The Impact and Valuation of Off-Balance-Sheet Activities

Concealed by Equity Method Accounting

Presented By:Intan OviantariIra GeraldinaNova Novita

The Importance of Footnote Disclosure

• The financial statement analysis literature emphasizes the importance of examining footnote disclosures for the existance of economic assets and liabilities that are not recognized under GAAP.

• Lasman and Weil (1978) :provide an early example• Chang (2002) : off-balance-sheet activities receive

increased attention in the post – Enron world

Research Question

• This paper examines financial analysis and valuation issues caused by off-balance-sheet activities that are not fully reported under equity method accounting.

• APB opinion No 18, investors must use the equity method for investments in common stock that provide “significant influence over operating and financial policies of an investees even though the investor holds 50% or less of the voting stock.

• There is a presumption that significant influence exists with ownership interests of 20%.

How to best reflect the investment in the investor’s financial statement?

• 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 summirezes the investors share of the investee’s net assets and net income in single lines in the balancesheet and income statement.

• An alternative approach consolidated 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 investess assets, liabilities, and income. These alternative approaches can produce large differences in the investor’s reported performance and leverage.

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.

• First conclusions: No substantive justification for continue use of the equity method….due to the method’s intrinsically limited informational characteristics

• Second conclusions: 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.

Proportionate consolidation is common outside the United States

• IASB recommended proportionate consolidation for jointly controlled entities

• Canadian accounting principles require proportionate of joint venture

Footnote Disclosure as the Primary Source of Financial data

• Some analysts regard the equity method as enabling firms to avoid balance sheet recognition of the assets and liabilities of investees (Ciesielski 2002)

• From a financial analysis perspective, the lack of detail about investee activities is a weakness of the equity method. The balance sheet does not report the investors interest in the individual assts and liabilities of an investees, and the income statement lack detail on investees revenues and expenses.

• Under GAAP, investing firm must present summarized information about the assets, liabilities, and operating results of material unconsolidated investees.

• Thus, unless the separate financial statements of investee can be obtained, these footnote disclosure are the primary source of financial data for these entities.

Equity Method and Proportionate Consolidation

• Under the equity method, a firm reports its investment in a nonconsolidated entity as a single line item in the balance sheet.

• The amount initially reported in the investment account is either (1)the investor’s capital contribution to form the entity, or (2)the price paid to acqire an interest in an ongoing enterprise.In each accounting period the investor’s income statement contains its proporstionate share of the investee’s net income (loss) as a single line item.

The Differences

• Any difference between the acquisition cost and the investor’s proportionate share of the net assets of an acquire investee is allocated to identifiable assets of the investee and/or to goodwil. When appropriate, ammortization of these fair value ajustments reduces both the investment account and the investor’s income from the investee.

• The investment account is reduced by any dividends received from the investee and increased if the investor makesadditional capital contributions. For these reasons, an investor’s periodic net income and stockholders’ equity does not differ between the equity method and consolidation.

Proportionate Consolidation

• Proponents of proportionate consolidation believe the equity method provides a ditorted picture of firm profitability and risk by relegating details about investee’s balance sheet and income statement composition to the financial statement footnotes.

• A key issue in the debate involves the relation between the investee and the investor. If the products and customers of the investee are unrelated to those of the investor, they including the results of the investment in single lines on the income statement and balance sheet may be reasonable.

• Howefer when the respective operations are closely related and the investor has significant influence over the operating and financial policies of the investee, analysts consider the investee as an integral part of the invetor.

White et al. (2003)

Recommend consolidating the investor’s pro rata share of investees’ assets, liabilities, revenues, expenses, and cash flows into its accounts.

Graham et al. (2003)

Provide a detailed example of the differences in a hypothetical investor’s financial statements using proportionate consolidation versus the equity method.

The Relation between The Investee and The Investor

Proportionate consolidation is not without controversy

• Some object to the investor recognizing its share of the investee’s individual assets because the investor does not control the benefits from using those asset criteria in FASB are not satisfied.

• Other object to recording investee liabilities on the investor’s books because, in the absence of explicit guarantees, the investor has no legal obligation to pay the debts of an investee.

• Because the same claim can be made when majority or wholly owned subsidiaries are fully consolidated, though, this represents an argument against consolidation in general. Finally, some financial analysts dislike proportionate consolidation as the integration of investor and investee accounts hinders separate evaluation of significant investees.

• While some parties do not favor proportionate consolidation in the primary financial statementss, most users want detailed supplemental disclosures. The information required under GAAP is often not sufficient for analysis purposes.

Research Related to Off-Balance Sheet Activities

Shelin (1987) The potential financial statement effects of off balance sheet activities exemined in the accounting literature include those related to research and development limited partnership

Dhaliwal (1986); Landsman (1986)

Pensions

Imhoff et al. (1993); Ely (1995)

Operating lease

Graham et al. (2003) Examine whether financial statements of Canadian firms prepare under proportionate consolidation provide better prediction of future profitability than proforma statements under the equity method.

Research about Valuation Related Issues

Graham and Levanowicz (1996)

Positive association between investor and investee stock returns around investee earnings and dividend announcement.• Conclude that the market value method may be appropriate for equity investment

Graham et al.(1998) Examine the value relevance of fair value disclosures of equity method investees with quoted market prices. •They find that investor stock prices are

positively associated with the difference

between book value recognized on the balance sheet and disclosed fair values.

Sample and Data

• Selected from 3,391 manufacturing firms (SIC code 2000-3999) available at Compustat.

• 431 publicly traded firms have available stock prices and non missing, non zero amounts for “equity in earnings”

• Although 359 of these firms are incoporated in the US, only 228 meet the calender year end requirement of this study.

• There are 90 firms in the year 2000, 76 also filed 2001 financial statement on Edgar prior to May 1, 2002

• 1 firm as an outlier• The final sample consist 150 firm yaer observations- 75 firms for the

years 2000-2001• Financial data source : compustat and The Center for Research in

Security Prices files

Equity Method

• Under the equity method, a firm report its investment in a nonconsolidatedentity as a single line item in the balance sheet.

• The amount initially reported in the investment account :(1) the investor capital contribution to form the entity(2) the price paid to acquire an interest in an ongoing enterprise

• The difference between the acquisition cost and the investor’s proportionate share of the net assets of an acquired investee is allocated to identifiable assets of the investee is allocated to identifiable asset of the investee and/or to goodwill.

• When appropriate, amortization of these fair value adjustment reduces both the investment account and the investor’s income from the investee.

• The investment account is reduced by any dividend received from the investee and increased if the investor makes additional capital contributions. For these reasons, an investor’s periodic net income and stockholders’ equity method and consolidation

• Proponents pf proportionate consolidation believe the equity method provides a distorted picture of firm profitability and risk by relegating details about investees’ balance sheet and income statement composition to the financial statement footnotes.

• For example : including its share of investee earnings in net income and understating the asset base used to generate these earnings overstates the investors return on assets.

• Similarly, netting investee assets and liabilities in the investment account impacts leverage ratios, and shielding investee interest expense in the one-line presentation of investee income overstates interest coverage

• A key issue in the debate involves the relation between the investee and the investor. If the products and customers of the investee are unrelated to those of the investor, then including the results of the investment in single lines on the income statement and balance sheet may be reason able.

• However when respective operations are closely related and the investor has significant influence over the operating and financial policies of the investee, analysts consider the investee as an integral part of the investor. In these cases, White et al (2003) recommend consolidating the investor’s pro rata share of investees’ assets , liabilities, revenues, expenses, and cash flows into its account.

• Graham et al.(2003, see figure 1) provide a detailed example of the differences in a hypothetical investor’s financial statements using proportionate consolidation versus the equity method.

• Proportionate consolidation is not without controversy. Some object to the investor recognizing its share of the investee’s individual assets because the investor does not control the benefits from using those assets, and the asset criteria in FASB are not satisfied.

• Other s object to recording investee liabilities on the investor’s books because, in the absence of explicit guarantees, the investor has no legal obligation to pay the debts of an investee.

• Because the same claim can be made when majority or wholly owned subsidiaries are fully consolidated , though , this represents an argument against consolidation in general.

• Finally, some financial analyst dislike proportionate consolidation as the integration of investor and investee accounts hinders separate evaluation of significant investees (AICPA 1994).

• While some parties do not favor proportionate consolidation in the primary financial statements, most users want detailed supplemental disclosures. But as shown below, the information required under GAAP is often not sufficient for analysis purposes.

Research Related to Off-Balance-Sheet Activities

• The potential financial statement effects of off-balance-sheet activities exemined in the accounting

FINDINGS

Paragraph 20 (d) of APB No. 18

Accounting Series Release No. 302 (SEC 1981)

SEC Rules about Disclosure

Firms reported their investment

Pro Forma Financial Statement

Misstated Pro Forma

Example

Investor’s share of investee liabilities

%8,27020,1

386

incomereporteedtotalinvestee

investeeofincometheinequityownershipcompositeyields

457,8$372,22%8,27 sliabilitieagregatedownershipcompositeyieldsliabilitieestimated

Another Problem

Magnitude of Investee Activities

Two offsetting errors

Valuation of Off-Balance-Sheet Activities

The empirical model in this study uses a general equity valuation model:

Modification:

Expect:

NI Β1 > 0

NI*LOSS Β2 < 0

ASSETS B3 > 0

LIABS B4 < 0

OBS*NOGUAR ?

OBS*GUAR B6 < 0

Results from estimation valuation modelVariable Estimate Results

NI Β1 > 0 15.67, t=5.86 √

NI*LOSS Β2 < 0 -17.46, t=-6.47 √

ASSETS B3 > 0 1.53, t=4,36 √

LIABS B4 < 0 -1.51, t=-3.17 √

OBS*NOGUAR ? -1.35, t=-1.10 X

OBS*GUAR B6 < 0 -1.35, t=-1.76 √

Summary

• This study examines the financial reporting effects of off-balance-sheet activities whose details are concealed by the equity method of accounting.

• First: based on a review of sample-firm footnote disclosure, I offer suggestion for improving the usefulness of these disclosures for financial analysis.

• Second: I estimate the market’s valuation of off-balance-sheet activities.

• The results indicate that market participants place more weight on off-balance-sheet liabilities than assets for firm that provide explicit guarantees of investee obligation

Implications

• First: although financial statement users can utilize footnote disclosures to consolidate investees on a pro forma basis, limitation of current disclosure requirements affect the accuracy of such analyses.

• Second: based on the association between firm value and off-balance-sheet activities of equity method investees, market participants generally find the disclosure of these off balance-sheet activities useful.

• The finding that market participants value off-balance-sheet liabilities supported by guarantees similar to reported liabilities provides empirical support for recent rulemaking.