Current standards: equity investments are placed relatively freely in income statements

As we speak, equity accounting is mainly regulated by IAS 28 and IFRS 11, which require interests in associated companies and joint ventures to be accounted for with the equity method.

If you have ever wondered about the difference between an associate and a joint venture, here are some answers:

1. An associate is an entity over which the consolidating group exercises significant influence: the group has power over decisions relating to the entity’s financial and operational policies without, however, having control or joint control over them. Significant influence is generally considered to be exercised when the group holds between 20% and 50% of the associate's voting rights.
2. A joint venture is a company in which control is joint with one or more partners. It is usually set up for a specific purpose and for a limited periodof time.    

While the accounting rules for equity investments are clear, the presentation of business income has so far been fairly loose. As a result, a group's share in the earnings of these associates or joint ventures can often be found invarious places within the income statement:

1. Within the operating result;
2. Just before the pre-tax result;
3. Between pre-tax profit and net profit.

What's worse, these classifications may not be mutually exclusive: it is not uncommon to find two separate lines for the share of the equity income: one in the operating income and the other down stream of the income statement.

In France, some companies' operating profit nowadays include associate and joint ventures whose activity they consider to be “core business”, in line with the 2020-2021 ANC recommendations. This is the case, for example, for LVMH, whose appendices state:

“Jointly controlled companies, as well as companies in which the Group exercises significant influence, are consolidated on the equity basis. These entities, although jointly controlled, are fully integrated into the operational activities of the Group. LVMH presents their net income, as well as the income of the activities put into equity [...], on a separate line within the current operating income."

Possible solutions: core business equity accounting, and investment equity accounting

This practice appears to have inspired the IASB’s reflections on the evolution of the income statement presentation. Inits “General Presentation and Disclosure” survey paper published in December 2019, the organization considers a separate presentation of integrated and non-integrated associates and joint ventures.

As a result, groups would need to make a distinction between:

1. Associates/joint ventures whose activities are intrinsically linked to those of the group: "integrated associates and jointventures".
2. Associates/joint ventures whose activities are independent from the group's and treated as investment activities: “non-integrated associates and joint ventures”.

Many criteria can determine how the distinction is made, for instance:

1. Business lines are integrated with the associate or joint venture.
2. The name or brand is shared with the group vis-à-vis third parties.
3. The entity is a key customer/supplier of the group, and thus difficult to replace.

It should be noted that this distinction would occur at the income statement level, but also within the balance sheet and the cash flow table.

Feedback from the survey briefing, which ended on September 30, 2020, showed a mixed reception to the equity component, questioning the merits of this initiative. An overview of current practics could help to inform the debate.

Current practices in Europe

So far, the available data on the accounting practices of groups in Europe is limited to the few dozen companies making up indexes such as the Eurostoxx 50. Based on the recently implemented ESEF data, we were able to expand this exploration to a panel of over 1.000 companies across 34 sectors in Europe – all of which consolidate companies through the equity method. The results show a wide variety of practices across sectors and markets, highlighting that equity investment integration into the operating result is far from anecdotal.

A quarter of the groups include equity in their operating result

Among our sample of 1.129 listed groups in Europe, 282 (25%) incorporate a contribution from equity investments to their operating profit.

The majority of groups (61%) report their income share of equity investment above pre-tax earnings. The others usually publish an equity line before the net income line (see full graph below).

Utilities, Industrial Services, Petroleum, and Telecommunications are among the sectors that most frequently include an equity line within the operating income. It should also be noted that Capital Goods makes up an important part of these companies; this over representation may be explained by the increased use of joint ventures in these more capital-intensive trades.

Conversely, this practice is more anecdotal for sectors such as Distribution, Energy Equipment and Services, Software and Services, Pharmacy and Banking (see full graph below).

English companies are more eager to integrate equity into the operating result than the average European company

A country-by-country approach shows a clear disparity in equity reporting practices between European countries. On one side, Sweden (68%), Austria (51%) and the United Kingdom (41%) widely include the income share of equity companies in their operating income.

On the other side, only 10% to 20% of the other European companies use this method, with France, Germany and Spain at the upper end of this range (see full graph below).

Conclusion

Including equity in the operating result is already common practice within the landscape of European listed companies. This warrants a deeper reflection on the income statement's presentation… if only to make operating margins more comparable. This is all the more essential since the practice is particularly wide spread in sectors where joint ventures are a necessary step of development.

Uses vary between countries, but it tends to be higher in the biggest markets. Its strong presence in the United Kingdom raises questions about practices in the Anglo-Saxon world. If the IASB’s ambition is to unify accounting standards, as well as to improve the use fulness of financial statements for investors, a further study of accounting practices in the United States may be relevant.

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2023 Corporatings. The information in this document is non-binding and does not constitute an investment recommendation. Past performance is not a good indicator of future performance and is not guaranteed. The information presented is the property of Corporatings and may not be reproduced without the consent of the company.