The New ED Proposal deliberately avoids fundamental issues of what exactly is significant influence and whether the equity method is a measurement basis or a one-line consolidation. However, the key issue that should have been addressed is why a fair value model, which is more relevant to investors, is not adopted for associates. A preferable alternative solution is that a fair value measurement for investments in listed associates should be required, while it will be optional for non-listed associates. This will enable investors to measure investments in associates at fair value through OCI, while dividends are recognized in profit or loss, thus avoiding market price fluctuations.
In September 2024 the IASB published the Exposure Draft Equity Method of Accounting, aiming to address application issues raised by stakeholders in particular circumstances. The proposed amendments include requiring an investor to recognize and measure contingent consideration at fair value, recognize its previously held equity interest at fair value when obtaining significant influence and recognize in full gains and losses resulting from all upstream and downstream transactions with its associates.
Although the proposals are expected to reduce diversity in practice and lead to more comparable information for users of financial statements, the massive elephants are intentionally still in the room – how to assess when significant influence exists and whether the equity method is a measurement basis, as evidenced by not restricting gains or losses for transactions with associates, or is it a “light” control concept leading to a one-line consolidation, as evidenced by the recognition of goodwill or a bargain purchase gain on obtaining significant influence. Those issues were deliberately excluded from the scope of the project, due to time constraints and standard setting priority.
Moreover, consistent with avoiding the enormous elephants, the proposals do not deal with the issue of transaction costs incurred on obtaining significant influence or purchasing an additional interest in the associate – are those costs recognized in profit or loss, analogizing to IFRS 3 as would be expected under the “light” control concept, or are they included, under the measurement basis view, as part of the carrying amount of the investment, similar to the accounting for transaction costs arising on the purchase of PPE?
To illustrate the inconsistencies of the equity method, assume an investor is interested in purchasing 40% of an asset, e.g. investment property. If an undivided interest in the asset is purchased directly, transaction costs would be capitalized, but the accounting treatment of contingent consideration will remain unresolved. In contrast, if alternatively, the asset is placed in a shell company and the investor purchases 40% of its shares, contingent consideration will be measured at fair value under the proposals, while the issue of transaction costs remains open.
Indeed, those issues are crucial, but the fundamental question not dealt with in the proposals is why a fair value model is not adopted for associates. Under IFRS 9, investments in shares are generally measured at fair value through profit or loss. However, an entity may elect at initial recognition to present subsequent changes in the fair value in other comprehensive income (OCI). In that case, dividends from that investment are recognized in profit or loss.
Thus, in a world where investments in shares with no significant influence are measured at fair value, regardless of whether they have a quoted market price, the key issue is how is it possible when significant influence exists that the equity method provides more relevant information for users of financial statements?
Moreover, where the associates are listed, and a quoted market price (Level 1 in the fair value hierarchy) is necessarily available, there is no logic in retaining the requirement to use the equity method to account for such associates, which notably provides less relevant information.
Indeed, under US GAAP an investor may elect to apply the fair value option, where investments in associates are measured at fair value through profit or loss, rather than applying the equity method. Furthermore, it is common for holding companies that invest in listed investees to voluntarily provide the net asset value (NAV) based on quoted market prices of subsidiaries and associates, as part of the Directors’ Report. This voluntary reporting indicates that the relevant information investors seek is current market-based data, rather than the data included in the financial statements under the equity method.
Measurement of investments in associates at fair value would resolve another fundamental question not dealt with in the proposals – what exactly is significant influence? Significant influence is defined as the power to participate in the financial and operating policy decisions of the investee, but the term participation is not defined. While the terms “control” and “joint control” are clearly defined, significant influence is often based in practice on the presumption of the investor holding 20% or more of the voting power of the investee, which is not consistent with principle-based guidance. To illustrate, assume “a loss” of significant influence occurs due to a decrease in the voting power from 22% to 14%. In this case, a gain would be recognized as if the whole investment of 22% were disposed of and the remaining investment were remeasured to fair value, although there was no substantive change in the power to participate in the decisions of the investee.
A Proposed Alternative Solution – the Fair Value Measurement
Given the above distortions, we believe a fair value model for investments in listed associates should be required, while it will be optional for non-listed associates. Under IFRS 9, fair value changes are generally presented in profit or loss, but an election can be made to present those changes in OCI while dividends are recognized in profit or loss.
Under the fair value model for associates, there will be no need to assess whether there is any objective evidence of impairment. In addition, investors would not be required to address the theoretical controversy regarding the distinction between the fair value of the associate and its value in use, for determining the recoverable amount. Furthermore, from a cost-benefit perspective, the fair value model is undeniably preferable.
To illustrate, assume Company A holds 20% of the shares of Company B, a listed technology company, since the establishment of Company B. Company B’s equity as of December 31, 2023, is $100 million, the net profit (loss) of Company B in 2024 and 2025 is a loss of $20 million and a profit of $50 million, respectively, and it distributed a dividend of $30 million in 2025. The market value of Company B at the end of 2023 and 2024 is $500 million and $400 million, respectively. For simplicity, assume that Company A’s activity includes only its investment in Company B, and ROE is based on the opening balance of the equity.
Ignoring tax effects, the following is a comparison between the two models for treating the investment in Company B in Company A’s financial statements for 2024 and 2025:
The above simple analysis reveals the enormous distortion created by the current guidance in IAS 28 in terms of the return on equity presented to Company A’s investors.
There is no doubt that the existing IFRS 9 model, although criticized, can serve as an appropriate solution. On the one hand, it will reflect the fair value of the investment and lead to a more relevant statement of financial position. It will thus eliminate the distortion under the equity method of non-recognition of intangible assets developed by the associate, given the new IASB project on intangible assets. On the other hand, it will enable the investor to recognize dividends in profit or loss, while avoiding volatility in the income statement, which is a significant deterrence for companies to adopt the fair value model. In addition, there will be no need to perform a PPA for each acquired layer, or to record the reversal of fair value adjustments.
Advantage for Investments in Startups
From another important perspective and despite common perception, the proposed alternative model is even more stable than the existing equity method in terms of the investor’s net profit, as it “absorbs” its share of losses of the associate through OCI (as can be clearly seen in the example above). Income statement stability is a very important element for management and will therefore greatly assist in the acceptance of the new model. Moreover, this is a great advantage in case the investee is a startup, recording large R&D expenses, and the investor is not a venture capital company (since IAS 28 currently permits VC companies to avoid using the equity method). With each dollar of R&D expense that is recognized, the fair value of the investment generally increases, while it is carrying amount under the equity method necessarily decreases. This gap illustrates the contrast between the two accounting alternatives in terms of relevance to investors.
This fair value through OCI solution, which avoids the recognition in profit or loss of negative changes in fair value, can be more advantageous to IFRS preparers over the alternative US model, which restricts the fair value option to only fair value through profit and loss, and thus greatly deters management who wish to avoid recognizing the effects of stock market fluctuations in the income statement.
(*) Written by Shlomi Shuv