OVERVIEW
Objective
¾
To explain what an associate is.¾
To explain the accounting treatment for associates.EQUITY ACCOUNTING
INTER-COMPANY ITEMS WITH AN
ASSOCIATE ACCOUNTING
TREATMENT
¾ Relationship to a group ¾ Basic rule
¾ Equity accounting
¾ Treatment in consolidated
statement of financial position
¾ Treatment in consolidated
statement of
comprehensive income
¾ Accounting policies and year
ends
¾ Impairment
¾ Exemptions to equity
accounting
¾ Inter-company trading ¾ Dividends
¾ Unrealised profit
DISCLOSURE ¾¾ Investments in associates Using the equity method ¾ Background
¾ Scope ¾ Definitions
¾ Significant influence
1
EQUITY ACCOUNTING
1.1
Background
¾
Where one company has a controlling investment in another company, a parent-subsidiary relationship is formed and accounted for as a group. Companies may also have substantial investments in other entities without actually having control. Thus, a parent-subsidiary relationship does not exist between the two.¾
If the investing company can exert significant influence over the financial and operating policies of the investee company, it will have an active interest in its net assets and results.¾
The nature of the relationship differs from that of a simple investment, i.e. it is not a passive interest.Commentary
Including the investment at cost in the company's accounts would not fairly present the investing interest.
¾
So that the investing entity (which may be a single company or a group) fairly reflects the nature of the interest in its accounts, the entity’s interest in the net assets and results of the company, the associate, needs to be reflected in the entity’s accounts. This is achieved through the use of equity accounting.1.2
Scope
¾
IAS 28 is applied in accounting for investments in associates. However, it does not apply to investments in associates held by: venture capital organisations, or
mutual funds, unit trusts and similar entities including investment-linked insurance funds
that upon initial recognition are designated as at fair value through profit or loss or are classified as held for trading and accounted for in accordance with IAS 39 Financial Instruments: Recognition and Measurement.
Commentary
1.3
Definitions
¾
An associate is an entity over which an investor has significant influence and which is neither a subsidiary nor a joint venture (i.e. an economic activity undertaken by two or more parties with joint control).¾
Significant influence is the power to participate in the financial andoperating policy decisions of the investee but is not control or joint control over those policies.
¾
Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.¾
The equity method is a method of accounting whereby the investment is initially recognised at cost and adjusted thereafter for the post acquisition change in the investor’s share of net assets of the investee. The profit or loss of the investor includes the investor’s share of the profit or loss of the investee.1.4
Significant influence
¾
The term significant influence means that an investor is involved, or has the right to be involved, in the financial and operating policy decisions of the investee.¾
The existence of significant influence by an investor is usually evidenced in one or more of the following ways: Representation on the board of directors or equivalent governing body; Participation in policy making processes;
Material transactions between the investor and the investee; Interchange of managerial personnel; or
Provision of essential technical information.
¾
A holding of 20% or more of the voting rights of the investee indicates significant influence, unless it can be demonstrated otherwise.Commentary
Conversely, a holding of less than 20% presumes that the holder does not have significant influence, unless such influence can be clearly demonstrated (e.g. representation on the board).
1.5
Separate financial statements
¾
Investors that are exempt from the requirement to equity account may present separate financial statements as their only financial statements.¾
In the separate financial statements, the investment in the associate should be accounted for: Under IFRS 5 if classified as held for sale; At cost or in accordance with IAS 39.
2
ACCOUNTING TREATMENT
2.1
Relationship to a group
¾
A group is defined as being a parent and all of its subsidiaries. An associate is not part of a group as it is not a subsidiary, i.e. it is not controlled by the group.¾
As such, the accounting treatment of the associate is different to that of subsidiaries.2.2
Basic rule
¾
An investment in an associate is accounted for using the equity method.¾
Associates must be accounted for using the equity method regardless of the fact that the investor may not have investments in subsidiaries and does not therefore prepare consolidated financial statements.2.3
Equity accounting
¾
The investment in an associate is initially recognised at cost and the carrying amount is increased or decreased to recognise the investor’s share of the profit or loss of the investee after the date of acquisition.Commentary
This is equivalent to taking the investor’s share of the net assets of the associate at the date of the financial statements plus goodwill.
¾
Distributions received from the associate reduce the carrying amount of the investment.¾
Adjustments to the carrying amount may also be necessary for changes in the investor’sproportionate interest in the associate arising from other items of comprehensive income that have not been recognised in the profit or loss.
Commentary
These changes will be reflected within the other comprehensive income section of the statement of comprehensive income.
¾
The investor’s share of the current year’s profit or loss of the associate is recognised in the investor’s profit or loss.¾
The associate is not consolidated line-by-line. Instead, the group share of the associate’s net assets is included in the consolidated statement of financial position in one line, and share of profits (after tax) in the consolidated statement of comprehensive income in one line.2.4
Treatment in a consolidated statement of financial position
¾
The methods described below apply equally to the financial statements of a non-group company that has an investment in an associate as they do to group accounts.¾
In group investments, replace the investment as shown in the individual company statement of financial position with: the group’s share of the associate’s net assets at the end of the reporting period, plus
the goodwill arising on acquisition, less any impairment of goodwill.
Commentary
As for business combinations under IFRS 3, IAS 28 does not permit the amortisation of goodwill.
¾
Do not consolidate line-by-line the associate’s net assets. The associate is not a subsidiary, therefore the net assets are not controlled as they are for a subsidiary.¾
In group reserves, include the parent’s share of the associate’s post-acquisition reserves (the same as for subsidiary).¾
Cancel the investment in associate in the individual company’s books against the share of the associate’s net assets acquired at fair value. The difference is goodwill.¾
The fair values of the associate’s assets and liabilities must be used in calculating goodwill. Any change in reserves, depreciation charges etc due to fair valuerevaluations must be taken into account (as they are when dealing with subsidiaries).
¾
Where the share of the associate’s net assets acquired at fair value are in excess of the cost of investment, the difference is included as income in determining the investor’s share of the associate’s profits or losses.¾
The amount to be placed in the statement of financial position will be: $ Share of net assets(Group % × Associate’s net assets at end of reporting period) X Goodwill on acquisition, less any impairment of goodwill X ___ X ___
This is not how IAS 28 phrases it. IAS 28 says that the carrying value of the investment should be:
Cost + share of associate’s post acquisition profit or loss
But Cost = share of associates net assets at acquisition + goodwill Hence Carrying value= share of net assets at acquisition + goodwill
+ share of post acquisition profit or loss
Which = Share of net assets at end of the reporting period + Goodwill
Example 1
P owns 80% of S and 40% of A. Statements of financial position of the three companies at 31 December 2007 are:
P S A
$ $ $
Investment: shares in S 800 – –
Investment: shares in A 600 – –
Other non-current assets 1,600 800 1,400
Current assets 2,200 3,300 3,250
______ ______ ______
5,200 4,100 4,650
______ ______ ______ Issued capital – $1 ordinary shares 1,000 400 800
Retained earnings 4,000 3,400 3,600
Liabilities 200 300 250
______ ______ ______
5,200 4,100 4,650
______ ______ ______ P acquired its shares in S seven years ago when S’s retained earnings were $520 and P acquired its shares in A on the 1 January 2007 when A’s retained
earnings were $400.
The goodwill in S was fully written off over five years.
There were no indications during the year that the investment in A was impaired.
Required:
Proforma solution
P: Consolidated statement of financial position as at 31 December 2007
$ Investment in associate
Non-current assets
Current assets ______
______
Issued capital
Retained earnings ______
Non-controlling interests
Liabilities ______
______
WORKINGS
(1) Group structure
(2) Net assets working
S Reporting Acquisition date
$ $
Issued capital
Retained earnings ______ ______
______ ______
A Reporting Acquisition date
$ $
Issued capital
Retained earnings ______ ______
(3) Goodwill
S $
Cost of investment
Net assets acquired ______
______
A $
Cost of investment
Net assets acquired ______
______
(4) Non-controlling interests
$ S only
______
(5) Retained earnings
$ P – from question
Share of S Share of A
Less Goodwill ______
______
(6) Investment in associate
$ Share of net assets
Goodwill remaining ______
2.5
Treatment in a consolidated statement of comprehensive income
¾
Treatment is consistent with consolidated statement of financial position and applies equally to a non-group company with an associate: Include group share of the associate’s profits after tax in the consolidated profit or loss. This replaces dividend income shown in the investing company’s own profit or loss.
Do not add in the associate’s revenue and expenses line-by-line as this is not a consolidation and the associate is not a subsidiary.
Time-apportion the associate’s results if acquired mid-year.
Example 2
P has owned 80% of S and 40% of A for several years. Statements of comprehensive income for the year ended 31 December 2007 are:
P S A $ $ $
Revenue 14,000 12,000 10,000
Cost of sales (9,000) (4,000) (3,000)
______ ______ ______
Gross profit 5,000 8,000 7,000
Administrative expenses (2,000) (6,000) (3,000)
______ ______ ______
3,000 2,000 4,000
Dividend from associate 400 – – ______ ______ ______
Profit before taxation 3,400 2,000 4,000
Income taxes (1,000) (1,200) (2,000) ______ ______ ______
Profit after taxation 2,400 800 2,000
Dividends (paid) (1,000) – (1,000)
______ ______ ______ Retained earnings for the period 1,400 800 1,000 ______ ______ ______ Goodwill was fully written off three years ago.
Required:
Proforma solution
P: Consolidated statement of comprehensive income for the year ending 31 December 2007
$ Revenue
Cost of sales ______
Gross profit
Administrative expenses ______
Operating profit
Income from associate ______
Profit before taxation
Income taxes ______
Profit after taxation
Non-controlling interests ______
Profit for the financial year ______
Dividends paid (included in SOCIE).
(1) Group structure
(2) Consolidation schedule
40%
P S A Adjustment Consolidation
$ $ $ $ $
Revenue Cost of sales
Administration expenses Income from assocociate
Tax ______
Profit after tax ______
(3) Non-controlling interest
2.6
Accounting policies and year ends
2.6.1
Accounting policies
¾
If an associate uses accounting policies other than those of the investor, adjustments must be made to conform the associate’s accounting policies to those of the investor in applying the equity method.2.6.2
Year ends
¾
The most recent available financial statements of the associate are used by the investor.¾
When the reporting dates of the investor and the associate are different, the associateprepares, for the use of the investor, financial statements as of the same date as the financial statements of the investor. Unless it is impracticable to do so.
¾
When it is not practicable to produce statements as at the same date, adjustments must be made for the effects of significant transactions or events that occur between that date and the date of the investor’s financial statements.¾
In any case, the difference between the reporting date of the associate and that of the investor must not be more than three months.2.7
Impairment
¾
After application of the equity method, including recognising the associate’s losses, the investor applies the requirements of IAS 36 to determine whether it is necessary to recognise any additional impairment loss.¾
Because goodwill included in the carrying amount of an investment in an associate is not separately recognised, it is not tested for impairment separately.¾
Instead, the entire carrying amount of the investment is tested for impairment, by comparing its recoverable amount with its carrying amount.¾
In determining the value in use of the investment, an entity estimates: its share of the present value of the estimated future cash flows expected to be generated by the associate, including the cash flows from the operations of the associate and the proceeds on the ultimate disposal of the investment; or
2.8
Exemptions to equity accounting
¾
An associate that is classified as held for sale is accounted for under IFRS 5 “Non-current Assets Held for Sale and Discontinued Operations”.Commentary
Under IFRS 5, if an associate is acquired and held with a view to disposal within twelve months, it will be measured at the lower of its carrying value (e.g. cost) and fair value less costs to sell.
¾
If the investor is also a parent company that has elected not to present consolidated financial statements the investment in the associate will be measured at cost or in accordance with IAS 39.¾
The investment in the associate will be measured at cost or in accordance with IAS 39 if all of the following apply: the investor is a wholly-owned subsidiary (or partially-owned and other owners do not object); and
the investor’s debt or equity instruments are not traded in a public market; and the investor does not file its financial statements with a securities regulator; and the ultimate (or any intermediate) parent of the investor produces consolidated
financial statements available for public use under IFRS.
Commentary
This allows investors who do not have investments in a subsidiary, but only have an investment in an associate, to be exempt from the requirement to equity account on the same basis as parents under IAS 27.
3
INTER-COMPANY ITEMS WITH AN ASSOCIATE
3.1
Inter-company trading
¾
Members of the group can sell to or make purchases from the associate. This trading will result in the recognition of receivables and payables in the individual company accounts.¾
Do not cancel inter-company balances on the statement of financial position and do not adjust sales and cost of sales for trading with associate.¾
In consolidated statement of financial position, show balances with associate separately from other receivables and payables.3.2
Dividends
¾
Consolidated statement of financial position: Ensure dividends payable/receivable are fully accounted for in individual companies’ books.
Include receivable in the consolidated statement of financial position for dividends due to group from associates.
Do not cancel inter-company balance for dividends.
¾
Consolidated statement of comprehensive income: Do not include dividends from the associate in the consolidated statement of comprehensive income. Parent’s share of the associate’s profit after tax (hence before dividends) is included under equity accounting in the income from associate.
Commentary
It would be double-counting to include dividend in the consolidated statement of comprehensive income as well in addition to this.
3.3
Unrealised profit
¾
If parent sells goods to associate and associate still has these goods in stock at the year end, their value will include the profit made by parent and recorded in its books. Hence, profit is included in inventory value in associate’s net assets (profit is unrealised); and parent’s statement of comprehensive income.¾
If associate sells to parent, a similar situation arises, with the profit being included in associate’s statement of comprehensive income and parent’s inventory.¾
To avoid double counting when equity accounting for associate, this unrealised profit needs to be eliminated.¾
Unrealised profits should be eliminated to the extent of the investor’s interest in the associate.¾
Unrealised losses should not be eliminated if the transaction provides evidence of an impairment in value of the asset that has been transferred.Example 3
Parent has a 40% associate.
Parent sells goods to associate for $150 which originally cost parent $100. The goods are still in associate’s inventory at the year end.
Required:
State how the unrealised profit will be dealt with in the consolidated accounts.
Solution
To eliminate unrealised profit.
¾
Deduct $50 from associate’s profit before tax in statement of comprehensive income, thus dealing with the profit or loss impact.¾
Deduct $50 from retained earnings at end of the reporting period in net assets working for associate, thus dealing with the statement of financial position impact.Share of net assets and post acquisition profits included under equity accounting will then be $20 (50 × 40%) lower.
4
DISCLOSURE
4.1
Investments in associates
¾
The fair value of investments in associates for which there are published price quotations.¾
Summarised financial information of associates (including aggregated amounts of assets, liabilities, revenues and profit or loss).¾
If relevant, the reason(s) why: there is significant influence if the voting power is less than 20 per cent; there is not significant influence if the voting power is more than 20 per cent.
¾
If relevant, the associate’s reporting date if different from that of the investor, and thereason for using a different reporting date (or different period).
¾
The nature and extent of any significant restrictions on the ability of associates to transfer funds to the investor (e.g. cash dividends or loan repayments).¾
The unrecognised share of losses of an associate for the period and cumulatively.¾
The fact that an associate is not accounted for using the equity method when exempt4.2
Using the equity method
¾
Classification as non-current assets.¾
The investor’s share of: profit or loss of such associates; discontinued operations (IFRS 5);
changes recognised directly in the associate’s equity (IAS 1); and
contingent liabilities incurred through joint and several liability (IAS 37).
FOCUS
You should now be able to:
¾
define an associate and explain the principles and reasoning for the use of equity accounting;EXAMPLE SOLUTIONS
Solution 1
P Consolidated statement of financial position as at 31 December 2007
$
Investment in associate 1,880
Non-current assets (1,600 + 800) 2,400
Current assets (2,200 + 3,300) 5,500
______ 9,780 ______
Issued capital 1,000
Retained earnings (W5) 7,520
______ 8,520
Non-controlling interests (W4) 760
Liabilities 500
______ 9,780 ______ WORKINGS
(1) Group structure
GROUP P
S
80% 40%
(2)
Net assets working
S Reporting Acquisition date
$ $
Issued capital 400 400
Retained earnings 3,400 520
______ ______
3,800 920
______ ______ A Reporting Acquisition
date
$ $
Issued capital 800 800
Retained earnings 3,600 400
______ ______
4,400 1,200
______ ______
(3) Goodwill
S $
Cost of investment 800
Net assets acquired (80% × 920 (W2)) (736) ______
64 ______
A $
Cost of investment 600
Net assets acquired (40% × 1,200 (W2)) (480) ______
120 ______
(4) Non-controlling interests
$
S only – (20% × 3,800) 760
______
(5) Retained earnings
$
P – from question 4,000
Share of S [80% × (3,400 – 520) (W2)] 2,304 Share of A [40% × (3,600 – 400) (W2)] 1,280 Less Goodwill impaired (W3 per Activity) (64)
(6) Investment in associate
$
Share of net assets (40% × 4,400) 1,760
Goodwill 120
______ 1,880 ______ Proof
Cost 600
Share of post acquisition profits 1,280
______ 1,832 ______
Solution 2
P Consolidated statement of comprehensive income for the year ending 31 December 2007
$ $
Turnover 26,000
Cost of sales (13,000)
______
Gross profit 13,000
Administrative expenses (8,000)
______
Operating profit 5,000
Income from associate 800
______
Profit before taxation 5,800
Income taxes (2,200)
______
Profit after taxation 3,600
Non-controlling interests (W3) (160)
______
Profit for the financial year 3,440
______
WORKINGS
(1) Group structure
P
S A
40% 80%
(2) Consolidation schedule
40%
P S A Adjustment Consolidation
$ $ $ $ $
Revenue 14,000 12,000 26,000
Cost of sales (9,000) (4,000) (13,000)
Administration expenses (2,000) (6,000) (8,000) Income from associate
40% × 2,000 800 800
Tax – group (1,000) (1,200) (2,200)
______
Profit after tax 800
______
(3) Non-controlling interest
S only 20% × 800 $160
