Limited information a challenge for investors
From an investor perspective, using the ‘one-line consolidation’ information provided by equity accounting is challenging. There is limited information contained in the share of profit and share of net assets (plus goodwill). Without additional data about the composition of that profit, the influence of unusual items, intangible amortisation arising from the notional purchase price allocation, operating margins, leverage, etc., it is difficult to get a good assessment of the performance of the investment in associates.
Companies that apply equity accounting are required to present separate summarised financial statements of their material associates but, in our view, these are generally too summarised to be of much use. The Vivendi disclosure related to Telecom Italia, of which we show the summarised income statement disclosure above, is a good illustration – we do not think this is enough. The income statement data essentially comprises just three metrics, with one of these being a non-GAAP measure for which there is no explanation of the adjustments applied. If an investor really wanted to dig deeper into the financials of these investments, it would be necessary to resort to the full financial statements of each company, with the equity accounting disclosures being of little help.
IASB proposed changes to equity accounting
The IASB is currently considering several changes to the application of equity accounting. The main aim seems to be to improve comparability, which we welcome. Details of the proposals are here.
None of the proposed changes affect the fundamentals of the equity method, nor is there any resolution to the question of whether the equity method is a measurement basis or a form of quasi one-line consolidation. Indeed, one could argue that the changes add to the confusion, with some proposed changes consistent with the quasi one-line consolidation view, and others not.
For example, the IASB proposes to introduce (clarify) a requirement to recognise (notional) deferred tax in respect of the (notional) fair value adjustments applied to the associate at the time of acquisition, which mirrors the adjustments applied in full consolidation. However, there is also a proposal to remove the requirement that ‘unrealised’ gains on transactions between the investor and the associate be eliminated, which is inconsistent with full consolidation.
Is it time to move on from equity accounting?
We do not think that equity accounting as applied to associates is useful for investors5Accounting for joint ventures may be a different story – perhaps a topic for another time.. As a measurement basis, it represents a form of cost accounting which is just not suited to equity investments, as evidenced by the lack of cost accounting for similar assets in IFRS 9 Financial Instruments. As a form of one-line consolidation, we think that the approach is conceptually confused, and lacks sufficient detail to offer much insight for investors.
Our preference would be to replace equity accounting with fair value measurement. We also think that changes in fair value should be reported in profit and loss,6For a discussion of our dislike of using OCI to report the change in value of equity investments, see our article ‘Ignore this recycled profit’. albeit with clear disaggregation of value changes from other profits and, particularly, from operating flows.
Fair value measurement is also consistent with how associates are generally included equity valuation. The enterprise value used in EV multiples is generally stated net of the fair value of associates and other ‘non-core’ assets. In discounted cash flow analysis, the profit and cash flow effects of associates are excluded from the flows used to determine an operating enterprise value, with the fair value of the associates separately added in the EV to equity value bridge.
We explain more about the composition of enterprise value in our article ‘Enterprise Value – Calculation and Miscalculation’.
In our view, investors are better off ignoring the equity accounting in financial statements and using either the disclosed fair value for these investments (which must be provided for listed associates) or estimating that fair value based upon the information given about the associates or, if particularly significant, through further analysis of the investee companies themselves.
Vivendi and fair values
Vivendi is effectively two businesses – a media and entertainment operating business for which the usual flow-based metrics (and predominantly historical cost accounting measurement) apply, and an investment fund holding minority equity stakes in other companies. We think the investments should be accounted for like any other investment fund – fair value measurement with the fair value gains and losses for the period transparently reported in profit and loss, and not artificially split between profit and loss and OCI.
We have estimated what the Vivendi financial statements would look like if associates were reported at fair value and all fair value changes were reported in profit and loss (i.e. no use of OCI).
Vivendi – As reported versus all equity investments at fair value
Vivendi financial statements 2020-22 and The Footnotes Analyst estimates
(1) Fair value data for the investments in associates are our estimates. We are not at all confident the figures above are accurate, particularly the fair value changes we show in profit and loss. We include them here to at least illustrate what a fair value through profit and loss approach would look like, even though the actual figures are unreliable.. Our main challenge was that, while balance sheet date fair values are given for listed associates, there is no ‘roll-forward’ provided for these figures, which makes it very difficult to differentiate the effects of changes in carrying value due to purchases, sales and reclassifications from the actual fair value changes in each period. We also had to assume the equity accounting value approximated fair value for other non-listed associates.
(2) Vivendi actually reports its associates in two lines where they differentiate between “operational” and “non- operational” investments – we commented on this approach here.
In the ‘as reported’ data above the results for equity investments are a confusing and complex mix of equity accounting and fair value, with some components of the overall return recognised in profit and loss and others in OCI. We do not think that any one of these figures by themselves have much relevance and the total certainly does not, not least because the ‘reclassification loss’ has nothing to do with actual economic changes in the year.
In our view, what really matters for investors is the value of this investment portfolio and the change in value during the year. Not only is this information more relevant for investment decisions, but it is far less complex and easier to understand. Investors can try and produce this data themselves, but, as we explain above, doing this accurately based on current disclosures is virtually impossible.
Insights for investors
- Equity accounting has limited merit as a measurement basis for investments. The balance sheet value is unlikely to reflect the investment fair value, and reported impairments are unlikely to reflect changes in that value.
- Equity accounting can be viewed as a form of one-line consolidation. However, the information provided in the group financial statements is limited and the conceptual basis for the accounting is questionable.
- Watch out for the impact of fair value adjustments applied when associates are acquired. If you wish to adjust intangible amortisation in respect of acquired intangibles, you may find that similar adjustments are necessary for associates.
- We think that measuring all non-controlled equity investments, including associates, at fair value (with changes in value reported in profit and loss) is most useful for investors.