Change in Accounting for Financial Instruments: A Small Change in Standard, but Big Impact on Companies

September 03, 2017

Over the years, investors, auditors, accountants, standard-setters have discussed and deliberated on issues regarding presentation of financial information in the financial statements.

Much has been argued about how quality of information related to accounting for financial instruments can be improved in the financial statements, so that shareholders can make more informed decisions about companies.

Current accounting rules for financial instruments

Lately, one of the standards by FASB on financial instruments “Recognition and Measurement of Financial Assets and Financial Liabilities” has come up as a hot topic of discussion that could have a big impact on how companies should account for their equity investments, in which they have less than 20% ownership.

While the objective of this standard is to provide better information for users of financial statements, it could have an unintended effect of distorting financial statements of companies with small investments in other companies like Alphabet and IBM.

Traditionally, when a company acquires less than 20% of another company, the investment is usually accounted for in the balance sheet at cost, i.e. the price that is paid as consideration for the investment.

Over time, if the value of investment decreases, this decrease in valuation is accounted for by a write-down in the income statement and on the balance sheet. However, if the value increases over a period, the company has the option to retain the investment at cost.

What this means is that investors are fully informed when investment value declines. But there is less transparency and clarity in the case of an increase in value of investment. And under current standards, accountants are not required to perform valuations of these difficult-to-value investments every quarter.

But all these look likely to change with the little-known new accounting rule introduced by the Financial Accounting Standards Board, FASB.

Change in accounting rules for Financial Instruments starting 2018

In 2018, under new Guidance in ASU 2016-01, it seems that minority investments are also required to be valued quarterly, regardless of an increase or decrease in value of investments.  

As quoted from ASU 2016-01, one of the significant amendments states that it : 

Require equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. However, an entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.

This seemingly small change could potentially have a big impact on earnings of some businesses.

Let’s use Alphabet’s investment in Uber as an example.

In 2013, Google Ventures, now part of Alphabet, invested in excess of $250 million in Uber. This investment is now worth billions of dollars today. Even though Uber has no relationship with the core business Google, the investment will now have to be valued to reflect the market price as a gain in the income statement.

Considering the net income of Alphabet, this could cause a significant distortion of Alphabet’s earnings, depending on the valuation of Uber.

What makes things more complicated is that Uber is non-listed, which implies market price of Uber will not be readily available. What do we do if Alphabet adopts a different approach to valuation compared to another investor in Uber?

Is this change in accounting for better or for worse?

Like all other initiatives by the FASB, the underlying intentions of change are good, as they increase transparency of value of investments for investors.

However, in my opinion, I foresee more questions being asked about the value of equity investments, and companies will probably need to constantly remind investors every quarter that fluctuations in investment value have no relationship to their core businesses.

To get a better picture of the company performance, the net income should be adjusted for these fluctuations in investment value for a more meaningful comparison over time.

What I foresee too is that companies are going to find it more difficult to comply with the new standards.

So, will this change in accounting for financial instruments indeed improve quality of information in financial statements?

My hunch is that financial statements could be even more confusing for investors who are not so savvy, and be more difficult for them to gauge performance of a company’s core business from the financial statements.

I hope I am wrong in this, but no one really knows now. Only time will tell. 

about author

Lee is currently pursuing a Master’s degree in Finance at INSEAD. Prior to his Master’s, he has worked for about five years in the treasury and accounting space. He graduated from SMU with a double degree in Accountancy and Finance, and is also a Chartered Accountant (Singapore). Other than building Excel spreadsheets and poring through annual reports, he spends his time reading and watching sci-fi movies.