How The Equity Method Can Result in Better Financial Performance?

Firstly, the accounting standard that governs the investment in associates is IAS 28. Associates are defined as entities that Parent Company has significant influence. The key word is influence because the company can have substantial ownership but fails to exercise influence over the company. The ‘general rule’ is when a firm is controlling 20%, or more of another entity is deemed to be an associate. One example that I can think of is if you control 20% of the company but one single owner controls 80%, it might be hard to exercise significant influence when the another company is apparently controlling it.

This article discusses the usage of equity method (which is the accounting method for associates) and how we can use judgment to analyze companies. Before we start, it must be noted that it will not cover the accounting treatments and standards hence these two articles are selected for readers that want a basic understanding of equity method and investment in associates.

http://www.iasplus.com/en-gb/standards/ias/ias28

http://macabacus.com/accounting/equity-method

Our case study will be based on one of the largest technology companies with market capitalization more than RM 300 billion (as of October 2016). What makes this interesting is that it owns over 30% of another technology company which it started to invest during the start-up phase for a small amount. After more than a decade, the value of the acquired company surged significantly and became one of the largest Internet companies in Asia. Eventually, the company’s investment paid off. The information discussed in this article is obtainable through public sources. However, we would like the company to remain anonymous.

1

The current equity stake of over 30%, by default, gave the company significant influence on the associate. Hence, it uses Equity Method to treat associate’s financial results. The key thing is that the company is relatively small compared to the associate which resulted in the majority of the earnings recognized in the account which has nothing to do with its core business operations. We will be assessing the implications of the equity method in financial analysis.

2

We start our analysis with the consolidated income statement. The first thing we look at is the net profit margin (without making any adjustments) which is around 17% (1,001 / 5,930). 17% is considered above average in our opinion. When you dig deeper, you might have noticed that the company registered an operating loss of $117m and there is an item called share of equity-accounted results (consists of earnings contributed by a number of business entities which the company has no control over). Earning contribution from associates, for instance, is recognized under this item which ‘enhanced the performance,

If we pause for a second, you may notice that the results only show the earnings rather than both the revenue and earnings. By ignoring the revenue, effectively we are increasing the numerator while holding the denominator unchanged. To demonstrate our points, we will see how the company derives its revenue:

3

The breakdown of income shows that the entity it acquired contributes almost $5.4b in revenue to the firm, the largest ‘revenue’ contributor. However, they also deduct the income from equity-accounted investments. Nearly half of the income reduced instantly from $12b to $6b because they do not need to recognize the revenue in the income statement.

4

Assume we have recognized the revenue in the income statement instead of ignoring it (scenario 1), the net profit margin will reduce considerably. From almost 17% to 8% holding everything constant. Of course, this is only to illustrate, the 8% profit margin is based on many products which we would not be able to determine whether 8% is overperforming or underperforming the peers. Some segments might have lesser profit than other segments hence we need to compare it with the relevant peers to conclude the performance.

5

Looking at the cash flow statement, the cash generated from operating activities is $454m against the net profit of $1,001m. So what is causing the significant difference?

6

The breakdown of cash from operations indicates that much operating profit was ‘vanished’ due to the profit from these business entities do not truly contribute cash inflow to the firm. For example, you own 30% of a company that earns RM100 and you entitled to RM30 earnings. Indeed, you will recognize RM30 as your income, but it does not belong to you unless it pays you, in the form of dividend usually.

 

So let us revise what IFRS says about the treatments:

“Under the equity method, the investment in an associate is initially recognised at cost and the carrying amount is increased or decreased to recognised the investor’s share of the profit or loss of the investee after the date of acquisition. The investor’s share of the profit or loss of the investee is recognised in the investor’s profit or loss. Distribution received from an investee reduce the carrying amount of the investment. Adjustments to the carrying amount may also be necessary for changes in the investor’s proportionate interest in the investee arising from changes in the investee’s other comprehensive income. Such changes include those arising from revaluation of property, plant and equipment and from foreign exchange translation differences. The investor’s share of those changes is recognised in other comprehensive income of the investor” IAS 28, paragraph 11.

 

Under the indirect method, the net cash flow from operating activities is determined by adjusting profit or loss for the effects of:

  1. a) changes during the period in inventories and operating receivables and payables;
  2. b) non-cash items such as depreciation, provisions, deferred taxes, unrealised foreign currency gains and losses, undistributed profits of associates, and non-controlling interests; and
  3. c) all other items for which the cash effects are investing or financing cash flow.” IAS 7, paragrah 20.

 

“When accounting for an investment in an associate or a subsidiary accounted for by use of the equity or cost method, an investor restricts its reporting in the statement of cash flow to the cash flows between itself and the investee, for example, to dividends and advances.” IAS 7, paragraph 37.

 

Essentially, it does not disuss about recognizing the revenue in the income statement. It only states that the investor’s share of the profit or loss is recognised in the income statement and distribution must reduce the carrying amount to avoid double counting.

IAS 7 relates to statement of cash flow requires the company to adjust for undistributed profits of associates hence while the restrict its reporting to the cash flows to dividends and advances. The company cannot report earnings with no visible cash inflow (usually in the form of dividend distribution).

 

Summary

Hopefully, we can use this example to demonstrate how equity method can enhance the profitability and its impact on the cash flow. If the associates are large enough, it will make the profit margins appear to be more lucrative than the reality. This is because the equity method only recognizes the second half of the equation but ignores the first half (the revenue). For analysis purposes, one must be aware that different method will result in different financial performance which do not necessary mean the company with lower profit margin is underperforming. Additional analysis is required to determine the relative performance. For those who are interested to study more, the relevant CFA book to look at is CFA level II, Volume 2, Reading 17.

 

Contributor: Jackson Yuen

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