Accounting for symmetrical put and call options over associates and joint ventures

Entities might issue put options or symmetrical put and call options over their equity interests in an associate or a joint venture. Where such options are issued over a non-controlling interest in a subsidiary’s equity, the group recognises a liability. The question arises whether management should apply the same accounting treatment for equity instruments of associates and joint ventures. The recognition of a liability in relation to such options is mandated by paragraph 23 of IAS 32, because of its reference to the group’s own equity. Since an associate or a joint venture is not part of a reporting group, the same accounting treatment cannot be applied to put options over equity interests of an associate or a joint venture. No liability should be recognised on the reporting group’s balance sheet. Whilst the recognition of a financial liability for the full obligation does not arise, the entity might have a derivative financial instrument, which would need to be recognised and measured in accordance with IFRS 9 (IAS 39).

Accounting for compound instruments issued by the associate or the joint venture to the entity

Entity A invests C100 in entity B. It first invests C40 for a 50% interest in the equity share capital of entity B. Entity B has equity share capital of C80. It then invests C60 for an interest in convertible debt of entity B. Entity A does not control or jointly control entity B, but it does have significant influence, and so entity B is an associate. The terms of the convertible debt are that entity A has the option to convert the debt into a fixed number of equity shares in entity B after five years.

In accordance with IAS 32, entity B has split the convertible debt that it issued into its liability and equity components. The debt component is valued at C40, and the equity option is valued at C20. An entity applies the measurement requirements of IFRS 9 to the entire financial instrument if the financial instrument is an asset that contains an embedded derivative. Entity A accounts for the convertible debt at fair value under IFRS 9. (Under IAS 39, the entity would split the financial instrument and account for the debt at amortised cost and the embedded derivative (equity conversion option) at fair value.) The summarised balance sheets of entities A and B (under IFRS 9) are as follows:

Entity A year 1 Entity B year 1 C C Investment in entity B at cost 40 − Loan to entity B (with conversion option) * 60 − Cash − 140 Convertible loan − (40) 100 100 Shares 100 80 Conversion option − 20 Profit and loss reserve − − 100 100 *

Under IAS 39, the loan to entity B would be shown as C40, with a separate line item for embedded derivative of C20. The share that entity A equity accounts for is its interest in the equity share capital of entity B of 50%. The potential ownership interest is ignored. Under the equity method of accounting, the carrying amount of the investment in entity B of C40 is adjusted to recognise entity A’s share of entity B’s profit or loss arising after the date of acquisition (including the effect of any fair value differences).

Assume, for the purpose of this example, that fair value of net assets equals book value, so that there are no adjustments required for the effect of fair value differences. On acquisition, entity A’s share of entity B’s net assets is C40 (that is, C80 × 50%). This compares to an initial cost of investment of C40 and no goodwill arises on the transaction. Immediately after the acquisition of the equity interest, entity B issues convertible debt of C60 and splits this into its debt and equity components. At the year end, entity A equity accounts for its share of the profit or loss and equity of entity B of C10 (that is, C20 × 50%).

The share of C10 arises because of the equity conversion option. An appropriate accounting treatment for this amount of C10 could be to eliminate it against the carrying value of the financial asset carried at fair value in entity A (which includes the equity conversion option), rather than to show a gain in profit or loss, because it could be argued that this reflects the substance of the transaction. This reflects the fact that the equity conversion option does not entirely dilute the interests of the other shareholders in entity B. 50% of the conversion option is ‘used’ to maintain the existing interest of entity A in entity B. The other 50% dilutes the interests of the other shareholders and increases entity A’s interest. In the example, entity B has 80 shares in issue and the option is for 20 more shares. When the option is converted, entity A will have a 60% interest in entity B. Its interest has increased by 10%, and the other shareholders’ interests have likewise decreased. It is only 10 of these 20 shares that actually increase entity A’s interest. It is appropriate to eliminate 50% of the option in entity B’s equity against the equity conversion option included in the financial asset in entity A’s books. If this accounting approach is followed, the resulting equity accounting adjustments can be summarised as follows:

Entity A year 1 Entity B year 1 Equity accounting adjustment s Entity A equity accounting for entity B C C C C Investment in entity B at cost 40 − (40) − Equity-accounted entity B − − 50 50 Loan to entity B (with conversion option) * 60 − (10) 50 Cash − 140 (140) − Convertible loan − (40) 40 − 100 100 (100) 100 Shares 100 80 (80) 100 Conversion option − 20 (20) − Profit and loss reserve − − − − 100 100 (100) 100 * Under IAS 39, the loan to entity B would be shown as C40, with a separate line item for embedded derivative of C10.

Assume that, during the following year, entity B makes a profit of C100, and the fair value of the financial asset increases by C10 (assuming, for the purposes of this example, that this is all attributable to the equity conversion option). The summarised balance sheets of entities A and B are as follows: Entity A year 2 Entity B year 2 C C Investment in entity B at cost 40 − Equity-accounted entity B − − Loan to entity B (with conversion option)* 70 − Cash − 240 Convertible loan − (40) 110 200 Shares 100 80 Conversion option − 20 Profit and loss reserve 10 100 110 200

* Under IAS 39, the loan to entity B would be shown as C40, with a separate line item for embedded derivative of C30. Under the equity method of accounting, the cost of investment in entity B of C40 is, again, adjusted to recognise entity A’s share of the profit or loss and equity of the associate since acquisition. Entity A’s share of entity B’s profit or loss under the equity method is C50 (that is, C100 × 50%). Under the accounting approach outlined above, the share of equity of C10 that arose in year 1 would continue to be eliminated against the carrying value of the financial asset in entity A. The equity accounting adjustments are summarised as follows:

Entity A year 2 Entity B year 2 Equity accounting adjustment s Entity A equity accounting for entity B C C C C Investment in entity B at cost 40 − (40) − Equity-accounted entity B − − 100 100 Loan to entity B (with conversion option) * 70 − (10) 60 Cash − 240 (240) − Convertible loan − (40) 40 − 110 200 (150) 160 Shares 100 80 (80) 100 Conversion option − 20 (20) − Profit and loss reserve 10 100 (50) 60 110 200 (150) 160

* Under IAS 39, the loan to entity B would be shown as C40, with a separate line item for embedded derivative of C20.

Accounting for cross-holdings of shares

One company (the entity) might issue shares to another company in exchange for shares in that other company. Without some adjustment, there will be an element of double counting if the entity equity accounts for its share of the investee’s net assets, which includes the holding of shares in the entity. This cross-holding needs to be eliminated, as explained in the following example. Entity H takes a 25% stake in entity A, which has net assets of C1 million. The market value of entity A’s shares is C1.5 million. The net asset carrying value and the fair value of the net assets is the same (that is, C1 million).

Entity H issues shares with a value of C375,000 to acquire its interest. Where entity H issues its shares to the owners of entity A in exchange for the 25% interest, entity H’s share capital and share premium would increase by C375,000, representing the cost of its investment in entity A. On equity accounting, the investment in entity A of C375,000 is allocated between the group’s share of the fair value of its net assets (that is, C250,000) and notional goodwill arising on the acquisition of C125,000 (that is, C375,000 – C250,000).

Now assume that there is an equity swap, such that entity H issues shares worth C500,000 to entity A in consideration for entity A issuing new shares to entity H. Entity A’s net assets increase by C500,000, which is the cost to it of the shares that it holds in entity H. Entity A’s worth has increased to C2,000,000 and it has net assets of C1,500,000. Entity H’s share of entity A’s increased net assets is C500,000 (that is, C2,000,000 × 25%). So it might appear that, on equity accounting, the value of entity H’s interest in its associate should be C500,000 (that is, C2,000,000 × 25%), but entity H’s interest in entity A should not exceed C375,000 (C2,000,000/25% less C500,000/25%), which is the worth of entity A less its interest in entity H shares that it has received.

If entity H had recognised its share as C500,000 instead, it would have inflated its balance sheet by recognising some value for its own internally generated goodwill/equity. To avoid double counting for the self-investment, it is necessary to eliminate the interest that entity H has in itself. It is appropriate to reduce the value of entity H’s investment in entity A’s net assets by C125,000 to C375,000. The rationale is that the net assets are reduced to eliminate the cross-holding, and this also ensures that purchased goodwill in entity A is recorded at the appropriate value. A problem arises if entity A subsequently sells its interest in entity H – an adjustment is required to bring entity H’s investment in entity A in its financial statements back up to the increased share of net assets of entity A (that is, to C500,000). In entity H’s income statement, entity H’s share of entity A’s results should exclude any dividends from entity A to entity H. In relation to dividends paid by entity H to entity A, the income statement of entity H should exclude a share of any dividends paid by entity H to entity A.

This approach is supported by analogy with the accounting that is applied to the treatment of gains/losses in a downstream transaction between an investor and its associate – that is, the entity’s share in the associate’s gains/losses are eliminated. [IAS 28 para 28]. Alternatively, it might be acceptable for the income statement of entity H to include a share of any dividends paid by entity H to entity A. This approach is supported by the fact that the dividend payment is a non-reciprocal transaction, with the result that the dividend is an actual resource of entity A. If there are structures that have more complicated cross-holdings, the amounts to be equity accounted can often be determined using simultaneous equations.

Listed associate’s period end more than three months before or after the entity’s period end

On 1 October 20X3 a group acquired an interest in an associate. The group’s year end is 31 December and the associate’s year end is 28 February. The associate is a listed company and it publishes interim accounts for the six months to 31 August. IAS 28 does not include an exception from the ‘three-month rule’ for situations where use of figures at a date not more than three months before the entity’s year end would divulge price-sensitive information. Under IAS 28, therefore, the correct approach would be to prepare financial statements for the associate either at the year end of the entity (that is, 31 December) or at 1 October (the date of acquisition), which is also not more than three months before the entity’s year end. The latter approach would have the advantage of providing balance sheet figures at the date of acquisition. In order to prevent the use of such information by the entity from releasing price-sensitive information, it would be necessary for the associate to publish its accounts prepared to 1 October.

Another option would be for the entity to use the financial statements prepared by the associate at its year end of 28 February, because this is only a two-month difference in reporting dates (as opposed to the three-month difference allowed in IAS 28). This approach would overcome the price-sensitive information issue. However, it might not be practical if the entity has to release its results before the associate publishes its February financial statements. The situation does not appear to be one where the use of the provisions of IAS 1, that allow a departure from a standard in certain situations, would be justified.

IAS 1 requires a departure where compliance with a standard would be so misleading that it would conflict with the objective of financial statements set out in the Framework and the relevant regulatory framework requires, or does not otherwise prohibit, such a departure. In this situation, a departure from IAS 28 would actually give a less reliable and relevant result than compliance with the standard. If the entity is not able to persuade the associate to prepare financial statements that would enable the entity to comply with the standard, it will need to reassess whether it is in a position where it has significant influence.

Abnormal transaction between associate’s period end and that of the entity

The associate or the joint venture might sell fixed assets to the group (or vice versa) during this period. Any adjustments made (due to significant transactions between year ends) will need to be reversed in the following years, as depicted in the examples below.

Example 1 – Significant transaction between associate’s period end and that of the entity

Entity A prepares financial statements to 31 January each year. One of entity A’s associates, entity Y, prepares financial statements to 31 December, but not to 31 January. On 30 January 20X2, entity Y suffered a major fire at one of its factories. This event was a non-adjusting post balance sheet event in entity Y’s financial statements. Entity Y also launched a significant sales campaign at the end of 20X1, with the result that sales and operating profits in January 20X2 were 45% higher than the previous year. The increased sales are material to entity A’s financial statements. The standard requires that, where the dates are within three months of each other and more recent statements are not prepared, adjustments are necessary for significant transactions or events in the intervening period. Entity A should treat the fire at entity Y’s factory as an adjusting event in entity A’s financial statements, in which entity Y is equity accounted. The event would remain a non-adjusting event for entity Y’s financial statements prepared to 31 December 20X1. Because the impact of the additional sales is material, entity A should calculate the impact of entity Y’s additional sales and make an appropriate adjustment to the financial statements of entity Y that are used to equity account entity Y’s results.

Example 2 – Associate pays dividend after its period end but before the entity’s period end

An entity has a number of associates. The reporting date for the entity’s consolidated financial statements is 31 December, while the reporting date for one of the associates is 30 September, and the group includes the associate’s financial statements made up to this earlier date. The group has received a dividend from the associate between 30 September and 31 December. Therefore, when it equity accounts for the associate at the entity’s year end, there is a mismatch, because the entity has received a dividend that has not been reflected within the associate’s financial statements as at 30 September. The consolidation adjustment required in this case is to debit the group’s profit and loss account (to remove the dividend received from the associate shown in the parent’s own separate accounts) and to credit the investment in the associate, reflecting the fact that the associate’s net assets have reduced as a consequence of paying the dividend.

Application of the equity method where the associate is a group of undertakings

Entity X has two associates, A and B. Associates A and B have holdings in another entity, C. The standard states that, in determining whether entity C is an associate of entity X, entity X should ignore the holdings of associates A and B, because entity X only has significant influence over these associates, and does not have control. Only the direct and indirect interests of the parent entity and its subsidiaries should be taken into account. The interests in entity C that derive from entity X’s holdings in associates A and B will be taken into account when entity X accounts for its share of their results under the equity method. The amount reflected in entity X’s group accounts in respect of associates A and B’s holdings in entity C will depend on how associates A and B account for those holdings – that is, whether they treat them as a trade investment (if entity C is not their associate) or as an associate (if entity C is an associate of associate A and/or B) or as a subsidiary, because the standard requires the net assets and profits or losses that should be taken into account on equity accounting to be those that are recognised in the associate’s financial statements (including the associate’s share of its associates). (Such financial statements might be either consolidated financial statements, if the associate has subsidiaries, or economic interest financial statements, if the associate only has associates.)

Elimination of upstream transactions

Example 1 – Elimination is made against the carrying amount of the associate

An entity has a 20% interest in an associate. The associate sells inventory costing C300 to the entity for cash of C500. The inventory has not been sold to third parties at the balance sheet date. The profit attributable to the entity is required to be eliminated from the consolidated financial statements. The associate recorded a profit of C200 on this transaction. The entity’s share of this profit is C40 (C200 × 20%). The entity eliminates its share of the profit against the carrying amount of the associate. The entity’s interest in its associate is not increased by the profits that it generates from selling upstream until the transaction has been crystallised by an onward sale to a third party.

This is consistent with the requirements of paragraph 10 of IAS 28, because the associate is carried at an amount equal to cost plus share of profits. The accounting entries are to debit the share of profit of the associate (C40) and to credit the investment in the associate (C40). Assuming that the entity sells the inventory to a third party in the following year for C500, it is necessary to reverse the profit elimination entry made on consolidation in the prior year, because the unrealised profit has now been crystallised by an onward sale. The accounting that results is consistent with the accounting for realised transactions. Overall, there is a profit on the transaction of C200, and the group’s share of this profit is taken up in the share of its associate’s result. Any additional profit made by the entity by selling the inventory would be recorded as part of operating profit in the normal way.

Example 2 – Elimination is made against the asset transferred

The facts are the same as in example 1, except that the entity’s share of the profit (C40) is eliminated against the asset transferred. In this case, the entity’s interest in its associate is increased by the profits that it generates from selling upstream before the transaction is crystallised by an onward sale. This is consistent with the requirements of paragraph 3 of IAS 28, because the associate is carried at an amount equal to cost plus a share of the change in net assets. The associate has received cash from the entity of C500, and so the upstream transaction does not impair the value of the associate investment. The accounting entries are to debit the share of profit of the associate (C40) and to credit inventory (C40). Assuming that the entity sells the inventory to a third party in the following year for C500, it is necessary to reverse the profit elimination entry made on consolidation in the prior year, because the profit has now been crystallised by an onward sale to a third party. The entity records its share of the profit arising on the upstream transaction, and it increases the cost of inventory.

The accounting that results is consistent with the accounting for realised transactions. Overall, there is a profit on the transaction of C200, and the group’s share of this profit is taken up in the share of its associate’s result. Any additional profit made by the entity by selling the inventory would be recorded as part of operating profit in the normal way. There are potentially different deferred tax consequences, depending on which alternative accounting treatment is adopted. Where the gain is eliminated against the carrying amount of the associate or the joint venture, there is generally no temporary difference on either the asset transferred or the associate or the joint venture. Where the gain is eliminated against the carrying value of the asset, entities need to consider whether there are temporary differences to account for. If, for example, the asset is property, plant or equipment, there are two temporary differences that only offset each other if the tax rates on the income of the entity are identical to the tax rate on undistributed profits from the associate or the joint venture.

Elimination of downstream transactions

The elimination of unrealised profits is against the carrying value of the associate or joint venture, because the asset considered has been transferred to the associate or joint venture. Unrealised losses should not be eliminated to the extent that the transaction provides evidence of an impairment of the asset transferred. An entity has a 20% interest in a joint venture. The entity sells inventory to the joint venture for C500. The original cost of the inventory was C300. The inventory has not been sold to a third party at the balance sheet date. The entity records a profit of C200. However, because the sale was to a joint venture, an element of this profit is unrealised and should be eliminated. The unrealised profit is C40 (20% × C200).

The adjustments required to be made in the entity’s books are to debit revenue of C100 (C500 × 20%), to credit cost of sales of C60 (C300 × 20%) (or the entity could debit the share of profit of the joint venture by C40), and to credit the investment in the joint venture of C40. The adjustments will be reversed by the entity when the joint venture sells the inventory on to a third party.

Downstream transactions: accounting for unrealised gains

Example 1 – Principles of paragraph 39 of IAS 28

Entity A owns 20% of the shares of its associate, entity B. Entity A sells an asset to entity B for cash of C400 in 20X5. The carrying amount of the asset in entity A’s financial statements before the transaction is C300. The total gain to entity A from the transaction is C100. The gain should be reduced in entity A’s consolidated financial statements by C20 (C100 × 20%) to reflect the entity’s interest. The carrying amount of entity A’s investment in entity B in its consolidated financial statements is C5 just before the transaction. Entity A has no legal or constructive obligation on behalf of entity B, and it has no long-term loans to entity B. Entity B earns profits of C60 in 20X6. The share of entity A in the profit of entity B is C12. At 31 December 20X6, entity B still owns the asset that it acquired from entity A. The asset is sold to a third party in 20X7. In 20X5, the unrealised gain of C20 is eliminated, up to the point at which the carrying amount of entity B in entity A’s consolidated financial statements is reduced to zero (that is, C5). No adjustment is made for the remaining gain of C15 that entity A recognised in its consolidated financial statements. Because entity B earns profits, entity A will eliminate the remaining excess gain, up to the amount of profits available. A further C12 (20% of C60) of unrealised gain is eliminated in 20X6. This means that no share of entity B’s profits is recognised in profit or loss. The asset is sold to a third party in 20X7. Thus, all of the previously deferred gain of C17 (C5 + C12) is recognised in 20X7.

Example 2 – Principles of paragraph 40 of IAS 28

The facts are the same as example 1. In 20X5, the unrealised gain of C20 is still eliminated, up to the point at which the carrying amount of the associate is reduced to zero (that is, C5). No adjustment is made for the remaining gain of C15 that entity A recognised in its consolidated financial statements. In 20X6, entity A will recognise its share of associate’s profit (that is, C12), recording an associate carrying amount of C12. The excess gain will not be eliminated against this profit. Instead, entity A should test the investment for impairment if there is any evidence that the associate’s carrying amount is impaired. In 20X7, because the asset is sold to a third party, the previous deferred profit of C5 is recognised.

Accounting for inter-company trading transactions

An entity has a 25% interest in an associate. The entity charges interest of C10,000 on a loan that it has made to the associate. Therefore, the entity has interest income in its profit and loss account of C10,000, and the associate has an interest expense of C10,000. On equity accounting for the associate, the entity would show, for these items, interest income of C10,000 and a share of the associate’s expense payable of C2,500 (as part of the overall share of the associate’s after-tax result). The entity has only recognised net income of C7,500, which represents the net interest charged by the entity to the associate.

Distributions from associate in excess of carrying amount of investment

Entity A has an associate, entity B. The carrying amount of entity A’s investment in entity B is C2,000. Entity B has distributed a dividend to entity A of C2,400. The dividend has no restrictions, and entity A cannot be required to refund the dividend. Entity A should reduce the carrying value of entity B to nil and recognise the excess of C400 as a gain in its consolidated or economic interest financial statements. Entity A has no obligation to repay the dividend, and there are no restrictions to recognise the benefit for the excess. In subsequent years, where entity B makes profits, entity A has to consider how to account for its share of entity B’s profits.

Entity A could increase the carrying value of its investment in entity B by its share of subsequent profits and then assess whether the investment is impaired. On the other hand, entity A might consider it appropriate not to recognise its share of entity B’s subsequent profits until the gain previously recognised in profit or loss has been ‘clawed back’. Entity A should select the accounting treatment that best reflects the facts and circumstances. For example, it might be the case that facts and circumstances indicate that the payment from an associate to its investor represents, in substance, a return of capital from the investor’s perspective. Such a return of capital might be seen as distinct in nature from future profits of the investee which the investor would recognise through equity accounting in subsequent periods. In such a case, there would be no need for a clawback of the previous return of capital.

Reduction of associate interest to an investment

Entity A has a 40% stake in entity B. It sells 75% of its stake (reducing its investment to 10%) for a consideration of C7.5 million. The carrying value of entity B (including goodwill) at the date of partial disposal is C9 million and it has a foreign currency translation reserve of C0.5 million. Hence, entity A retains a 10% stake of entity B at a fair value of C2.5 million. On disposal, entity A will recognise its remaining 10% stake in entity B as a financial asset at its fair value of C2.5 million, record the consideration received of C7.5 million, de-recognise the associate at C9 million, and recycle entity B’s foreign currency translation reserve of 0.5 million to the profit and loss as part of the gain or loss made on disposal. The resulting difference gives a gain on disposal of C1.5 million ((7.5m + 2.5m – 9m) + 0.5m).

Entity’s stake in associate is diluted

Entity A has an associate, entity B, that has 100 shares in issue, of which entity A owns 30. At the time when the investment was made, the fair value of entity B’s net assets was C233 and the initial carrying value of the investment was C100, including C30 of goodwill. Since the investment was made, entity B has generated profits and the carrying value of the investment is now C127. Entity B now has a fair value of C600. Entity B issues 50 shares at C300 (fair value) to investors other than entity A. Entity A’s holding is now diluted to 20% (30/150 shares). The dilution means that entity A has ‘disposed’ of one-third of its interest in entity B, because the interest is diluted from a 30% to a 20% shareholding. The dilution gain or loss is calculated by comparing the carrying value of the disposed interest (C127 × 1/3 = C42) to entity A’s share of the proceeds received for the new shares issued (C300 × 20% = C60), represented by an increase in the associate’s net assets. The gain on dilution is, therefore, C18. A portion (C42) of the carrying value of the associate is de-recognised, including de-recognition of C10 of goodwill, being one-third of the original goodwill of C30. The share of proceeds (C60) is added to the carrying value of the investment in the associate. The gain (C18) increases the carrying value of the associate and is recorded in profit or loss.