We receive comments, questions, opinion, feedback, etc on investing from our subscribers almost every day. We try our best to reply to all of them, assuming they have stated their names in their correspondence. Our stance is no name, no response. When we reply, we will publish them in icapital.biz and i Capital, so that all subscribers will benefit from them. One has to remember that icapital.biz and i Capital is not any subscriber's personal investment adviser.
In addition, we prioritise the questions and our replies. When we prioritise, we take into account the urgency and importance of the subject matter, not just from the point of view of the subscriber who wrote in but also from the point of the other subscribers. In other words, while it may be important to a particular subscriber, i Capital will play the role of a judge in deciding whether the subject or issue raised is of priority to the other subscribers. As we said, i Capital is not anyone's personal adviser. With this clarification, we share our reply to an email from Derrick Yeoh, who wrote to us on 20 Jul 2004 asking the following questions:
"I have been having a doubt for some time and no one can give me a satisfactory reply
. my doubts are :
(1) Company X owns some shareholdings in Company ABC. If Company X owns only 10% of ABC, it is only permitted to include the dividends it receives from ABC into its own P&L Account. But if it owns 20% of ABC, it is permitted to include 20% (or a proportionate share if its ownership is more than 20%) of the profit of ABC into its own P&L even if no dividend is paid out. For this reason, most corporations try to own more than 20% of their investee companies.
Actually there isn't any cash flowing into Company X, besides the dividends from ABC (if there is any). So, this is just for accounting "show" only and the shareholders (especially the public) would be impressed. Am I right? Please correct me if I'm wrong.
Other than having more voting rights in meetings, what is the business sense behind this between holding more or less than 20% ?
(2) Is there any difference if the Company ABC above is a Sdn Bhd?
(3) Is there any difference if a person owns Company ABC instead of Company X?"
There are a few pertinent points raised by our subscriber but as some of his questions are not that clear, our reply is based on our interpretation of his email.
First, i Capital will have a look at the principles behind "investment in associates". Since the Companies Act does not define 'associates', it will have to rely on accounting standards as a reference. From an accounting standpoint, Malaysian Accounting Standards Board's Standard number 12 on Accounting in Associates defines an associate as an enterprise in which an investor (Company X in our case) has the power to participate in the financial and operating policy decisions of the investee (Company ABC in our case) but not control over those policies. When there is control, Company ABC will be a subsidiary. In short, Company X must have significant influence over Company ABC's financial and operating policies, not just either one of them. Significant influence in this instance is usually evidenced by meaningful representation on the board of directors.
Usually, Company ABC will be an associate of Company X when X holds 20% to 50% of ABC's equity. However, the ultimate test for an associate lies with the significant influence criterion. Thus, if Company X holds more than 20% equity shares of ABC but does not have representation in ABC's board of directors, ABC is not an associate of Company X because no significant influence can be asserted. The opposite is also true. If X holds less than 20% but have representation on ABC's board of directors, ABC is an associate, although this situation seldom occurs. With this in mind, it is not the percentage of shareholding that determines whether a company is an associate but the ability to exert significant influence that determines it.
As for accounting treatment, if Company X has no significant influence, X would have to record its investment in ABC using the cost method, ie the investment would have to be recorded at cost in its financial statements. Dividends distributed by ABC would form the income for X and are recognized in the profit and loss statement of X. The investment account stated at cost in the balance sheet will only be adjusted for any distributions in excess of the accumulated profit and loss of ABC after the acquisition date.
A simple example would be, say, Company X purchased 20% of Company ABC on 1 Jan 01 with RM70, 000 but has no significant influence over ABC. At the date of purchase, ABC has a capital of RM200,000 and retained profits of RM150,000. At 31 Dec 01, Company ABC declared dividends of RM20,000 and recorded attributable profit of RM30,000.
[i]. Profit and loss impact
Company X would have to record RM4,000 (RM20,000 X 20%) as income. In short, the profit and loss account of X would show a profit of RM4,000 under the cost method.
[ii]. Balance sheet impact
The impact on the balance sheet of X, before and after dividend, is shown below in Table 1. The retained profit of X rose by RM4,000 and the cash in its current asset also rose by RM4,000.
On the other hand, if Company X has significant influence over ABC, the equity method is used. Under this method, the investment is initially recorded at cost and the carrying amount is adjusted to recognize Company X's share of profits or losses and changes in equity that have not been included in the profit and loss statement of ABC after the date of acquisition. Please note that the cost of investment is not the same as the carrying amount of the investment. Carrying amount is cost of investment plus Company X's share of ABC's post-acquisition profit.
[i]. Profit and loss impact
Using the same example above, Company X will consolidate RM6,000 (RM30,000 X 20%) into its profit and loss statement, which one can see as contributions from associate/s. In short, the profit of Company X will show RM6,000 instead of only RM4,000 under the cost method. Although Company X would record dividends received from Company ABC (assuming ABC pays a dividend) in its account, as a group, the dividends are eliminated upon consolidation.
[ii]. Balance sheet impact
The impact on the balance sheet of X, before and after dividend, is shown below in Table 2. The retained profit of Company X rose by RM6,000 and the value of its investment in ABC also rose by RM6,000.
It is obvious from the above examples that the profit and loss statement and balance sheet of Company X looks better under the equity accounting method. The investing public may, therefore, be more impressed with Company X under equity accounting and may even value Company X more which should not be the case. So, by allowing Company X to equity account the results of ABC, is it just for "accounting show" only?
In a broad sense, yes. Though i Capital is neither an audit nor an accounting firm, allow i Capital to present its view on accounting. If one takes a broad and philosophical view of accounting and accounting standards, they are all just approximations of the underlying business realities and are all therefore "accounting shows". Is depreciating an asset at 10% instead of 20% an "accounting show"? Would depreciating the same asset at 20% instead of 10% also be an "accounting show"?
A business can be deemed as a never-ending movie that plays on and on. Financial statements are snapshots of the scenes in the movies to freeze certain scenes that might be of interest to the viewers, not the end of the movie. Theoretically, the best way to present financial statements would be to cease the business at year-end, sell off all the assets, pay off all the liabilities, calculate the profits and start all over again tomorrow. This is more accurate, but not practical. As snapshots, financial statements tell you the position as at' a particular date or period.
Since X is involved in directing the financial and operating direction of ABC, it would be fair to require X to reflect ABC's performance in X's own financial statements. In its exercise of influence, X has a measure of responsibility for ABC's performance, and accordingly, should account for this by taking its share of the results in ABC. Remember this "accounting show" has to also apply when ABC is reporting losses. In this case, the equity accounting method would be less favourable than the cost method. In addition, irrespective of whether dividends are distributed by ABC or not, Company X's share of the post-acquisition profits or losses of ABC will be accounted for in the books of X. Note that in equity accounting, other issues such as impairment loss, related party transactions, unrealised profits and loss, etc must be taken into consideration and reflected in the financial statements. However, the equity accounting method is still useful. With the disclosure, readers of the financial statements are able to track the performance of ABC and asked relevant questions: Why is ABC continuously losing or making profits? Should it be disposed? Should the stake be increased? What is the impact of the disposal of ABC ? In short, there is value in making such disclosures, provided they are disclosed in a fair and consistent manner.
Valuation and business sense
But does the type of accounting treatment matter to the business owner or for valuation purposes? From the business standpoint, it does not matter whether it is cost method or equity accounting. The intrinsic values of ABC and also that of Company X are not affected by the choice of accounting methods. The same, for example, applies to depreciation rates. A depreciation rate of 10% would give a company higher profit than a rate of, say, 20%. But does this change the fundamental valuation of the company in question ? No. Subscribers must be able to distinguish between economic and accounting profits. Accounting profit is affected by the accounting policy or method adopted. But economic profit is not. The question then becomes how does one arrive at economic profit ? Well, as our managing director advised someone, this is the "secret" and probably the most difficult part of successful investing and if he were to give a seminar on such valuations, he would have to charge by the thousands. So it would be an accounting show only to those who are not able to or are not willing to dig deeper than the superficial accounting profit. An excellent start for those who are really keen would be to read "Security Analysis" by Graham and Dodd, not once but over and over again. Get it ?
As for the advantages of having more or less than 20%, as explained, the percentage of holding per se does not determine the relationship and the accounting treatment. If X holds less than 20% and yet want to equity account ABC's results, the burden is on X to prove its ability to assert significant influence. Note that board representation is only one of the evidences of the existence of significant influence as the argument on this matter can be subjective. Other forms may include interchange of managerial personnel, existence of material transactions, etc. As to whether there is a difference if Company ABC is a Sdn Bhd, the accounting treatment will be similar.
The above topic is more of a bottom-up issue. From a market-timing standpoint, however, stock markets everywhere received some long awaited relief from soaring oil prices. As to whether the relief is temporary or permanent, the jury is still out. We reckon that the multi-year oil rally is not over yet.