With IAS 28 now in force, it’s a good time to consider how it affects you. But be prepared - not everything in the standard is as cut and dried as might be hoped, says Graham Holt
Studying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.
In May 2011, the International Accounting Standards Board (IASB) issued a new version of IAS 28, Investments in Associates and Joint Ventures, that requires both joint ventures and associates to be equity-accounted. The standard is effective from 1 January 2013 and entities need to be aware of its implications, although the EU has endorsed IAS 28 from 1 January 2014.
An associate is an entity in which the investor has significant influence, but which is neither a subsidiary nor a joint venture of the investor. 'Significant influence' is the power to participate in the financial and operating policy decisions of the investee, but not to control those policy decisions. It is presumed to exist when the investor holds at least 20 per cent of the investee's voting power. If the holding is less than 20 per cent, the entity will be presumed not to have significant influence unless such influence can be clearly demonstrated. A substantial or majority ownership by another investor does not preclude an entity from having significant influence.
Loss of influence
An entity loses significant influence over an investee when it loses the power to participate in the financial and operating policy decisions of that investee. The loss of significant influence can occur with or without a change in absolute or relative ownership levels.
A joint venture is defined as a joint arrangement where the parties in joint control have rights to the net assets of the joint arrangement. Associates and joint ventures are accounted for using the equity method unless they meet the criteria to be classified as 'held for sale' under IFRS 5, Non-current Assets Held for Sale and Discontinued Operations.
On initial recognition, the investment in an associate or a joint venture is 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.
IFRS 9, Financial Instruments, does not apply to interests in associates and joint ventures that are accounted for using the equity method.
Instruments containing potential voting rights in an associate or a joint venture are accounted for in accordance with IFRS 9 unless they currently give access to the returns associated with an ownership interest in an associate or a joint venture. An entity's interest in an associate or a joint venture is determined solely on the basis of existing ownership interests and, generally, does not reflect the possible exercise or conversion of potential voting rights.
Investments in associates or joint ventures are classified as non-current assets inclusive of goodwill on acquisition and presented as one-line items in the statement of financial position. The investment is tested for impairment in accordance with IAS 36, Impairment of Assets, as single assets, if there are impairment indicators under IAS 39, Financial Instruments: Recognition and Measurement.
The entire carrying amount of the investment is tested for impairment as a single asset - that is, goodwill is not tested separately. The recoverable amount of an investment in an associate is assessed for each individual associate or joint venture, unless the associate or joint venture does not generate cashflows independently.
IFRS 5 applies to associates and joint ventures that meet the classification criteria. Any portion of the investment that has not been classified as held for sale is still equity-accounted until the disposal. After disposal, if the retained interest continues to be an associate or joint venture, it is equity-accounted.
Under the previous version of the standard, the cessation of significant interest or joint control triggered remeasurement of any retained investment even where significant influence was succeeded by joint control. IAS 28 now requires that any retained interest is not remeasured. If an entity's interest in an associate or joint venture is reduced but the equity method continues to be applied, then the entity reclassifies to profit or loss the proportion of the gain or loss previously recognised in other comprehensive income relative to that reduction in ownership interest.
The IASB states that many of the procedures appropriate for equity accounting are similar to those for consolidation of entities and the concepts used in accounting for the acquisition of a subsidiary are also applicable to the acquisition of an associate or joint venture.
However, it is not always appropriate to apply IFRS 10, Consolidated Financial Statements, or IFRS 3, Business Combinations. There is disagreement over whether equity accounting is a one-line consolidation or a valuation approach. When an associate is impairment-tested, it is treated as a single asset and not as a collection of assets as would be the case under acquisition accounting.
Additionally as associates and joint ventures are not part of the group, not all of the consolidation principles will apply in the context of equity accounting.
There is no definition of the cost of an associate or joint venture in IAS 28. There is debate over whether costs should be defined as including the purchase price and other costs directly attributable to the acquisition such as professional fees and other transaction costs. It might be appropriate to include transaction costs in the initial cost of an equity-accounted investment, but IFRS 3 would require these to be expensed if they relate to the acquisition of businesses. IFRS 9 includes directly attributable transaction costs in the initial value of the investment.
IAS 28 states that profits and losses resulting from 'upstream' and 'downstream' transactions between an investor (including its consolidated subsidiaries) and an associate or joint venture are recognised only to the extent of the unrelated investors' interests in the associate or joint venture. Upstream transactions are sales of assets from an associate to the investor and downstream transactions are sales of assets by the investor to the associate.
There is no specific guidance on how the elimination should be carried out but generally in the case of downstream transactions any unrealised gains should be eliminated against the carrying value of the associate. In the case of upstream transactions any unrealised gains could be eliminated either against the carrying value of the associate or against the asset transferred.
The standards are currently unclear on whether this elimination also applies to unrealised gains and losses arising on transfer of subsidiaries, joint ventures and associates. An example would be where an investor sells its subsidiary to its associate and the question would be whether part of the gain on the transaction should be eliminated.
There is an inconsistency between guidance dealing with the loss of control of a subsidiary and the restrictions on recognising gains and losses arising from sales of non-monetary assets to an associate or a joint venture. IFRS 10 requires recognition of both the realised gain on disposal and the unrealised holding gain on the retained interest. In contrast, IAS 28 requires gains or losses on the sale of a non-monetary asset to an associate or a joint venture to be recognised only to the extent of the other party's interest.
The IASB accordingly issued an exposure draft in December 2012 stating that any gain or loss resulting from the sale of an asset that does not constitute a business between an investor and its associate or joint venture should be partially recognised. However, any gain or loss arising from the sale of an asset that does constitute a business between an investor and its associate or joint venture should be fully recognised.
IFRS 3 defines a business as an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return directly to investors or other owners, members or participants.
Under the equity method, the investment is initially recognised at cost and adjusted to recognise the investor's share of the profit or loss and other comprehensive income (OCI) of the investee. Additionally, the investment is reduced by distributions received from the invest.
However, IAS 28 is silent on how to treat other changes in the net assets of the investee in the investor's accounts, which might include:
- issues of additional share capital to parties other than the investor;
- buybacks of equity instruments from shareholders other than the investor;
- writing of a put option over the investee's own equity instruments to other shareholders;
- purchase or sale of non-controlling interests in the investee's subsidiaries'
- equity-settled share-based payments.
The IASB proposed in an exposure draft issued in November 2012 that an investor's share of certain net asset changes in the investee should be recognised in the investor's equity. The draft contains an alternative view by one board member who believes the amendment to be inconsistent with the concepts of IAS 1 and IFRS 10, and would cause serious conceptual confusion. This board member believes this short-term solution would not improve financial reporting and would undermine a basic concept of consolidated financial statements.
The draft notes that an investor may discontinue the use of the equity method for various reasons including where the investment in the investee becomes a subsidiary or a financial asset. The draft proposes that an investor should reclassify to profit or loss the cumulative amount of other net asset changes previously recognised in the investor's equity when an investor discontinues the use of the equity method for any reason.
Graham Holt is associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School.
CPD technical article
"A substantial or majority ownership by another investor does not preclude an entity from having significant influence"