Valuation of equity participations - an accounting perspective
We will divide this issue into two different points of view (one article will be devoted to each point of view) – First, we will look at how equity interests are valued from an accounting perspective (i.e. how they are presented in the financial statements), and in the second article we will look at how valuation is done from the perspective of valuers.
First of all, we have to say what equity participation is - it is a so-called equity security that entitles its holders to participate in the management of the entity that issued the relevant securities, including the right to a share in the profits and the right to a share in the liquidation balance - the holder of these securities, on the other hand, is not entitled to the return of the capital invested. Typical examples are shares and stocks. From an accounting perspective, equity securities are securities that the entity intends to hold for the long term (whether for control purposes or for the payment of dividends - from an accounting perspective this is irrelevant). In contrast, securities purchased on speculation (i.e. securities that are purchased with the intention of selling them soon, ideally at a higher price than they were purchased for) are not included in equity - these securities are reported in current assets and will not be dealt with in this paper.
Securities are valued at two different points in time in the accounting system in two different ways. The first point in time at which valuation takes place is when they are acquired - at this point, they are valued at cost, i.e. purchase price + incidental acquisition costs, which are necessary to make the acquisition (typically broker fees). The second time securities are valued is at the balance sheet date (or any other time at which the accounts are prepared) - here the securities must be revalued to their fair value, which may be more complex than it first appears.
Revaluation to fair value is easiest for securities (typically stocks) traded on a regulated market - here, the fair value is the value of the relevant share obtained from the regulated market, from the period closest to the time of valuation, and not later than the time of valuation (e.g. this year the date of 31 December falls on a Sunday - as there is no trading on stock exchanges at the weekend, securities valued using this method will be valued at the value they had on Friday 29 December). Another common variation of this valuation method is the valuation by expert opinion - we will discuss this valuation method more in the next article, and today we will only mention it.
The method of valuation of equity described above relates to the presentation of the equity in the individual financial statements - other methods of presentation in the accounts are consolidation methods, which are introduced below. The notional 'holy trinity' of consolidation methods is the equity method, the full method, and the proportionate method.
The equivalence method is the only one of the above methods that can be used for both consolidated and individual financial statements - in the case of individual financial statements, it is necessary to consider which method more closely approximates reality and thus complies with the principle of a true and fair view. The equity method is also (in my opinion) the simplest of the consolidation methods (so simple that it is not considered a consolidation method by international accounting standards). The calculation is made as the product of the percentage interest in the subsidiary and the fair value of the subsidiary's equity. In consolidation, this method is used when I have significant, but not controlling, influence over the controlled entity (i.e. I have access to material information provided by the subsidiary but cannot control it myself despite others).
The full method is the consolidation method that the CU uses when it has decisive influence (i.e. it can control the entity despite other co-owners due to its ownership interest). Under this method, there are no ownership interests in the consolidated companies on the consolidated balance sheet - instead, there is a kind of aggregation of the accounting data of the individual entities into one comprehensive statement, excluding all transactions within the consolidated group (e.g. if firm A has a receivable from firm B and both are consolidated within the same group, I exclude both A's receivable and B's payable). The aggregation of data is done by adding up line by line - taking into account the above rules, I sum up the individual lines in the statements (except for the equity of the consolidated entities - I do not add them up). Assuming that the consolidating mother does not have a 100% interest in the consolidated companies, non-controlling (minority) interests will be reported - these are the equity interests of the daughters that do not belong to the mother.
The proportionate method is the method used when an entity has joint control (i.e. when two or more entities jointly exercise controlling influence over another entity (e.g. under a joint control agreement)) and at the same time none of those CUs is able to exercise controlling influence in that CU on its own). The procedure is similar to the full method described above, except that I aggregate the subsidiaries' individual items only to the extent of their interest in the unit. As a result, minority interests are also not reported.
That's all on the topic of valuing equity interests in financial statements - next time we'll look at valuation using expert methods. Should you have any questions after reading this article, please do not hesitate to contact our experts who will be happy to provide you with their services.
