Equity accounting has been in accounting standards in its current form since 1971 (see ‘A significant year’, below), a time that pre-dates many important developments in financial reporting, particularly the more widespread use of fair value to measure financial instruments. 

While on the face of it, equity accounting seems straightforward, in practice it can be complex with many unresolved application questions and some diversity in practice. The International Accounting Standards Board is presently reviewing many of these issues and plans to propose amendments to IFRS Accounting Standards as a result, with an Exposure Draft expected in 2024. 

Many of the problems stem from the uncertain conceptual basis for equity accounting. The approach can either be regarded as a type of cost-based measurement basis for an equity investment or as a form of quasi (one-line) consolidation. 

Equity accounting viewed as a cost-based measurement for an investment

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 other comprehensive income (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. 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.

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 that investments in associates are measured (essentially) at cost, whereas smaller minority equity investments are reported at fair value. The somewhat nebulous concept of ‘significant influence’ does not seem to justify 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 group perspective of the group, the individual assets and liabilities are ‘acquired’ at this point, and fair value represents their purchase price.

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.

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. 

Does one-line consolidation make sense?

The problem with equity accounting when 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. Consolidation style adjustments make little sense where full consolidation is not applied.

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 the fair value adjustments? In our view, they add complexity and are of little benefit to 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 these are generally too summarised to be of much use. 

Is it time to move on? 

We do not think that equity accounting as applied to associates is useful for investors. 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, 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 by investors in equity valuation. The enterprise value (EV) 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 EV, with the fair value of the associates separately added in the EV to equity value bridge. 

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.

• A longer version of this article was first published on Steve Cooper’s blog, footnotesanalyst.com

Steve Cooper, Independent Analyst and former member of the International Accounting Standards Board