Chapter 2: Scope

An investor uses the equity method to account for its interests in joint ventures and associates unless the entity is exempted from applying the equity method as specified in the Standard.

Equity method:

The Standard defines the equity method as 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 its share of the profit or loss of the investee and the other comprehensive income of the investor includes its share of other comprehensive income of the investee. Such changes include those arising from the revaluation of property, plant and equipment and from foreign exchange translation differences.

Exceptions from using the equity method

An investment in an associate or a joint venture must be accounted for using the equity method under IAS 28, unless one of the following applies:

• The investment is classified as held for sale in accordance with IFRS 5.
• The reporting entity is a parent exempt from preparing consolidated or economic interest financial statements.
• The investment in associate or joint venture is held by (or is held indirectly through):

1. venture capital organisations; or
2. mutual funds, unit trusts and similar entities including investment-linked insurance funds.

The exemption from using the equity method in the third bullet is available if the investments are measured at fair value through profit or loss in accordance with IFRS 9 (IAS 39). An entity can make this election separately for each associate or joint venture at initial recognition.

What are the characteristics of ‘venture capital’ investments? A ‘venture capital’ investment can be distinguished from other investments by considering: a. the way it is managed, b. the nature of the investment, and c. expected returns. ‘Venture capital’ investments are often in high-risk start-up ventures, where the entity looks for capital growth rather than an income return. ‘Venture Capital’ investments ‘Non-venture Capital’ investments 1. Held as part of an investment portfolio, where their value is through their marketable value rather than as a medium through which the entity carries out its business. Strategic investments are held for the longer term and might generate benefits in addition to growth in the investments’ fair value.   2. The entity aims to generate growth in the value of its investments in the medium term and usually identifies an exit strategy or strategies when the investments are made. The investments are made for strategic purposes, rather than for medium-term growth in fair value.     3. The investments are typically in businesses unrelated to the entity’s business.   An entity might make a strategic investment in a similar or related business, to derive synergy or other benefits or as the first step towards acquisition.   4. The investments are managed on a fair value basis. Held for strategic growth and therefore not managed on a fair value basis.

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Practical issues relating to ‘venture capital’ organisations  What are the characteristics of ‘venture capital’ organisations? Where an entity is a member of a recognised venture capital organisation, or it meets the conditions for membership of a recognised venture capital organisation, this would be evidence that it met the conditions for exemption in IAS 28. In less obvious situations, the following characteristics indicate that an entity is a venture capital organisation: It has, as its principal business, the provision of equity finance to unquoted companies and makes its returns mainly through medium to long-term capital gain. These activities might include start-up and other early-stage expansion, management buy-out or management buy-in investment which includes an ‘equity-type’ return. It takes an active role in helping to build and develop the companies in which it invests. It is a member of a recognised regulatory authority, where appropriate.  Is the exemption available if the entity undertakes both venture capital and other business activities? In this case, the distinction might be more difficult to make. The exemption applies to venture capital ‘organisations. The ‘organisation’ does not have to be a separate legal entity, but it does have to be a division or a branch that is clearly separated and managed independently from the entity’s other business activities (for example, the division or branch might have its own management team). The ‘organisation’ must undertake a venture capital business that is managed with the objective of earning a return on its venture capital investments.  Is the exemption available if the investment held by the ‘venture capital’ organisation is accounted for at fair value through other comprehensive income?  IFRS 9 – No. To take advantage of the scope exemption in IAS 28 for a venture capital organisation’s economic interest or consolidated financial statements, a venture capital organisation cannot make the irrevocable election, on initial recognition, to present changes in fair value in other comprehensive income as allowed under IFRS 9, because the scope exemption in IAS 28 requires fair value changes to be recognised in profit or loss.  IAS 39 – A venture capital organisation holds investments for periods up to three to five years and classifies such investments under IAS 39 as available-for-sale. To take advantage of the scope exemption in IAS 28, these investments need to be designated as at fair value through profit or loss on initial recognition and not classified as available-for-sale under IAS 39. The classification as available-for-sale would not result in fair value changes being recognised in profit or loss; instead, such changes are recognised in other comprehensive income. The entity could designate such investments as fair value through profit or loss only if they satisfy the principle of IAS 39.  Does the exemption apply where the ‘venture capital’ organisation is a subsidiary? The exemption in IAS 28 applies if the venture capital organisation is a subsidiary included in the parent’s consolidated financial statements, even if the parent itself is not a venture capital organisation. However, the scope exemption is not applied to investments in the same investee that are held by the parent’s other subsidiaries or divisions that are not venture capital organisations. It would also be necessary to consider whether the investment made by the subsidiary venture capital organisation in a related group entity is a venture capital investment, and whether the parent (in its consolidated financial statements) and subsidiary (in its own financial statements) should equity account the investment instead.

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Venture capital organisations that undertake both venture capital and other business activities  Example 1 – Entity undertakes both venture capital and other business activities An entity is interested in making investments in high-growth start-up companies. Some of the investments might be over 20%. Some of the investments are likely to qualify as associates under IAS 28, but others will not. Management would like to hold the investments for the medium term, but would seek to exit as soon as a flotation or sale occurred. The entity itself has an established business in the retail sector, but it would be treating these investments as an ‘incubator fund’ separate from its main business. The high-growth start-up entities that it is interested in investing in will typically not be retail. The fund is managed independently from the retail activities and has its own management team. The incubator fund is a clearly separate business of the entity, managed independently from the retail activities. The incubator fund’s investments are managed on a fair value basis as part of a portfolio, they are acquired for growth in fair value, and the businesses of the investments in the fund are typically unrelated to the reporting entity’s principal operations (that is, not retail). In addition, fair value measurement would produce more relevant information for management and the entity’s investors. Therefore, it would be appropriate for management to take the IAS 28 exemption in relation to investments in the incubator fund.  Example 2 – The entity is a professional adviser with ancillary venture capital activities An entity is not precluded from being a venture capital organisation if it provides advisory and management services and takes an active role in helping to build and develop the entities in which it invests. However, where an entity is a professional adviser, and its venture capital activities are ancillary to its main activity of corporate advisory services, the circumstances need to be examined carefully to determine whether the exemption is available, as the following example illustrates. An entity provides corporate advisory and management services to start-up and developing entities in the technology sector. In return, the entity takes equity stakes in the technology companies, which it intends to hold for the medium to long term. Some of these might be interests of 20% or more. Some or all of these will qualify as associates under IAS 28. In this specific situation, it might be argued that: a. the principal activity is corporate advisory services; b. the investment activity is ancillary to that activity; and c. this is not a clearly segregated business of the entity. Therefore, the entity should not be treated as a venture capital organisation. There will be situations where such an argument would be the correct one, particularly if the entity provided a majority of its services for cash and only took equity occasionally (such as might be the situation with a large professional firm of accountants or lawyers). However, where the entity takes equity stakes almost exclusively as consideration, and then treats the investments as a portfolio like a venture capitalist, it would be treated as qualifying for the exemption in IAS 28.

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What are the characteristics of mutual funds, unit trusts and similar entities including investment-linked insurance funds? The exemption from equity accounting in IAS 28 also applies to mutual funds, unit trusts and similar entities including investment-linked insurance funds. Investment-linked insurance funds are insurance structures in which policy holders participate directly in the risks and returns from those investments. Unit trusts, mutual funds and similar funds typically pay a return on their liabilities that is contractually linked to changes in the fair value of an asset or a pool of assets. The application of the exemption avoids a mismatch between the measurement of the assets and liabilities. The exemption might be applied by these types of entity where changes in the returns on the trusts or fund’s liabilities are contractually linked to the fair value of associate investments or a pool of assets that includes the associate investments.

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How to account for a change in intention The standard does not provide guidance on how to account for an associate to which the venture capital organisation exemption was taken but where that exemption is no longer applicable. Entities might change their intention and might no longer plan to exit from the investment in the foreseeable future. In our view, such a change in intention should be seen in a similar way to a ‘step up’ to an associate. Although no physical increase in the investment has taken place, the change in intention results in a different investment, for which the accounting under IFRS 9 (IAS 39) is no longer relevant. The initial cost of the equity-accounted associate can be determined by applying one of two methods.

An entity uses the equity method to account for its investments in associates or joint ventures in its consolidated financial statements. An entity that does not have any subsidiaries also uses the equity method to account for its investments in associates or joint ventures in its financial statements even though those are not described as consolidated financial statements.

An entity could elect to use the equity method in its separate financial statements that it presents in accordance with IAS 27 Separate Financial Statements. The investor’s share of those changes is recognised in the investor’s other comprehensive income

The recognition of income on the basis of distributions received may not be an adequate measure of the income earned by an investor on an investment in an associate or a joint venture because the distributions received may bear little relation to the performance of the associate or joint venture.

Because the investor has joint control of, or significant influence over, the investee, the investor has an interest in the associate’s or joint venture’s performance and, as a result, the return on its investment.

The investor accounts for this interest by extending the scope of its financial statements to include its share of the profit or loss of such an investee. As a result, application of the equity method provides more informative reporting of the investor’s net assets and profit or loss.

When potential voting rights or other derivatives containing potential voting rights exist, an entity’s interest in an associate or a joint venture is determined solely on the basis of existing ownership interests and does not reflect the possible exercise or conversion of potential voting rights and other derivative instruments, unless the below applies.

In some circumstances, an entity has, in substance, an existing ownership as a result of a transaction that currently gives it access to the returns associated with an ownership interest. In such circumstances, the proportion allocated to the entity is determined by taking into account the eventual exercise of those potential voting rights and other derivative instruments that currently give the entity access to the returns.

IFRS 9 Financial Instruments does not apply to interests in associates and joint ventures that are accounted for using the equity method. When instruments containing potential voting rights in substance currently give access to the returns associated with an ownership interest in an associate or a joint venture, the instruments are not subject to IFRS 9.

In all other cases, instruments containing potential voting rights in an associate or a joint venture are accounted for in accordance with IFRS 9.

An entity also applies IFRS 9 to other financial instruments in an associate or joint venture to which the equity method is not applied. These include long-term interests that, in substance, form part of the entity’s net investment in an associate or joint venture. An entity applies IFRS 9 to such long-term interests before it applies paragraph 38 and paragraphs 40–43 of this Standard.

In applying IFRS 9, the entity does not take account of any adjustments to the carrying amount of long-term interests that arise from applying this Standard.

Unless an investment, or a portion of an investment, in an associate or a joint venture is classified as held for sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations, the investment, or any retained interest in the investment not classified as held for sale, shall be classified as a non-current asset.

An investor measures an associate or a joint venture that is classified as held for sale at the lower of it carrying amount at the date of classification as held for sale and fair value less costs to sell.

Discontinuing the use of the equity method:

An entity shall discontinue the use of the equity method from the date when its investment ceases to be an associate or a joint venture as follows:

1. If the investment becomes a subsidiary, the entity shall account for its investment following IFRS 3 Business Combinations and IFRS 10.
2. If the retained interest in the former associate or joint venture is a financial asset, the entity shall measure the retained interest at fair value. The fair value of the retained interest shall be regarded as its fair value on initial recognition as a financial asset in accordance with IFRS 9. The entity shall recognise in profit or loss any difference between:
3. the fair value of any retained interest and any proceeds from disposing of a part interest in the associate or joint venture; and
4. the carrying amount of the investment at the date the equity method was discontinued.
5. When an entity discontinues the use of the equity method, the entity shall account for all amounts previously recognised in other comprehensive income in relation to that investment on the same basis as would have been required if the investee had directly disposed of the related assets or liabilities.

Therefore, if a gain or loss previously recognised in other comprehensive income by the investee would be reclassified to profit or loss on the disposal of the related assets or liabilities, the entity reclassifies the gain or loss from equity to profit or loss (as a reclassification adjustment) when the equity method is discontinued.

For example, if an associate or a joint venture has cumulative exchange differences relating to a foreign operation and the entity discontinues the use of the equity method, the entity shall reclassify to profit or loss the gain or loss that had previously been recognised in other comprehensive income in relation to the foreign operation.

If an investment in an associate becomes an investment in a joint venture or an investment in a joint venture becomes an investment in an associate, the entity continues to apply the equity method and does not remeasure the retained interest.

Exemption from preparing consolidated or economic interest financial statements

Some parent companies and investors with investments in subsidiaries, associates or joint ventures are exempt from the requirement to prepare consolidated financial statements or economic interest financial statements. Those parent companies and investors, therefore, do not consolidate and equity account for their interests.

An entity that is not a parent but that has an investment in an associate or a joint venture must prepare financial statements that include the associate or the joint venture on an equity accounting basis. These financial statements are referred to in this chapter as ‘economic interest’ financial statements.

Entities that only have investments in associates or joint ventures are exempt from the requirement to prepare ‘economic interest’ financial statements if certain conditions are met. These conditions, all of which must be met, are:

• The entity is a wholly owned subsidiary, or is a partially owned subsidiary of another entity and its other owners have been informed about, and do not object to, the entity not applying the equity method.
• The entity’s debt or equity instruments are not traded in a public market and the entity did not file, and is not in the process of issuing, any class of instruments in a public market.
• The ultimate or any intermediate parent of the entity produces consolidated financial statements available for public use that comply with IFRS.

Availability of the exemption from preparing consolidated or economic interest financial statements The exemption is available where an explicit and unreserved statement of compliance with IFRS can be made by the ultimate or intermediate parent that produces consolidated financial statements. Local regulatory requirements might dictate the requirement to prepare consolidated or economic interest financial statements, and, so an exemption from producing consolidated or economic interest financial statements might also be available under these circumstances. The existence of legislation or regulation that permits the entity not to produce consolidated financial statements under IFRS does not override the requirement in IAS 28. Separate entity financial statements that include an explicit and unreserved statement of compliance with IFRS must be accompanied by a set of consolidated financial statements, unless the exemptions IAS 28 apply. Where separate financial statements do not include the statement of compliance (but state, for example, ‘IFRS as endorsed in the EU’ instead), such financial statements could take advantage of a regulatory exemption that exempts the entity from preparing consolidated financial statements.

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Is the exemption available in relation to economic interest financial statements? Entity A is a 60% unlisted subsidiary of another entity that produces publicly available consolidated financial statements in accordance with IFRS. Entity A has an associate but no subsidiaries. Entity A has no plans to issue shares or debentures to the public. The other 40% shareholders of entity A have been informed of entity A’s intention not to produce ‘economic interest’ financial statements and have not objected. Entity A is entitled to the exemption from preparing economic interest financial statements, because it meets all of the conditions for exemption set out in IAS 28. However, it must prepare separate financial statements. The facts are the same as above, except that entity A is listed on a recognised stock exchange. In this situation, entity A is not entitled to the exemption, because its shares are listed. The facts are the same as the original scenario, except that the parent company’s consolidated financial statements are prepared in accordance with US GAAP. In this situation, the exemption does not apply, because the parent company’s consolidated financial statements are not in accordance with IFRS.

Entities that are exempt from preparing economic interest financial statements prepare ‘separate’ financial statements as their only financial statements. Separate financial statements include subsidiaries, associates and joint ventures, either at cost, in accordance with IFRS 9 (IAS 39), or using the equity method.