ACCA paper f 7 financial reporting F7FR session24 d08

SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES OVERVIEW Objective To explain what an associate is To explain the accounting treatment for associates EQUITY ACCOUNTING INTER-COMPANY ITEMS WITH AN ASSOCIATE ACCOUNTING TREATMENT Relationship to a group Basic rule Equity accounting Treatment in consolidated statement of financial position Treatment in consolidated statement of comprehensive income Accounting policies and year ends Impairment Exemptions to equity accounting Background Scope Definitions Significant influence Separate financial statements Inter-company trading Dividends Unrealised profit DISCLOSURE Investments in associates Using the equity method 2401 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES EQUITY ACCOUNTING 1.1 Background Where one company has a controlling investment in another company, a parentsubsidiary 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 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 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 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 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 Such investments are measured at fair value in accordance with IAS 39, with changes in fair value recognised in profit or loss in the period of the change 2402 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES 1.3 Definitions 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) 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 Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities 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 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 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 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) When significant influence is lost, the carrying amount of the investment at that date is regarded as its cost on initial measurement thereafter (and will be accounted for as a financial asset in accordance with IAS 39) 2403 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES 1.5 Separate financial statements Investors that are exempt from the requirement to equity account may present separate financial statements as their only financial statements In the separate financial statements, the investment in the associate should be accounted for: Under IFRS if classified as held for sale; At cost or in accordance with IAS 39 ACCOUNTING TREATMENT 2.1 Relationship to a group 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 As such, the accounting treatment of the associate is different to that of subsidiaries 2.2 Basic rule An investment in an associate is accounted for using the equity method 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 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 Distributions received from the associate reduce the carrying amount of the investment Adjustments to the carrying amount may also be necessary for changes in the investor’s proportionate interest in the associate arising from other items of comprehensive income that have not been recognised in the profit or loss Such changes include those arising from the revaluation of property, plant and equipment and from foreign exchange translation differences 2404 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES Commentary These changes will be reflected within the other comprehensive income section of the statement of comprehensive income The investor’s share of the current year’s profit or loss of the associate is recognised in the investor’s profit or loss 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 The methods described below apply equally to the financial statements of a non-group company that has an investment in an associate as they to group accounts 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 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 In group reserves, include the parent’s share of the associate’s post-acquisition reserves (the same as for subsidiary) 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 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 value revaluations must be taken into account (as they are when dealing with subsidiaries) 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 To calculate amounts for net assets and post-acquisition reserves, use a net assets working for the associate (the same as for the subsidiary) 2405 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES 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) Goodwill on acquisition, less any impairment of goodwill $ X 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 Therefore the carrying value can easily be calculated with reference to the share of net assets at the end of the reporting period 2406 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES Example 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 Issued capital – $1 ordinary shares Retained earnings Liabilities 5,200 4,100 4,650 1,000 4,000 200 400 3,400 300 800 3,600 250 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 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: Prepare the consolidated statement of financial position at 31 December 2007 2407 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES 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 Issued capital Retained earnings A Issued capital Retained earnings 2408 Reporting date $ Acquisition Reporting date $ Acquisition $ $ SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES (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 $ 2409 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES 2.5 Treatment in a consolidated statement of comprehensive income 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 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 $ 14,000 (9,000) S $ 12,000 (4,000) A $ 10,000 (3,000) Gross profit Administrative expenses 5,000 (2,000) 8,000 (6,000) 7,000 (3,000) Dividend from associate 3,000 400 2,000 – 4,000 – Profit before taxation Income taxes 3,400 (1,000) 2,000 (1,200) 4,000 (2,000) Profit after taxation Dividends (paid) 2,400 (1,000) 800 – 2,000 (1,000) Retained earnings for the period 1,400 800 1,000 Revenue Cost of sales Goodwill was fully written off three years ago Required: Prepare the consolidated statement of comprehensive income for the year ended 31 December 2007 2410 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES 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 Revenue Cost of sales Administration expenses Income from assocociate Tax Profit after tax (3) P $ S $ 40% A Adjustment Consolidation $ $ $ Non-controlling interest S only 2411 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES 2.6 Accounting policies and year ends 2.6.1 Accounting policies 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 The most recent available financial statements of the associate are used by the investor When the reporting dates of the investor and the associate are different, the associate prepares, 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 so 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 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 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 Because goodwill included in the carrying amount of an investment in an associate is not separately recognised, it is not tested for impairment separately Instead, the entire carrying amount of the investment is tested for impairment, by comparing its recoverable amount with its carrying amount 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 the present value of the estimated future cash flows expected to arise from dividends to be received from the investment and from its ultimate disposal 2412 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES 2.8 Exemptions to equity accounting An associate that is classified as held for sale is accounted for under IFRS “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 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 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 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 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 INTER-COMPANY ITEMS WITH AN ASSOCIATE 3.1 Inter-company trading 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 Do not cancel inter-company balances on the statement of financial position and not adjust sales and cost of sales for trading with associate In consolidated statement of financial position, show balances with associate separately from other receivables and payables The associate is not part of the group It is therefore appropriate to show amounts owed to the group by the associate as assets and amounts owed to the associate by the group as liabilities 2413 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES 3.2 Dividends 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 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 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 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 To avoid double counting when equity accounting for associate, this unrealised profit needs to be eliminated Unrealised profits should be eliminated to the extent of the investor’s interest in the associate Unrealised losses should not be eliminated if the transaction provides evidence of an impairment in value of the asset that has been transferred To eliminate unrealised profit, deduct the profit from associate’s profit before tax and retained earnings in the net assets working before equity accounting for associate, irrespective of whether sale is from associate to parent or vice versa 2414 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES Example 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 Deduct $50 from associate’s profit before tax in statement of comprehensive income, thus dealing with the profit or loss impact 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 DISCLOSURE 4.1 Investments in associates The 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) 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 If relevant, the associate’s reporting date if different from that of the investor, and the reason for using a different reporting date (or different period) 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) The unrecognised share of losses of an associate for the period and cumulatively The fact that an associate is not accounted for using the equity method when exempt from doing so 2415 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES 4.2 Using the equity method Classification as non-current assets 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: define an associate and explain the principles and reasoning for the use of equity accounting; prepare consolidated financial statements to include a single subsidiary and an associate 2416 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES EXAMPLE SOLUTIONS Solution P Consolidated statement of financial position as at 31 December 2007 $ 1,880 2,400 5,500 Investment in associate Non-current assets (1,600 + 800) Current assets (2,200 + 3,300) 9,780 Issued capital Retained earnings (W5) 1,000 7,520 Non-controlling interests (W4) Liabilities 8,520 760 500 9,780 WORKINGS (1) Group structure P 80% GROUP S 40% A 2417 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES (2) Net assets working S Issued capital Retained earnings A Issued capital Retained earnings (3) Reporting date $ 400 3,400 Acquisition 3,800 920 Reporting date $ 800 3,600 Acquisition 4,400 1,200 $ 400 520 $ 800 400 Goodwill S Cost of investment Net assets acquired (80% × 920 (W2)) $ 800 (736) 64 A Cost of investment Net assets acquired (40% × 1,200 (W2)) $ 600 (480) 120 (4) Non-controlling interests S only – (20% × 3,800) (5) Retained earnings P – from question Share of S [80% × (3,400 – 520) (W2)] Share of A [40% × (3,600 – 400) (W2)] Less Goodwill impaired (W3 per Activity) $ 760 $ 4,000 2,304 1,280 (64) 7,520 2418 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES (6) Investment in associate $ 1,760 120 Share of net assets (40% × 4,400) Goodwill 1,880 Proof Cost Share of post acquisition profits 600 1,280 1,832 Solution P Consolidated statement of comprehensive income for the year ending 31 December 2007 Turnover Cost of sales $ $ 26,000 (13,000) Gross profit Administrative expenses 13,000 (8,000) Operating profit Income from associate 5,000 800 Profit before taxation Income taxes 5,800 (2,200) Profit after taxation Non-controlling interests (W3) 3,600 (160) Profit for the financial year 3,440 Dividends paid (included in SOCIE) 1,000 2419 SESSION 24 – IAS 28 INVESTMENTS IN ASSOCIATES WORKINGS (1) Group structure P 40% 80% S (2) Consolidation schedule Revenue Cost of sales Administration expenses Income from associate 40% × 2,000 Tax – group Profit after tax (3) P $ 14,000 (9,000) (2,000) S $ 12,000 (4,000) (6,000) (1,000) (1,200) 800 Non-controlling interest S only 2420 A 20% × 800 $160 40% A Adjustment Consolidation $ $ $ 26,000 (13,000) (8,000) 800 800 (2,200) ... cent If relevant, the associate’s reporting date if different from that of the investor, and the reason for using a different reporting date (or different period) The nature and extent of any... Gross profit Administrative expenses Operating profit Income from associate Profit before taxation Income taxes Profit after taxation Non-controlling interests Profit for the financial. .. financial statements of the associate are used by the investor When the reporting dates of the investor and the associate are different, the associate prepares, for the use of the investor, financial