INVESTMENTS IN ASSOCIATES AND INTERESTS IN JOINT VENTURES
Associates
Sometimes the investment in another entity is not enough to give it control, but such is the amount of voting power acquired that the investor exercises significant influence over the investee.
In this case, the entity in which such an investment is held is called an “associate” company.
Thus, the associate is an entity over which the investor has significant influence and that is neither a subsidiary nor an interest in a joint venture.
Significant influence is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies. The standard goes on to state that if the investor has 20% or more of the voting power of the investee, then there is a presumption of participating interest.
A shareholding of less than 20% does not give significant influence, unless such influence can be clearly demonstrated.
However, an important point to understand is that, though a shareholding of between 20% and 50% will normally constitute an investment in an associate, the investor must actually exercise its significant influence.
This is usually evidenced by:
- Representation on the board of directors
- Participation in policy making processes
- Material transactions between parties
- Interchange on managerial personnel
- Provision of essential technical information
EQUITY METHOD OF ACCOUNTING
Associates are accounted for using the equity method of accounting. This is a method whereby the investment is initially recognised at cost and adjusted thereafter for the post-acquisition change in the investor’s share of net assets in the investee.
In the Statement of Comprehensive Income, the profit or loss of the investee is included in the profit or loss of the investee.
The investment in an associate must be accounted for using the equity method, except in the following circumstances:
- The investment is classified as held for sale in accordance with IFRS 5.
- If a parent also has an investment in an associate, but that parent is itself a subsidiary, then it does not have to present consolidated financial statements.
- Similar exemptions apply to IAS 27, mentioned in the previous chapters.
Use of the equity method must cease if the investor loses significant influence over an associate.
Differing Dates
When applying the equity method, the associate company’s most recent financial statements are used. When the accounting dates differ, the associate should produce financial statements at the same date of the investor. Where this is impracticable, the financial statements of the different date may be used, but subject to adjustment for significant events and transactions.
Differing Accounting Policies
If the associate uses different accounting policies from the investor, adjustments must be made to bring the associates policies into line with the investors, when the equity method is being applied.
DISCLOSURE REQUIREMENTS
The following must be disclosed in respect of an associate:
- Fair value of investments in associates for which there are published price quotations
- Summarised financial information of associates, including aggregated amounts of assets, liabilities, revenues and profit or loss
- Reasons explaining the existence or otherwise of significant influence
- Reporting date of associate if different to investor and reasons for the difference
- Nature and extent of any significant restrictions on the ability of the associates to transfer funds to the investor
- Unrecognised share of losses of an associate, both for the period and cumulatively, if an investor has discontinued recognition of its share of losses of an associate
- The fact that an associate is not accounted for using the equity method, together with summarised financial information of such associates, including total assets, total liabilities, revenues and profit or loss
- The investors share of contingent liabilities of an associate incurred jointly with other investors and those contingent liabilities that arise because the investor is severally liable for all or part of the liabilities of the associate
Investments in associates accounted for using the equity method must be classified as non-current assets. The investor’s share of the profit or loss of the associates, and the carrying amount of the investment, must be disclosed separately in the accounts.
MECHANICS AND TECHNIQUES
None of the individual assets and liabilities of the associate are consolidated with those of the parent and subsidiaries.
Under equity accounting, the investment in an associate is carried to the consolidated balance sheet at a valuation. This valuation is calculated as:
Original cost of investment
+ group share of post acquisition profits of associate
(or – group share of post acquisition losses of associate)
To achieve this, the journal entry required will be:
Dr Investment in Associate
Cr Reserves of Parent
With the group share of post-acquisition profits of associate
In addition, the goodwill arising on acquisition of the shares in the investment must be calculated. This goodwill is not separately shown; rather it is included in the cost of the investment.
However, if the goodwill becomes impaired, this will reduce the value of the investment.
Therefore:
Dr Reserves of Parent
Cr Investment in Associate
With the amount of goodwill impaired
TRANSACTIONS BETWEEN GROUP AND ASSOCIATE
Inter-Company Sales
An adjustment is only required in the case of sales between the associate and the group if inventories remain at the balance sheet date as a result of the trading.
Thus:
- Calculate the profit on inventory
- Calculate the group share of the profit
- Cancel the group share of profit. This is done as follows:
Dr Reserves of Parent
Cr Investment in Associate
With the group share of profit on inventory
(Note: If the inventory lies with the parent, credit inventory instead of investment in associate)
Inter-Company Debts
Because the associate company is not consolidated, inter-company loans (between the investor and associate) will not be cancelled out.
Loans to and from associates and parents are not netted off. Long-term loans may appear, sometimes, in the same section as investments in associates, though this is rarely done.
INTERESTS IN JOINT VENTURES
IAS 31 outlines the accounting treatment necessary in dealing with joint ventures.
A joint venture is a contractual arrangement whereby two or more parties undertake an economic activity that is subject to joint control. (Note that the term joint venture can also refer to an entity that is jointly controlled by other entities).
Joint control is the contractually agreed sharing of control over an economic activity and it exists only when the strategic financial and operating decisions relating to the activity require the unanimous consent of the parties sharing control. (These parties are known as the venturers).
The contract therefore becomes a very important factor in a joint venture. The contract may take a variety of forms e.g. a contract between the venturers, the minutes of discussions between venturers or writing an arrangement into the articles of the joint venture.
However, it is usually in writing and deals with such matters as:
- The activity, duration and reporting obligations of the joint venture
- The appointment of the board of directors of the joint venture
- The voting rights of the venturers
- Capital contributions of the venturers
- Profit sharing arrangements
The contractual arrangement must ensure that no single venturer is in a position to control the activity on their own. Duties may be delegated to different venturers but if one has the power to govern the financial and operating policies of the economic activity, then the venture becomes a subsidiary and not a joint venture.
Types of Joint Ventures
There are three different types of joint venture
- Jointly controlled operations
- Jointly controlled assets
- Jointly controlled entities
Jointly Controlled Operations
In this joint venture, the venturers use their own assets and resources rather than establishing a corporation, partnership or other entity. Each venturer uses its own property, plant and equipment and carries its own inventories. It also incurs its own expenses and liabilities and raises its own finance. The activities of the joint venture might be carried out by the venturer’s employees alongside the venturer’s other, similar activities.
The agreement between the venturers usually indicates how the revenue and any expenses incurred in common are to be shared out.
An example would be where two venturers, X and Y, combine their resources and expertise to build a new rocket. Different parts of the manufacturing process are carried out by each. Each incurs its own cost and share the revenue, as agreed by contract.
Each venturer should recognise in its financial statements:
- The assets that it controls and the liability that it incurs; and
- The expenses that it incurs and the share of income that it earns from the joint venture
Separate accounting records for the joint venture might not be kept. But the venturers might prepare management accounts in order to assess performance.
Jointly Controlled Assets
This is where the joint venturers jointly control (and often jointly own) one or more assets which are dedicated to the purposes of the joint venture.
Each venturer takes a share of the output from the assets and each bears an agreed share of the expenses incurred.
Such a joint venture is often used in the oil, gas and mineral extraction industries. For example a number of oil companies may jointly own a pipeline. Each uses it to transport their own oil and each pays an agreed proportion of the expenses.
Each venturer should recognise in its financial statements:
- Its share of the jointly controlled asset, classified by nature
- Any liabilities it has incurred
- Its share of liabilities jointly incurred with other venturers
- Income from the sale or use of the output of the assets, together with expenses incurred
Accounting records may be limited in the case of jointly controlled assets, perhaps merely recording common expenses.
Jointly Controlled Entity
This is a joint venture which establishes a corporation, partnership or other entity in which each venturer has an interest. In essence, it operates like other entities, but the venturers exercise joint control over its activities.
The jointly controlled entity has its own assets, liabilities, income and expenses. Each venturer is entitled to a share of the profits of the joint venture.
The jointly controlled entity maintains its own records and prepares its own financial statements. Each venturer contributes cash and/or other resources which are included in the records of the venturer as an investment in a joint venture.
In the preparation of consolidated financial statements, IAS 31 recognises two methods that are acceptable:
- Proportionate (proportional) Consolidation
- The Equity Method
The equity method approach treats the joint venture in the same way as an associate, i.e. the investment in the joint venture is increased by the group share of the post acquisition profits of the joint venture.
Proportionate Consolidation
This is a method of accounting whereby a venturer’s share of each of the assets, liabilities, income and expenses of a jointly controlled entity is combined, line by line, with similar items in the venturer’s financial statements or reported as separate line items in the venturer’s financial statements.
Applying this method means that the balance sheet of the venturer includes its share of the assets that it jointly controls and its share of the liabilities it is jointly responsible for.
The Statement of Comprehensive Income of the venturer will include its share of the income and expenses.
Exceptions to Proportionate Consolidation and Equity Method
Interests in jointly controlled entities that are classified as held for sale must be accounted for in accordance with IFRS 5.
DISCLOSURE
A venturer must disclose the aggregate of the following contingent liabilities, unless probability of loss is remote, separately from the amount of other contingent liabilities:
- Any contingent liabilities the venturer has incurred in relation to its interests in joint ventures, and its share of contingent liabilities incurred jointly with other venturers.
- Its share of the contingent liabilities of the joint ventures themselves for which it is contingently liable.
- Those contingent liabilities arising because the venturer is contingently liable for the liabilities of other venturers in the joint venture.
A venturer must disclose commitments in respect of the joint venture separately to other commitments.
A venturer must disclose a listing and description of interests in significant joint ventures and the proportion of ownership held in jointly controlled entities.
A venturer must also disclose the method it uses to account for its interest in jointly controlled entities.
