For an extended period of time, Australian corporate regulation precluded the use of equity accounting in statutory financial statements. Specifically, the pre recognition reporting requirements of AASB1016 Disclosure of Information about Investments in Associated Companies (which was effective from June 1989 to June 1998 in Australia) required equity accounted values to be reported in an incremental manner in the notes to the accounts of company annual reports. This requirement resulted in accounting values determined by two measurement techniques being reported to the market - one recognised in the body of the financial statements (the cost method) and the other disclosed in the notes to the accounts (equity accounting).
This thesis initially investigates the value relevance of equity accounting compared with the cost method over the period 1991 to 1996 within the pre recognition regulatory period in
Australia. Valuation links and agency theory are advanced to establish the expectation that equity accounting is value relevant compared with the cost method of accounting. This expectation is tested using both valuation and returns models. The results indicate that equity accounting is value relevant both relative and incrementally to the cost method in the valuation models. The returns model provides evidence only of the incremental value relevance of equity accounting.
The research question is then extended to consider the value the market assigns to income and book value of an investment that is outside of the economic entity. Agency costs of free cash flows predict that the earnings and book value of the investment in associates have lower associations with company value than do the earnings and book value of the economic entity. It is also expected that marketability of the investment mitigates these agency costs since companies with investments in
mainly listed associates have greater opportunity to create their own dividend stream by selling their investment in the market. The results of the valuation model show a discount on the earnings and book values of associates when compared with the group for the full sample. Earnings of associates are statistically different from earnings of the group for investments in largely unlisted associated entities. However, book value of the investment in associates is statistically different from the group only for investments with at least 50% of listed entities.
During the period of the study, some companies voluntarily provided equity supplementary financial statements. The final hypothesis predicts that the use of supplementary equity accounted financial statements has a greater association with company value than equity accounting reported by way of note disclosure because managers use equity accounting to signal a higher level of integration between the
associate and the investor-company to the market. The results do not support this expectation. Non-parametric tests of the differences between company years on the basis of the method of reporting are performed. Statistically significant results are obtained in relation to two attributes. These are: (i) a greater proportion of companies providing 'upfront' supplementary financial statements have investments in listed associates; and (ii) a greater proportion of companies with supplementary financial statements have associates that pay a dividend. These observations are consistent with the results of prior research that establish equity accounting as an efficient accounting policy choice.
Other factors identified as having the potential to influence the value relevance of equity accounting and the investment itself are also investigated. These are –
• the inclusion of loss-making associates in the
• the provision of guarantees and loans to loss-making associates and
• the disclosure of market values for investments entirely in listed associates.
Splitting the sample on the basis of profit and loss making investments finds that the incremental losses earned by associates are value relevant whilst the incremental equity accounted book value of these investments is not. This finding is inconsistent with expectations founded on the results of Collins et. al. (1999). However, when the model is re specified to measure the whole contribution of associates (rather than just the incremental effect of equity accounting) in two separate variables (i) share of associates profit and (ii) equity carrying amount of associates, the results are consistent with Collins et. al. (1999).
The provision of guarantees and loans is also found to
have an impact on the value relevance of equity accounting for loss making associates. The dummy variable measuring guarantees and loans is statistically significant, as is the interaction of this variable with the incremental equity accounted book value. This result implies that, where guarantees and loans are provided to loss-making investments, book value provides an indication of future earnings for going concern investments and liquidation value for failing investments.
Finally, statistical evidence of the value relevance of market value disclosure for investments in listed associates is found. Market value is shown to have incremental value relevance to the cost method. However, equity accounting is shown to have value relevance incremental to market value.