Private Equity Accounting | Learn How to Demystify Complexities of Private Equity Accounting

Introduction

Make no mistake about the level of accounting compliance topics that accountants must deal with daily. Private equity (PE) has become an integral part of the global financial ecosystem, playing a pivotal role in funding companies and fostering growth, especially in emerging markets.

Accounting for private equity investments, however, presents unique challenges to professional accountants. The nature of private equity investments—ranging from passive minority stakes to full control—requires careful consideration of the International Financial Reporting Standards (IFRS) to ensure accurate financial reporting.

In this article, we will explore the key accounting standards that govern private equity accounting, offering insights into the nuances of control, influence, and fair value measurement.

Real-world examples are also incorporated to illustrate the practical applications of these standards for clearer understanding. Before we dive in fully, let us start with gaining an understanding of what Private Equity Investment is.

Understanding the Nature of Private Equity Investments

Private equity involves investing in companies that are not listed on public exchanges. PE firms typically aim to add value to their portfolio companies by enhancing operational efficiency, restructuring, and eventually exiting through an Initial Public Offering (IPO), sale, merger or on rare occasion abandonment when the business fails.

The accounting treatment of these investments varies depending on the level of control or influence the investor holds over the investee company.

Key Accounting Standards for Private Equity Accounting

IFRS 10: Consolidated Financial Statements

Under IFRS 10, a private equity firm that gains control of an investee company must consolidate the investee’s financial statements into its own. Control is usually defined as owning more than 50% of the voting shares or having the power to govern the financial and operating policies of the company.

Example: KKR’s Acquisition of Walgreens Boots Alliance In 2020, KKR & Co., a leading global private equity firm, acquired a majority stake in Walgreens Boots Alliance. Under IFRS 10, KKR was required to consolidate Walgreens’ financial statements into its own. This included recognizing all of Walgreens’ assets and liabilities at fair value, with the 30% stake not acquired being reported as non-controlling interest.

Accounting Treatment:

1. The assets and liabilities of Walgreens were recognized at fair value on KKR’s balance sheet.
2. KKR recorded any difference between the purchase price and the fair value of net assets as goodwill in accordance with IFRS3.
3. The non-controlling interest (30%) was presented separately in equity.

IFRS 3: Business Combinations

When a private equity firm acquires a company, IFRS 3 applies if the acquisition qualifies as a business combination. A Purchase Price Allocation (PPA) process is conducted, where the identifiable assets, liabilities, and contingent liabilities of the acquired company are recognized at fair value.

Example: Blackstone’s Purchase of Refinitiv In 2019, Blackstone acquired a majority stake in Refinitiv, a leading financial data provider. Following IFRS 3, Blackstone allocated the purchase price across Refinitiv’s identifiable assets, including intangible assets like customer relationships and software. Any excess over the fair value of net assets was recorded as goodwill.

Accounting Treatment:

1. Blackstone recognized the identifiable assets (such as customer contracts and software) at fair value.
2. The excess purchase price over fair value was recorded as goodwill.
3. Any bargain purchase (where the fair value of net assets exceeds the purchase price) would be recognized as a gain in profit or loss.

IAS 28: Investments in Associates and Joint Ventures

IAS 28 governs investments where the private equity firm has significant influence but not control, typically represented by ownership of 20% to 50%. In such cases, the equity method is applied. Under the equity method, the investment is initially recognized at cost, and the investor’s share of post-acquisition profits or losses is included in the investor’s financial statements.

Example: Carlyle Group’s Investment in McDonald’s China Operations; Carlyle Group owns a 28% stake in McDonald’s China. Since Carlyle holds significant influence but does not control McDonald’s China, it applies the equity method under IAS 28. Carlyle recognizes its share of McDonald’s China’s profit or loss in its income statement, adjusted for dividends received.

Accounting Treatment:

1. Carlyle records its investment at cost on the acquisition date.
2. The carrying amount of the investment is adjusted by Carlyle’s share of McDonald’s China’s post-acquisition profits or losses.
3. The dividends received reduce the carrying amount of the investment.

IFRS 9: Financial Instruments

For minority investments where the private equity firm does not have significant influence or control (usually less than 20%), IFRS 9 applies. These investments are generally measured at Fair Value Through Profit or Loss (FVTPL).

Example: SoftBank’s Minority Stake in DoorDash SoftBank held a 10% stake in DoorDash before its IPO, with no significant influence over operations. In line with IFRS 9, SoftBank accounted for this investment at fair value, recognizing changes in the fair value of its stake in DoorDash in its profit or loss statement.

Accounting Treatment:

1. The investment is initially recognized at fair value, with changes in fair value recorded in profit or loss.
2. Dividends are recognized in profit or loss when the right to receive payment is established.
3. When the investment is sold, any gain or loss is recognized in profit or loss.

Fair Value Measurement: IFRS 13

Fair value is a crucial aspect of private equity accounting, especially for investments measured at FVTPL. Under IFRS 13, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.

Private equity firms often use Level 3 inputs for fair value measurement, as these investments are typically in illiquid markets. This involves the use of discounted cash flow models, market multiples, and comparable company analysis to estimate fair value.

Example: Valuation of Private Equity Holdings by TPG TPG, a large private equity firm, uses Level 3 inputs to value its illiquid investments in private companies. TPG relies on projected relevant cash flows, discount rates, and market comparable to estimate the fair value of its portfolio, which is updated quarterly.

Impairment Testing: IAS 36

For private equity investments accounted for under the equity method, IAS 36 requires impairment testing if there is an indication of impairment. Impairment occurs if the carrying amount of the investment exceeds its recoverable amount.

Example: Impairment of KKR’s Investment in Toys “R” Us Following the bankruptcy of Toys “R” Us, KKR had to write down the value of its investment in the company. Under IAS 36, the recoverable amount of KKR’s stake was significantly lower than its carrying value, leading to an impairment loss.

Accounting Treatment:

• The carrying amount of the investment is reduced to its recoverable amount.
• The impairment loss is recognized in profit or loss.

Conclusion

Accounting for private equity investments under IFRS requires careful consideration of the investor’s level of control or influence, as well as the appropriate standards such as IFRS 3, IFRS 10, IAS 28, and IFRS 9.

Real-world examples, such as KKR’s acquisition of Walgreens, Blackstone’s purchase of Refinitiv, and Carlyle’s stake in McDonald’s China, illustrate the practical application of these accounting principles. Fair value measurement and impairment testing also play critical roles in ensuring the accuracy of financial statements.

For accounting professionals, understanding the complexities of private equity accounting under IFRS is essential to providing clear and reliable financial reporting for these often-complex investments.

Be assured that adhering to these standards, private equity firms ensure transparency and consistency in their financial reporting, providing stakeholders with a true and fair view of the financial performance of their portfolio investments.