CONSOLIDATED FINANCIAL STATEMENTS VERSUS
EQUITY METHOD OF ACCOUNTING: PROVISIONS, STUDIES AND CASES
Introduction
“There is a growing practice of companies conducting parts of their business through other companies in which they have a substantial but not a controlling interest. While consolidation is not appropriate for such holdings, it is also not efficient to disclose only the cost of investment and dividend income as this would lead to misstated EPS and P/E ratios of the investing company.”
This paper analyzes the effectiveness of consolidated financial statement compared to other types of disclosure involving an investment stake in a separate business or venture. The significant part of this paper shows how equity method can surpass the characteristics of consolidated financial statements. The paper is separated into three major sub-headings; namely, provisions, empirical studies and corporate cases. There is a significant discussion about creative accounting in which the characteristics of different disclosure methods will be appraised. Creative accounting is what Enron and Worldcom corporate scandals attributed for the reason of their crash.
Provisions for Consolidated Financial Statements
Different from the requirement of equity method, consolidation is applied to a parent company that has control to the subsidiary. A parent company is created when it acquires more than fifty percent (50%) of subsidiary’s voting rights. Under consolidation, all subsidiaries of the parent company should be accounted regardless if they are operating abroad, under different industries, under long-term restriction to transfer funds and currently held for sale (IAS 27). Similar to equity method, intra-group transactions and financial adjustments of them are eliminated where as impairment loss is accounted for the affected assets (). Further, similarity is also eminent in the reporting date of the parent company and its subsidiaries. Singular accounting policies must also be followed when consolidating financial statements. If the share of minority interests on losses exceeds their equity, the Group should absorb them.
Consolidated accounting is a method applied by an investor to a subsidiary wherein all the activities of the latter and the activities of the former are reflected in a summarized form (). This form of disclosure allows users to view the entire performance of the group instead of the investor or the subsidiary alone. As a general rule, whole is greater than its parts which mean that the users can best use the information when consolidation is used. When a company already retains control to a subsidiary, consolidated financial statements is the primary information database in which performance of the two companies are evaluated by the users.
Provisions for Equity Method of Accounting
Substantial influence takes place when an investing company holds at least twenty percent (20%) of the voting power in the subsidiary (IAS 28). When an investing company has substantial influence in a subsidiary it does not necessarily mean that it has the control of the latter. It is not the parent of the subsidiary as there can be several other significant investors. In this stance, the investing company has the power to participate in the transactions and policies pertaining to the financial and operating aspects of the subsidiary. Accounting for subsidiaries under this condition should be applied with equity method of accounting.
According to accounting standards, an ownership interest in a subsidiary or associate should be recognized at acquisition value including additions or reductions against the original investment to reflect the carrying amount of the inventor’s share of profits and losses (AASB). In this condition, it is clear that equity method of accounting is useful. There is, however, a provision that the carrying amount of the investment must not exceed its recoverable value. In extreme cases, equity method must be withdrawn when the investment of the investor in the subsidiary is bound to be reduced to zero through deductions of losses and in reserves. In addition, equity method must be discontinued when the subsidiary or subsidiary declines to continue association with the investor.
There are three exceptional cases when equity method of accounting should not be used in presenting financial statements ( 1993). First, when the investment is bound to be disposed within twelve (12) months from the date of acquisition. The changes in the fair value will be recognized directly in the profit and loss account. Second, when the parent is exempted by special provisions in preparing consolidated financial statements wherein they can prepare distinct reports attributable to the subsidiary. Third, when the following conditions are present such as the investor is a wholly-owned subsidiary, its debt and equity is not publicly traded, it did not confirm corporation to SEC and the parent company of the investor already furnished consolidated financial statements.
There are many disclosure requirements when equity method of accounting is applied (1991). The carrying amount of the investor’s investment is adjusted whenever distributions such as dividends are received. Whenever there is a positive or negative residual resulting from the acquisition, this will be accounted as share of the investor to goodwill. Unrealized profits either in downstream or upstream should be disregarded particularly in the part of the investor. In contrast, when there is evidence of asset impairment, the investor should consider unrealized losses. The date of subsidiary’s financial statements must also not exceed three months the date of investor counterpart. Ideally, they should be on the same accounting period or most recent subsidiary financial statements with adjustments reflecting the major transactions in the lagged periods. There is also need of adjustment to subsidiary’s financial statements when it deviates to the accounting policies used by the investor.
Provisions for Joint Ventures
Since joint control simply means that no individual venturer has control to the activity, it is within the context of substantial influence defined in equity method (IAS 31). Joint venture does not create a subsidiary or separate entity rather involves combination of resources from venturers. Acting as separate entities with unique set of assets, liabilities and other financials, venturers must specify their share of income and losses from the venture. Whereas combination of assets is easily reflected in the financial records of each venturer, sharing interest to give rise to joint control over an entity requires additional working. In this situation, venturers can use either proportionate consolidation or equity method.
However, these two methods are not required to be used under exceptional circumstances mentioned in equity method (IAS 31). Proportionate consolidation allows venturers to include into their reports the share of assets, liabilities and profits in the joint venture. There is an option to combine or separate similar items. Equity method is described above with emphasis that accounts should be record at cost. In the case when the venturer give or sold asset to the joint venture, gains should only be recorded in favor of other venturers while any decline in value must be recognize in its report. In the same manner when a venturer bought assets from the joint venture, gains will not be recorded until the same venturer sold it to an independent company while the venturer has to shoulder any decline in value while it holds possession of the purchased asset.
Features of Different Accounting Methods
Equity method has limited information to be offered to the users of financial statements (2003). Although proportional consolidation is available, the format of presentation is only the difference with the equity method with contents largely the same degree of limited information. Equity method provides the firm an incentive to prevent disclosure of certain assets and liabilities of subsidiaries (1996). The core lacking of equity method is to inform user’s specific activities of subsidiaries. One example of distortion is the calculating the adjusted subsidiary assets or liabilities in the investment account of the investor which can change leverage ratios of the subsidiary by overstating interest coverage ( 1995).
However, one of the strength of equity method is to separate financial statements of two companies that operates in different industries (1999). Proportionate consolidation has also its share of limitations apart from its ability to mitigate the lacking of equity method in related industries (1986). One is the recognition of subsidiary’s assets due to indirect control in operations of the parent company. There is also the absence of legal obligation accruing to the parent company when subsidiary liabilities are recorded into its books without defined guarantees (1987).
There are three kinds of equity method; namely, simple, partial and full ( 2002 ). The first refers to disclosure of parent’s investment account with the acquisition cost and share of the parent in the net income less dividends. The second refers exactly as the first but with adjustments made to accounts for any excesses/ losses in cost over book values. The third refers to adjustments of inter-company transactions which the partial version does not allow to account for unrealized profits at the date of financial report.
Creative Accounting in Corporations
Creative accounting is an earnings management that results to data manipulation and departure from the standard accounting practices (1999). It is also cited as the cause of recent business scandals of Enron and Worldcom. Usually it is attained by lengthening the life of an asset to reduce depreciation costs and designing accrual accounts to the benefit of an organization (Answers.com). As being creative, accountants entail to bypass rules and some ethics to achieve organizational or self-vested interests and goals. Their skills is dependent on the benefits of creative accounting which can result to attract new investors, receive debt, cut on taxes, defer on employee benefits and mitigating the effects of litigation. The more creative they are the more benefits that can be realized.
Creative accounting also undermines the spirit of accounting rules and principles when firms become protagonist in blaming implicit guidelines to guide action. As most policies have standardization aims, the practice is hardly discovered and sanctioned until the likes of Enron and Worldcom results. The reactive and result-based basis of regulatory bodies allows firms to build the learning curve for creative accounting unnoticed. Its adverse effects are isolated when the information is used internally, however, when it is published in the public scrutiny, it can be destructive. There can be widespread inefficient allocation of resources because investors and creditors are misled in their decisions. In addition, NGOs and the government would end up building support and infrastructures to entities that do not really needs them or acquire them through uncompetitive means (cheating). In aggregate, firms using creative accounting are provided with business as well as social relationships to continue operations within a corrupt and false rationale. This can be said a form of injustice and social disruption atypical for a firm and profession entrusted by the public to perform professional duties.
Creative accounting can be practiced through recognition of premature and fictitious revenue, aggressive capitalization and extended amortization policies, misreported assets and liabilities, getting creative with the income statement and problems cash flow reporting (). These actions are needed by the company and intended for different purposes like getting analysts sympathy especially among publicly listed companies. Big bath accounting is one form of creating accounting in which a recently taken-over company’s profits is manipulatively reduced from its original performance (1998). The purpose for this is to save the current profits to future undertakings while passing the low performance to past managers. Obviously, former employees cannot raise their cases as they left the company leaving a large room for opportunism to come in.
Another scenario is when a heavily regulated company wants to prevent political spotlight and hinder its implicit monopolistic position. It would want to avoid tax losses that make the decision for creative accounting to serve its purpose. Further, off balance sheet finance is used to reduce debts that can increase the credit rating of a company. This is commonly coupled with increasing the reported shareholders funds by reporting higher profits. As a result, debt covenant with creditors are made possible. This is utilized when the firm is in the upper level of its gearing ratio to look more lightly endowed with debts even if otherwise.
There are many ways to practice creative accounting and it depends on the skill of accountant on where the limit will be set. However, top level managers should be also cooperative in executing the manipulation. If the company wants to imply that it is very liquid, it should borrow money from the banks and should not report it and instruct efficiency measures in the entire processes. This is because when the firm is not efficient from the time of make-over such funds would only be used to sustain operations. In the contrary, cost savings can even support the claim. In view of this, creative accounting is a combination of accounting skill and managerial direction. Late Enron Chairman and CEO had his financial head Schilling to cover-up the famous corporate scandal. Without the right combination, it will not maximize its purpose and even lead to its disastrous publicity. The latter happening, however, will be hardly occur if the symptoms are not obvious enough or its effects does not lead to “too much” gains. In 2001, Schilling resigned as CEO while Lay filed for bankruptcy few months after the resignation. This serves as a sign for employees, shareholders and other business partners to seek legal investigation to give rationale to the previously industry and stock market performer.
Lastly, off-balance sheet (OBS) entities formed its part to distort share price as Enron misuse the good side of such legal provision which primarily aims to aid corporations to finance ventures ( 2002). As a result, EHM strong-form did not emerged in share price adjustment due to insider agreements within the firm (Wikipedia.com). If only Enron did not overuse the socio-economic spirit of OBS, the market may not erred in interpreting the corporation’s financial reports. In fact, OBS gave Enron high rating evaluation from rating agencies (2002). OBS entities are bounded for special purpose like access to capital and hedge risk available for Enron transforming its return on assets or ROA and leverage looks excessively profitable and “on-boom”. The company abused OBS opportunity that ultimately led to its removal and the introduction of more stringent GAAP codes and other related laws.
Conclusions
Due to accounting standards, the use of consolidated financial statements is limited to companies standing as parent firms of subsidiaries. As a result, several firms are able to apply creative accounting into their financial statements. Equity method of accounting has been proven lacking in capacity to gauge misinterpretations of investing companies even if full version is applied. In addition, joint ventures use of proportionate consolidation is also ineffective in improving the accounting practices of some companies. Profit-orientation of several large companies that are able to purchase a significant part of a separate business leads them in using accounting standards to manipulate information. This substantially impact potential and existing shareholders that are basing their decisions in financial statements particularly earning rations like EPS or P/ E ratios. Unless full consolidation is applied to parent, investing and venture companies, creative accounting can easily be considered and even tighter regulations cannot deter these actions as accounting standards are used as cloak to protect confiscation of such acts.
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