Academic journal article Accounting Horizons

The Impact and Valuation of Off-Balance-Sheet Activities Concealed by Equity Method Accounting

Academic journal article Accounting Horizons

The Impact and Valuation of Off-Balance-Sheet Activities Concealed by Equity Method Accounting

Article excerpt

SYNOPSIS: This paper reports the results of a study of the financial reporting effects of off-balance-sheet activities concealed by the equity method of accounting. The study examines footnote disclosures relating to equity method investees, offers suggestions for improving the usefulness of those disclosures, and estimates the valuation effects of information in the disclosures. An important empirical finding is that the market places significant negative values on investor-guaranteed off-balance-sheet obligations.

INTRODUCTION

Financial analysts have long been concerned with the effect of off-balance-sheet activities on a firm's financial condition. The financial statement analysis literature emphasizes the importance of examining footnote disclosures for the existence of economic assets and liabilities that are not recognized under generally accepted accounting principles (GAAP); Lasman and Weil (1978) provide an early example. Further, off-balance-sheet activities receive increased attention in the post-Enron world (Chang 2002).

This paper examines financial analysis and valuation issues caused by off-balance-sheet activities that are not fully reported under equity method accounting. Described in Accounting Principles Board (APB) Opinion No. 18 (APB No. 18, APB 1971), investors must use the equity method for investments in common stock that provide "significant influence over operating and financial policies of an investee even though the investor holds 50% or less of the voting stock" (APB No. 18, [paragraph] 17). There is a presumption that significant influence exists with ownership interests of 20 percent.

Given that GAAP requires the equity method, in analysis a key issue is how to best reflect the investment in the investor's financial statements. In most cases, the equity method summarizes the investor's share of the investee's net assets and net income in single lines in the balance sheet and income statement, respectively. An alternative approach consolidates the components of the investee's assets, liabilities, and income with those of the investor. Another alternative approach consolidates only the investor's proportionate share of the components of the investee's assets, liabilities, and income. These alternative approaches can produce large differences in the investor's reported performance and leverage. (1)

The equity method of accounting is controversial. Davis and Largay (1999, 281) perform a critical analysis of the accounting for significant influence equity investments, defined as "situations where one entity possesses more than a passive investment in another entity but does not control that entity." They develop two conclusions based on financial analysis considerations, consolidation theory, and aggregation issues. First, they find "no substantive justification for continued use of the equity method ... due to the method's intrinsically limited informational characteristics" (Davis and Largay 1999, 281). Second, they recommend alternative accounting methods--proportionate consolidation and the expanded equity method. Proportionate consolidation and the expanded equity method are substantially similar, differing only in presentation format. For purposes of this paper, I consider these methods equivalent.

Proportionate consolidation is common outside the United States. International Accounting Standard No. 31 (International Accounting Standards Board [IASB] 1990) recommends proportionate consolidation for jointly controlled entities and Canadian accounting principles require proportionate consolidation of joint ventures (CICA Handbook, Section 3055, Canadian Institute of Chartered Accountants (2000)). Bierman (1992) advocates the use of proportionate consolidation even for majority-owned subsidiaries.

Some analysts regard the equity method as enabling firms to avoid balance sheet recognition of the assets and liabilities of investees (e. …

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