Measurement of Financial Assets and Financial Liabilities
By Ryan Siebel, Partner, Assurance Services
The Financial Accounting Standards Board issued a new accounting rule that will significantly change the way both large and small companies account for their equity investments in other companies, particularly those that amount to stakes of less than 20 percent. “Financial Instruments—Overall: Recognition and Measurement of Financial Assets and Financial Liabilities,” (ASU 2016-01) is set to go into effect Dec. 15, 2017, and that deadline has many companies rushing to comply.
This rule is meant to offer investors and creditors with better information by providing greater clarity regarding a company’s financial statements. Despite the noble-sounding intentions, the net outcome of the new rules could actually distort the way a company making an investment reports its subsequent earnings.
Currently, when a company buys a stake of less than 20 percent in another company it accounts for the investment on its balance sheet at cost. In other words, what’s accounted for is the price paid for the ownership interest. Over time, if the value of the investment declines, then a corresponding write-down of the value, both through the company’s income statement and its balance sheet, follows. If the value increases, the investment could be kept at cost.
The implication is that investors are fully informed when an investment loses value, but there is less transparency when an investment increases in value. The logic applied to this situation was meant to account for the challenge in placing numbers on often difficult-to-value investments each quarter.
After Dec. 15, each minority investment a public company makes will need to be valued quarterly, whether the value has increased or decreased. Any potential volatility will need to flow through a company’s income statement, with the possibility of causing fluctuations to earnings per share from something that is not even a core business. Corporate executives will have two choices on how to approach valuing these investments:
- The investment can be valued per standard practices at the end of the quarter by the executives, an accounting firm or a valuation firm.
- The investment can be valued when there is a market-driven event, then the value of the investment is marked up or down accordingly.
How a company chooses to value an investment, either by option one or two, must be selected in advance and then cannot be changed.
One of the wrinkles in this accounting model is that any return on an investment technically has nothing to do with a company’s core business. It’s only a carrying value. Under the new rules, these investments will need to reflect market values, and any increases will flow through a possible parent company’s income statement. This can have quite a distorting effect. There could be a similarly distorting effect if the value of the stake in another company takes a tumble.
An additional complicating factor could arise if the minority stake holder values its investment one way, and the company in which it invested values it a different way.
While the new disclosures are meant to add transparency and to provide a better understanding of what outside investments are worth, the water is still a bit murky. The new rules might actually confuse investors regarding the value of these equity stakes. Executives will need to explain that fluctuations in the value of the minority investments have nothing to do with their core business and possibly suggest that they be ignored. An “adjusted net income” without these fluctuations might be the answer. Ultimately, identifying observable price changes for the investments would require new policies, processes and controls to ensure that they comply with the new standards.
If you have any questions about the new rule, or need information regarding valuations, contact Ryan Siebel, Partner, Assurance Services.