In the November article on foreign exchange rate gains and losses, we promised our readers that we would get back to the revaluation of equity investments in greater detail and provide you with some of the opinions that have been part of discussions on the approach to the revaluation of equity investments.
Pursuant to the Czech The Accounting Act 563/1991 Coll. (hereinafter “Accounting Act”), the accounting records are to be maintained in Czech crowns. Thus, equity investments in business corporations and equity securities shall also be recognised in Czech crowns. This also applies in the event that the currency in which the equity investments in business corporations and/or equity securities are primarily recognised is a foreign currency.
For equity investments in business corporations and equity securities primarily denominated in foreign currencies, reporting entities have to translate the value of the investments and/or securities to the Czech currency both upon acquisition and at the balance sheet date, or alternatively at another date as of which the financial statements are prepared.
Valuation upon the Acquisition of Equity Investments
Equity investments and equity securities are usually acquired by transfer or through investment.
When equity investments or equity securities denominated in foreign currencies are acquired by transfer, the purchasing reporting entity shall value the equity investment or equity security, as appropriate, at acquisition cost, using the foreign exchange rate promulgated by the Czech National Bank effective as of the transfer date.
Upon the acquisition of equity interests through investment, the investor transfers a portion of its assets or business to the acquiring entity. Through this, the acquirer’s equity increases by the value of the investment made. On the other hand, the investor receives an equity investment or shares, depending on the type of corporation. Because in cases like these, no foreign exchange rate gains and losses arise, we will no longer pay attention to this type of acquisition in this article.
Upon acquisition, investors report equity investments depending on their investment purpose; most commonly, they classify their equity investments under non-current financial assets as follows: under balance sheet item “B.III.1. ‒ Equity investments – controlled or controlling entity” (account no. 061) ‒ in the event of a controlling influence; or under balance sheet item “B.III.3. ‒ Equity investments in associates” (account no. 062) ‒ in the event of a substantial influence. Rarely, equity investments are reported as part of current financial assets, under balance sheet item “C.III.1. ‒ Investments ‒ controlled or controlling entity” (eg account nos. 251, 252) ‒ in the event that equity investments are acquired for trading, or when there is no clear purpose to hold them for over one year.
Valuation at the Balance Sheet Date
At the balance sheet date, equity investments and equity securities which represent investments in controlled entities (controlling influence) or in associates (substantial influence) can either be revalued using the equity method of accounting; or reported at cost, while the impairment shall be tested using provisions against equity investments. Equity investments with a controlling or substantial influence may not be measured at fair value (Section 24 (2) (b) in combination with Section 27 (1) (a) of the Accounting Act).
When reporting equity investments primarily denominated in foreign currencies, they shall be translated using the foreign exchange rate of the Czech National Bank effective at the balance sheet date or another date of preparing the financial statements. The resulting foreign exchange rate gains or losses shall be reported in accordance with Section 51 (3) of the Regulation 500/2002 Coll., for Businesses (hereinafter “Regulation for Business”) using account no. “414 ‒ Gains or losses from the revaluation of assets and liabilities”. When disposing of equity investments denominated in foreign currencies, first of all, the entry in the “Gains and losses from the revaluation of assets” shall be derecognised from the accounting records and only after that, the relevant security that represents equity investments shall be disposed of in the usual manner using profit and loss accounts.
- Valuation Using the Equity Method of Accounting
Applying the equity method of accounting is voluntary. However, as soon as a decision is made to apply this valuation method, it ought to be applied for the valuation of all such equity investments.
Valuation using the equity method of accounting is made by adjusting the cost of the relevant equity investment to the value that corresponds to the degree of the reporting entity’s investment in the given business corporation’s equity, in which the reporting entity holds a share. The impact of revaluation using the equity method of accounting is recorded using account no. “414 ‒ Gains or losses from the revaluation of assets and liabilities” (Section 51 (3) of the Regulation for Businesses). This is accompanied by the impact of the change in the foreign exchange rate as follows: A comparison is made between the carrying value and the value determined by multiplying the degree of interest in equity denominated in a foreign currency by the foreign exchange rate of the Czech National Bank effective as of the balance sheet date. When disposing of equity investments denominated in foreign currencies and valued using the equity method of accounting, the procedure will be similar to the procedure applied when using valuation at cost, as described above.
For the sake of completeness, it shall be added that the adjustment of the TOTAL valuation of investments using valuation at cost is generally made solely downwards (ie the impairment of investments is taken into account solely in amounts lower than the cost). On the other hand, when using the equity method of accounting, the valuation can also be made upwards (ie also the appreciation of investments above the cost including the impact of the foreign exchange rates is taken into account).
Combination of Foreign Exchange Rate Movements and the Total Investment Impairment
In regular business, situations may occur, in which the impact of investment appreciation arising from foreign exchange rate movements combines with the impact of the total investment impairment (for instance, say at 100%). The question is what impact this has on individual valuation methods.
In terms of valuation at cost, first of all, the foreign exchange rate movement shall be reflected. That is, in the event of depreciation of the Czech crown, the value of the investment increases; the increase in the value is recognised in equity. As the next step, however, with regard to the total impairment of the investment, a provision is additionally created of up to 100% of the investment value. This is recognised in the profit and loss account.
In terms of the equity method of accounting, the investment value is already zero based on the past recognition, whereas the total effect is reported in equity. Specifically, the resulting combination of investment appreciation arising from foreign exchange rate movements and the total investment impairment has no impact on the balances presented in the accounting records.
Thus, it can be seen that when applying the method of valuation at cost, in some cases, the foreign currency translation required by Czech accounting regulations may be unsystematic and apparently does not generate any added value. Strictly speaking, in the event of using the method of valuation at cost, the benefit for the users is solely the comparison between the historical cost denominated in CZK and the current investment value denominated in CZK determined by way of the degree of equity interest and the fair value or the carrying value of equity of the entity in which the investment was made, while the current investment value denominated in CZK already includes the impact of foreign exchange rate movements, be it in one way or another. In general, the impact of foreign exchange rate movements does not generate any added value for the users of the financial statements.
The question is whether the reporting entity’s management would dare to revalue investments in a situation as specified above if the impact were equal to several or tens of percent of the company’s total profit or loss and equity (without the current year’s profit or loss). Another question is whether this approach would result in a true and fair view of the financial statements.