Introduction
Financial accounting, a cornerstone for establishing trust and providing a clear overview of a company’s operations, can occasionally be convoluted and subject to potential manipulation. The equity method of accounting, while critical for an accurate representation of a company’s investment status, carries an inherent risk for misuse, thereby presenting a skewed picture of a company’s financial health (Young, Cohen, & Bens, 2018).
Understanding the Equity Method
The equity method is an accounting practice wherein an investor company adjusts the value of its investment in an affiliate to reflect its share in the latter’s profit or loss. This approach provides a realistic portrayal of the investor’s economic interest in the affiliate company. However, it’s important to note that such an accounting method is applicable when a company has significant influence, usually determined by the ownership of 20%-50% of voting shares, over an affiliate. This grey area, where the investor company neither exercises full control nor is merely an ordinary investor, is often where the complexities and potential for manipulations creep in.
Manipulation Tactics and Examples
Companies might resort to a tactical alteration in the ownership percentage to circumvent the drawbacks of the affiliate company’s financial situation or to capitalize on its profits. This alteration could either dip below the 20% mark or rise above the 50% threshold. For instance, consider a scenario where the affiliate company is experiencing substantial losses. The investor company, to evade reflecting these losses in their financial statements, might decrease its ownership interest below 20%. Conversely, when the affiliate company is realizing considerable profits, the investor company might increase its stake beyond the 50% mark, thereby consolidating the financial statements to report the affiliate’s profits as their own (Young et al., 2018).
In addition to this, companies may also manipulate the equity method by delaying the recognition of losses from an investee company. This is often done by not reducing the carrying amount of the investment, even when there is clear evidence of a loss in value. This ‘big bath’ strategy allows companies to improve future profits by absorbing more losses in the present (Healy & Wahlen, 2020).
Detection and Prevention
Discerning such manipulation can be intricate for financial statement readers. However, vigilant monitoring of yearly changes in ownership interests and their impact on financial statements can offer insightful indicators of possible manipulation. Additionally, reading the footnotes in a company’s annual report can provide clues about a company’s accounting practices. Any significant changes in investment value or abrupt changes in the investor’s stake might signal potential manipulation.
Preventive measures should center around robust corporate governance practices. This could encompass thorough internal checks and balances, routine external audits, and advocating for stricter regulations around the ownership percentage reporting from regulatory authorities. Companies can also foster an ethical corporate culture that discourages manipulative accounting practices, promoting honesty and transparency in financial reporting (Eberhart, 2021).
Conclusion
In a nutshell, while the equity method of accounting plays a pivotal role in financial reporting, it is not impervious to manipulation. Companies can misrepresent their financial health, skewing the picture presented to shareholders and the market. To mitigate such practices, companies need to strengthen their governance mechanisms, endorse more stringent regulatory oversight, and promote ethical business conduct. In doing so, financial accounting can truly serve its role as a harbinger of trust and transparency between businesses, their stakeholders, and the broader financial market.
References
Young, S. D., Cohen, J., & Bens, D. A. (2018). Corporate financial reporting and analysis (4th ed.). Wiley. ISBN-13: 9781119494577.
Eberhart, R. (2021). Corporate Governance and Accounting Outcomes. Annual Review of Financial Economics, 13, 1–19. https://doi.org/10.1146/annurev-financial-102020-114634.
Healy, P. M., & Wahlen, J. M. (2020). A Review of the Earnings Management Literature and its Implications for Standard Setting. Accounting Horizons, 13(4), 365-383.
