Inherent Distortion in IFRS 18: the Expected Impact on Operating Results of Companies Whose Main Business Activity Includes Investing in Associates and Joint Ventures Accounted for Using the Equity Method

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Companies that Invest in associates and joint ventures accounted for using the equity method as part of their main business activities may “fall between the cracks” under IFRS 18. This could be the case, for example, with holding companies, developers in the renewable energy sector and companies that expand their global operations through local partners abroad. The problem arises from the requirement to classify the holding company’s share of profit/loss of investments accounted for using the equity method in the investing category of the statement of profit or loss, regardless of whether they are an integral part of the holding company’s activities and even when they constitute a main business activity. In our opinion, this requirement reflects an accounting distortion that will misrepresent operating profitability. In extreme cases, it may even lead to ongoing presentation of operating losses due to general and administrative expenses, even when the holding company’s actual business activity is profitable. We believe it is appropriate to amend the standard before its effective date to address this issue, together with amendments in respect of additional distortions such as the classification of maintenance expenses for investment property of a company whose investment property is not a main business activity.

IFRS 18, which will become effective at the beginning of 2027, carries with it a significant improvement for investors regarding the structure of the statement of profit or loss. Beyond improving comparability among companies’ operating profitability, the statement of profit or loss in the new structure is expected to be consistent with methodologies used for valuation assessments and pricing of shares from investors’ perspective, thereby providing more relevant information. The hope is that the next step of the IFRS on this matter will be creating coherence for this structure with the statement of financial position (grouping assets and liabilities based on main categories) and in the statement of cash flows, which following the application of the new standard will have a similar structure to that of the statement of profit or loss, although not identical.

However, within this important move, an inherent distortion has been created in the new standard that affects holding companies that have significant investments in associates and joint ventures accounted for using the equity method. In addition, the distortion affects developers who operate through joint ventures, as is customary in the renewable energy sector, and manufacturing companies that expand their global operations through local partners abroad. These companies, which until now in many cases have included the share of profit of those investments within their operating profit, fall under the new standard “between the cracks” and are required to classify that income without exception in the investing category of the statement of profit or loss, rather than in the operating category.

It is important to emphasize that in accordance with the practice that has developed in companies implementing IFRS and in accordance with interpretations of current IFRS accounting standards (before adopting IFRS 18), there is an accepted approach to include the share of profit of associates and joint ventures whose activity is integral to the activity of the reporting entity within operating profit or an alternative measure presented in the statement of profit or loss (such as EBIT).

Examples of this approach can be seen, for instance, in the following European companies: BP (Britain), Mercedes-Benz Group (Germany), Coca-Cola HBC (formerly Coca-Cola Hellenic Bottling Company) (Switzerland) and Equinor (Norway) as well as in Israeli companies such as Strauss Group and OPC Energy. For example, the investments in associates and joint ventures of Mercedes-Benz, which operates in the automotive and transportation sector, include an investment in Daimler Truck Holding AG (commercial vehicle manufacturer), an investment in Beijing Benz Automotive Co. Ltd. (which manufactures and distributes Mercedes-Benz cars in China), an investment in Automotive Cells Company SE (which develops and manufactures high-performance battery cells and modules) and others.

Specified Main Business Activity

IFRS 18 requires an entity to assess whether it has a specified main business activity, namely a main business activity of investing in certain types of assets, or of providing financing to customers. This is important because an entity with a specified main business activity classifies in the operating category certain income and expenses that would have been classified in the investing category or in the financing category, had the activity not been a main business activity.

The assets that an entity is required to determine whether it invests in them as a main business activity include, among others, investments in associates or joint ventures held by a venture capital organization (and certain other entities) that the entity has chosen to measure at fair value through profit or loss, as permitted under IAS 28, rather than using the equity method, investments in subsidiaries measured at fair value by investment entities, certain investments in financial assets as well as investment property. These provisions may be relevant to entities such as private equity funds, venture capital organizations, REITs as well as real estate companies. However, under the new standard, an entity is not required or permitted to determine that it has a main business activity for investments in associates and joint ventures accounted for using the equity method. Consequently, income from those investments will always be classified in the investing category.

As a result, the new standard is expected to create an accounting mismatch in the statement of profit or loss for companies that invest as part of their main business activity in associates or joint ventures accounted for using the equity method. On the one hand, the share of profit of those investments will be classified in the investing category, even when they constitute an integral part of the holding company’s activity. On the other hand, the holding company’s expenses (such as general and administrative expenses) will inconsistently be classified in the operating category. In extreme cases, such companies may regularly report operating losses, even if their activity is profitable over time.

The problem for joint ventures is more acute, since for more than a decade, the proportionate consolidation method is no longer permitted under IFRS. If the proportionate consolidation method were still applicable, it would require including the share of the operating income and expenses of joint ventures within the relevant line items of the reporting entity, thus avoiding the significant distortion in operating profit as a result of implementing IFRS 18.

Even when putting aside the question of whether the equity method is appropriate and relevant to investors in general, and its application to listed associates with quoted share price in particular, the requirement to classify the share of profit of investments in associates and joint ventures in the investing category can create additional inconsistencies. To illustrate, assume that a company holds as part of its main business activity investments in associates and joint ventures accounted for using the equity method as well as investments in shares of other companies without significant influence that are accounted for as financial assets at fair value through profit or loss. In this case, the remeasurement of the financial assets (as well as dividend income) will be classified in the operating category, while the share of profit of the associates and joint ventures will be classified in the investing category. As a result, inconsistency in the classification between categories in profit or loss will be created in respect of the two components of the main business activity for the same company.

The Proposal that was Not Accepted

As part of the deliberations on IFRS 18 before its publication, a proposal was raised to classify income from investments accounted for using the equity method in the operating category where they are integral to the activity of the holding company, and in the investing category where they are not. Two main arguments can be found in the Basis for Conclusions on the new standard for the decision not to classify such income in the operating category but in the investing category only.

The first argument relates to the fact that the equity method combines income and expenses that users of financial statements usually analyze separately, including finance expenses and income taxes. Accordingly, the classification of these incomes and expenses in the operating category would disrupt users’ analysis of operating margins. Also, an entity does not control the activities of associates and joint ventures. Therefore, the decision to prohibit entities from classifying such income in the operating category was intended to create alignment with the way users of financial statements use information for analyzing investments in associates and joint ventures.

The second argument was that the requirement to classify all income from investments accounted for using the equity method in the same category improves consistency among different reporting entities and may simplify the standard’s requirements. Also, the distinction between “integral” investments and “non-integral” ones might be subjective and create complexities and diversity in practice.

However, we believe it is appropriate to reconsider the classification of such income in the statement of profit or loss of companies that invest in associates or joint ventures as a main business activity, in order to solve the inconsistency between different items of the same company, as previously explained. Regarding the first argument mentioned, it should be noted that in many aspects, the modern view of the equity method is of a measurement method, rather than as a one-line consolidation. This view was evidenced in the proposed amendment to IAS 28 published in September 2024, in which it was proposed to remove the requirement to partially eliminate gains and losses resulting from intercompany transactions with associates. It should also be noted that just as an entity does not control investments in associates and joint ventures, it also does not control investments in shares without significant influence that form part of a main business activity. In our opinion, the incoherence between the classification of income from financial assets that are part of a main business activity (in the operating category) and the classification of income from investments measured using the equity method that are part of the same main business activity (in the investing category) creates problematic issues for investors.

Regarding the second argument above, it should be noted that the two fundamental qualitative characteristics of financial information are relevance and faithful representation (reliability). Relevant financial information is information that can change the decisions made by users. In contrast, comparability is one of the additional qualitative characteristics, i.e. qualitative characteristics that improve the usefulness of information that is both relevant and provides a faithful representation of what it purports to represent. However, comparability is not one of the fundamental characteristics. Thus, it appears that the decision to require entities to classify all income from investments accounted for using the equity method in the investing category (even when the investments are held as a main business activity) gives precedence to a secondary characteristic over a primary one and is inconsistent with the provisions of the Conceptual Framework. In addition, it appears that this approach is not consistent with the concept of the new standardization, especially in light of the management approach.

Partial Remedies

It is permitted under IFRS 18 to present an additional subtotal in certain circumstances. For example, an entity might present income and expenses from investments accounted for using the equity method that are classified in the investing category as the first line item after operating profit and then present a subtotal for “operating profit and income and expenses from investments accounted for using the equity method”. However, this possibility does not solve the problem of mismatch in terms of operating profit.

Another partial solution may arise from a different provision within the new standard, which is the inclusion of management-defined performance measures (MPMs), such as applying the proportionate consolidation method instead of the equity method. However, although this solution may provide additional information disclosed in the notes, it will have no effect on the information presented in the primary financial statements. In our view, this is not a desirable solution, especially when dealing with a new standard that is intended to improve the relevance of an entity’s results. In our opinion, it is appropriate to remove inherent distortions that cause the information in the primary financial statements to move away from the economic context. It should also be noted that covenants and other financial ratios often refer specifically to amounts in the primary financial statements.

The transition provisions of IFRS 18 provide another possible solution to this problem, which may be relevant for certain entities. As part of the transition provisions of IFRS 18, it was determined that at the date of initial application, an entity that is eligible to apply paragraph 18 of IAS 28 (such as a venture capital organization, mutual fund and certain other entities) is permitted to change its election for measuring an investment in an associate or joint venture from the equity method to fair value through profit or loss under IFRS 9. If these assets, that are measured at fair value through profit or loss, are part of a main business activity, remeasurement gains or losses (as well as dividend income) will be classified in the operating category. Since changing the election is permitted only from the equity method to fair value, and not vice versa, it appears that the IASB was aware of the issue regarding the classification of such income, and an attempt was made to provide a partial solution. However, this can be relevant only to investments in associates or joint ventures held (directly or indirectly) by an entity that is a venture capital organization, mutual fund or certain other entities, and does not provide a comprehensive remedy to the problem.

Correcting Matching Distortions

As mentioned, the distortion can be seen as a mismatch between income and expenses in terms of classification between categories in profit or loss. Where most of the reporting entity’s income is classified in the investing category, we would usually expect appropriate matching in the classification of general and administrative expenses. That is, since these expenses resulted from activities classified in the investing category, it appears they should also be classified in the same category. In such a situation, the operating category of a company whose entire activity is investing in companies accounted for using the equity method would show no results but at least it would not appear to be loss-making. Beyond the strange situation (which the new standard probably did not aim for) whereby an active entity would have no operating activities at all, if it were possible to classify general and administrative expenses in such situations as part of the investing category, this would provide a partial solution, even if inferior to the problem.

The desirable solution is to classify in the operating category the income from investments in associates and joint ventures accounted for using the equity method that an entity invests in as a main business activity or that are integral to its main business activity. For certain companies, this will prevent significant reporting distortions that stem from the legal structure of their business activity rather than the economic substance. A situation where accounting standardization affects business considerations, including whether to expand business activity through joint ventures, or whether to avoid an initial public offering, is not desirable. In addition, the accounting distortion may affect the manner of establishing a joint arrangement, since unlike a joint venture, results from a joint operation will be classified in the relevant categories, including the operating category.

In our view, it is appropriate to amend the standard on this issue before its effective date, together with removing additional matching distortions in the new standard, such as the classification of maintenance expenses for investment property when that activity is not a main business activity. In such a situation, according to the current wording of the new standard, while the effects on profit or loss from rental income as well as fair value remeasurements or depreciation expenses of investment property will be classified in the investing category, maintenance expenses for the same investment property will be classified in the operating category.