The axe: a much neglected tool for standard setting

17 February 2015

Follow Mary Dolson on twitter @MaMaDolson

This blog was inspired by PJ O’Rourke who famously said when talking about farm subsidies ‘drag the thing out behind the barn and kill it with an axe.’ I don’t have a view on farm subsidies but some things should not be allowed to evolve further or be reformed - radical action is needed.

That’s exactly how I feel about equity accounting. Should the IASB take out the axe and kill off equity accounting? Has it come to end of its useful life? Had its day in the sun? And a recent bit of standard setting by the IASB has only cemented my view.

I’ll try and explain without using foul language.

Equity accounting came into widespread use in the 1970s. The definition of ‘subsidiary’ was form driven and equity accounting was a way to capture activity that was important to the investors business but not ‘caught’ by consolidation rules.

Equity accounting applies to associates, which are investments where the company has ‘significant influence’. Significant influence means different things to different people; so it’s a judgement. My husband would probably say he has significant influence over my wardrobe (I seek and value his opinion but am not bound by it). So we are starting out with a vague and variable concept before the equity accounting even gets underway. 

Equity accounting then has an interesting measurement approach. It begins with a cost based measurement (what you spent to buy it) but then if that’s not the ‘right’ number, IAS 28 says you can record a gain for any ‘negative goodwill’ if you get a good deal or have a day one impairment loss if you overpaid (both in the income statement). And there’s the ‘notional’ purchase price allocation. This is like miniature business combination accounting except you don’t have control so you’re working from either what the company will tell you or what’s in the public domain.  You must amortise your notional PPA adjustments (see below on day 2 accounting) so it does have an impact on earnings. 

Now your investment makes some money (hurrah – earnings), you add your share to your recorded investment.  If it pays you dividends then you reduce your investment. Don’t forget to amortise your notional assets and reduce your notional liabilities (including deferred tax). But if I don’t have control then my cash flows (which my investors are interested in) can only come through dividends or through sale. What is all this other stuff I’m accounting for?

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. 

Here’s a quote from a recent IASB Update:

        The IASB tentatively decided to clarify the requirements of IFRS 10 and IAS 28 by:

a.      amending IFRS 10 to explain that, in the limited circumstances described, the cost on initial recognition of the retained investment is the fair value of that investment; and any gains or losses eliminated are a subsequent adjustment; and

b.      amending IAS 28 for circumstances in which:

  • an associate or joint venture arises from the residual interest retained following the loss of control of a subsidiary; and
  • that associate or joint venture does not include a business;

to explain that, for the purposes of the acquisition accounting required in paragraph 32 of that Standard, the cost on initial recognition of that associate or joint venture is the fair value of the investment at the date that control is lost and is determined before any elimination of the gains or losses required by paragraph 99A of IFRS 10.

Do you understand the paragraph above? Could you apply it if someone asked you to? This is where equity accounting has gotten to – they are amending an amendment that was published in December 2014. I could explain it to you (and provide an illustrative example) but I have a personal rule limiting my blog to less than 10 pages. If you really want to understand, let me know.

And 14 smart people spent time talking about this at last month’s 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.

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


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Fair value or cost.....fair value wins on relevance grounds

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