Chapter 4: Measurement under the equity method

Overview of the equity method

The equity method presents the investment in the associate or joint venture in a single line in the balance sheet. The investment is initially recognised at cost and adjusted thereafter for the post-acquisition change in the investor’s share of the investee’s net assets (‘share of results’) of the associate or joint venture.

An overview of the equity method is as follows:

• The investment is stated as one line item, initially recognised at cost.
• A notional ‘purchase price allocation’ is carried out to recognise any necessary fair value adjustments, similar to business combination accounting.
• The investor recognises its share of the profit or loss of the associate or joint venture for the period in the income statement, with an adjustment to the carrying amount of the investment.
• The investor’s share of profit or loss is adjusted for the effect of any fair value adjustments that arose in the notional purchase price allocation at initial recognition and any adjustments to conform to accounting policies.
• Appropriate adjustments are made for any unrealised profits or losses arising from upstream and downstream transactions.
• Any distributions received from the associate or the joint venture reduce the investment’s carrying amount.
• The investor recognises directly in other comprehensive income its share of other comprehensive income of the associate or joint venture. Amounts might be reported in other comprehensive income, for example, from the revaluation of property, plant and equipment, remeasurements of net defined benefit obligations or from foreign exchange translation differences.
• Investments in associates and joint ventures are tested for impairment using the measurement guidance in IAS 36, where indicators of impairment under IAS 28 (previously IAS 39) are present.
• Equity accounting ceases when significant influence or joint control is no longer present.

Application of the basic principles of equity accounting Entity A acquired a 30% interest in entity C and achieved significant influence. The cost of the investment was C250,000. The associate has net assets of C500,000 at the date of acquisition. The fair value of those net assets is C600,000, because the fair value of property, plant and equipment is C100,000 higher than its book value. This property, plant and equipment has a remaining useful life of 10 years. After acquisition, entity C recognised profit after tax of C100,000 and paid a dividend of C9,000 out of these profits. Entity C also recognised exchange losses of C20,000 directly in other comprehensive income. Entity A’s interest in entity C at the end of the year is calculated as follows: C Balance on acquisition under the equity method (including goodwill of C70,000 (C250,000 – (30% × C600,000)) 250,000 Entity A’s share of entity C’s after-tax profit (30% × C100,000) 30,000 Elimination of dividend received by entity A from entity C (30% × C9,000) (2,700) Entity A’s share of entity C’s exchange differences (30% × C20,000) (6,000) Entity A’s share of amortisation of the fair value uplift (30% × C10,000) (3,000) Entity A’s interest in entity C at the end of the year under the equity method (including goodwill) 268,300 Entity C has net assets at the end of the year of C571,000 (that is, net assets at the start of the year of C500,000, plus profit during the year of C100,000, less dividends of C9,000, less foreign exchange losses of C20,000). Entity A’s interest in entity C at the end of the year is made up of: C Entity A’s share of entity C’s net assets (30% × C571,000) 171,300 Goodwill 70,000 Entity A’s share of entity C’s fair value adjustments (the initial fair value difference of C100,000 has been reduced by C10,000, due to depreciation in the year) (30% × C90,000) 27,000 Entity A’s interest in entity C 268,300

Types of equity accounting adjustment The types of adjustment that might be necessary cover the following matters: Recognising goodwill and dealing with fair value adjustments arising on the associate’s or joint venture’s acquisition. Achieving consistent accounting policies. Eliminating the effects of transactions with associates or joint ventures: Profits and losses included in assets. Inter-company trading transactions. Long-term loans to associates or joint ventures. Distributions from associates or joint ventures. Translating the results of associates or joint ventures with a functional currency different from the entity’s presentation currency.

Implications of limited access to associate’s financial information 1. Implications of limited access to financial information The primary difference between an associate interest and an interest in a subsidiary is the level of the entity’s influence. An entity controls its subsidiaries and, therefore, has access to the information necessary for carrying out certain procedures at acquisition and on consolidation, but it exercises only significant influence over its associates and joint control over its joint ventures. This might mean that access to information to ascertain fair values on acquiring an associate or a joint venture interest, or that is necessary to make the required adjustments, is limited. The standard does not give any guidance on the extent of these procedures. Although estimates could be used, such a limitation in itself might call into question the entity’s relationship with its associate. Where the information available is extremely limited, the entity will need to reassess whether or not it actually has significant influence over the associate. 2. Implications of regulations regarding dissemination of information of associate The standard makes no reference to regulations on the dissemination of information that could possibly restrict the extent to which the financial statements of an entity might contain information about its associates, unless such information is available to other interested parties at the same time. This is of particular importance where the associate is itself listed. An entity should, therefore, consider how to satisfy any regulations that apply concerning the publication of price sensitive information about its associates.

There might be circumstances where an associate or joint venture of the investor has a change in net assets that does not affect profit or loss or other comprehensive income. IAS 28 is silent on these transactions. In 2012, the IASB added this issue to its agenda as a separate amendment rather than an annual improvement.

Due to insufficient votes in favour of the amendment, the IASB decided not to proceed with the amendment, and this issue might be reconsidered, depending on the outcome of the research project on the equity method of accounting.

Accounting for other changes in net assets of the associate or joint venture IAS 28 is silent on how to treat changes in the equity of an associate or a joint venture, other than those that are recorded in other comprehensive income. Such changes include, for example, gains and losses arising on an associate’s transactions with non-controlling interest shareholders of its subsidiaries (recorded directly in equity in the associate’s books) and movements in the share-based payment reserves of the associate or the joint venture. In these cases, the effects of the transactions are recorded in equity of the associate, but outside profit or loss and other comprehensive income. In the absence of any specific guidance in terms of the presentation of such transactions by the entity, the reporting entity needs to develop and apply consistently an accounting policy that best reflects the substance of these transactions.

Split measurement accounting

An investor might hold its interest (or a portion of its interest) in a joint venture or an associate indirectly through venture capital organisations, or mutual funds, unit trusts and similar entities. The investor might elect to measure that portion at fair value through profit or loss under IFRS 9 (IAS 39).

This treatment is available even if the investor has significant influence over the investment. The remaining investment is accounted for using the equity method of accounting.

Accounting in the consolidated financial statements of the parent A group has an investment in an associate, and this investment is held by more than one of its subsidiaries. One subsidiary, which is an investment linked insurance fund (or mutual fund, unit trust or venture capital organisation), accounts for the investment in its associate, on initial recognition in its separate financial statements, at fair value through profit or loss in accordance with IFRS 9 (IAS 39). Another subsidiary accounts for its investment in the same associate in accordance with IAS 28, and thus uses the equity accounting method. Can both measurement bases be used in the consolidated financial statements of their parent? Different measurement bases can be applied to portions of an investment in an associate, where part of the investment is designated, on initial recognition, at fair value through profit or loss in accordance with the venture capital scope exemption. The group is required to determine if it has significant influence over that investment and, if it does, the group measures the portion of the investment in the associate to which the venture capital scope exemption is applied at fair value through profit or loss, and the remaining investment in the associate is accounted for using the equity method of accounting.