Chapter 8: Share of the associate or joint venture

An investor records its share of the results of each associate or joint venture. The ‘share’ to be accounted for might be straightforward, where an investor has a single investment of a specified number of common shares in an associate or joint venture, with no other types of shares or potential voting rights in issue.

However, determining the investor’s ‘share’ in results might be complicated by holdings by other members of the group, potential voting rights, cross-holdings and similar issues. The group’s share in an associate or joint venture is the aggregate of its holdings in that investment by the parent and its subsidiaries, ignoring any holdings through other associates or joint ventures.

The investor needs to establish what ‘share’ of the associate or joint venture it owns, in order to apply the equity method.

Determination of the group’s share or holding The meaning of a group’s share or holding is not defined in the standard. Where the entity only has an interest in the equity share capital of the associate or the joint venture, the share to be equity accounted will normally be the number of shares held as a percentage of the total number of equity shares in issue. This amount will equate to the entity’s entitlement to dividends and other distributions. Complications arise where the investee has different classes of equity shares or where the entitlement to dividends, or capital on winding up, varies. The rights attaching to each class of share, as well as the substance of the respective right, need to be considered carefully to determine the appropriate percentage to be brought into the equity interest calculation. In many situations, the share to be taken into account will be derived from the percentage holding in shares; in other situations, the economic interest might differ from the shareholding, but it will be the appropriate interest to take into account. For example, the shareholdings in an associate might be 40:60, but the entities share profits in the ratio 30:70. In this case, it would be appropriate to equity account for the economic share rather than the equity participation.

Subsidiary has an investment in an associate Entity A has an 80% interest in entity B. Entity B has a 40% investment in an associate. Entity A’s consolidated financial statements include 100% of the figures in entity B’s consolidated financial statements (that is, financial statements including the associate on an equity accounting basis). This means that, when calculating the appropriate share of the associate’s results to include in the consolidated profit and loss account for the group, it is the straight 40% investment that is brought into the group’s consolidated financial statements (and not 32% (80% × 40%)). This means that if, for example, the equity of the associate is C100 including a net profit for the period of C20, the investment in the associate is shown as C40 in the balance sheet, and the share of associate profit amounts to C8 (20 × 40%) and not C6.4 ((20 × 40%) × 80%). The difference of C1.6 is attributed to the non-controlling interests at the foot of the statement of comprehensive income, and C6.4 is attributed to the equity holders of the parent.

Indirect holding in an associate Group A has two associates, entity B (22%) and entity C (25%). Entity B also has a 1% interest in entity C. In entity B’s books, the 1% interest in entity C is accounted for as an investment; and, in the consolidated financial statements, this investment is included as part of the net assets of entity B for the purposes of calculating the equity-accounted amount for entity B. The share of entity C that is taken into account in equity accounting for entity C is only the direct interest in entity C of 25%.

Impact of preference shares on share of results

An associate or a joint venture might issue preference shares. Preference shares need to be classified as a financial liability, an equity instrument, or a compound instrument with both liability and equity components. Classification is based on the substance of the contractual arrangements. Classification as an equity instrument will have implications for the investor’s equity accounting.

Dividends on preference shares classified as equity that are held by parties other than the investor are deducted from profit or loss of the associate or joint venture by the investor when measuring its share of profit or loss of the associate or joint venture, regardless of whether the dividends are declared. The investor, to the extent that it does not hold the preference share, is not entitled to a share of the after-tax result that is notionally ‘used’ to pay the preference dividend.

Dividends on preference shares classified as a liability are shown as interest. The investor’s share of the associate’s share of results is determined after deduction of the preference dividend, and it is based solely on the investor’s equity interest.

Impact of options, warrants and convertible debt on share of results

Potential voting rights (such as share warrants, options and convertibles) held by an entity in an associate or joint venture should be considered when determining whether an entity has significant influence. However, those potential voting rights are not included when determining the investor’s proportion of the net assets and profit or loss of the associate or joint venture, unless they constitute a present ownership interest.

An investor might have, in substance, an interest in an associate or joint venture that gives it access to the returns associated with an ownership interest. The share of results allocated to the entity is determined after considering the eventual exercise of the potential voting rights and other derivative instruments that currently give the entity access to the returns.

If the investor includes returns from potential voting rights in its share of results, the instruments that give rise to those rights are not subject to the requirements of IFRS 9 (IAS 39).

The investor has included a greater share of the results of its associate or joint venture under the equity method than that which would arise on the basis of the entity’s existing equity holding. The investor does not simultaneously fair value the instruments held in the associate to reflect the increase in their market value.

The costs of exercising the potential voting rights should also be taken into account, and any notional goodwill is calculated on the increase in stake.

Determination of present ownership interest An entity might, in substance, have a present ownership interest when, for example, it sells and simultaneously agrees to repurchase an ownership interest, but does not lose control of the ability to affect returns associated with that ownership interest. Where this is the case, the eventual exercise of the potential voting rights should be taken into account when determining the entity’s share to be equity accounted; this is because, in substance, the rights currently give access to affect the returns associated with an ownership interest and are considered a present ownership interest. An entity could simultaneously write put options to, and purchase call options from, an entity, with the options having substantially the same fixed strike prices and being exercisable at the same future date. In this situation, it is virtually certain that one or other party will exercise the option, because it will be in the economic interests of one of them to do so. If the share price falls below the fixed strike price, the other party will exercise the put option and sell the shares (that is, the entity has retained access to the risks); or, if the share price increases above the fixed strike price, the entity will exercise the call option and buy the shares (that is, the entity has retained access to the benefits). For a present ownership interest to exist, the potential voting rights must give access to the economic benefits associated with an ownership interest. It will be difficult to argue that potential voting rights give rise to a present ownership interest where the actual shareholder has the rights to dividends. It is wrong to equity account for profits that are more likely to be paid as dividend to the actual holder of the shares than to the entity holding the potential right. Although potential voting rights do not give a present ownership interest, the exercise price might be structured so as to give the holder of the potential voting right the effective interest in the dividends, and this would indicate that the holder of the potential voting right retains the economic benefits of the investment.

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 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).

Impact of compound instruments issued to the investor on share of results

The investor ignores potential ownership interests, and considers its present ownership interest, when determining the share to be equity accounted for. This includes a share in the equity element of any convertible loan recorded by the associate or the joint venture. The investor could eliminate the share of the equity element of the convertible loan against the value of the financial asset recorded by the investor.

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 Investment in entity B at cost 40 C C Loan to entity B (with conversion option) * 40 – Cash 60 – Convertible loan – 140 Shares – (40) Conversion option 100 100 Profit and loss reserve 100 80 – 20 – – 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 adjustments 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 10 100 Profit and loss reserve 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 adjustments 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.

Impact of cross-holdings on share of results

Cross-holdings (where the investor and its associate or joint venture own shares in each other) complicate the application of the equity method. No specific guidance is provided in the standard in respect of cross-holdings. The investor needs to develop an approach that follows the principles of IAS 28.

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. 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.