Profits and losses included in assets

An investor might sell assets to its associate or joint venture (that is, downstream transactions). The associate or joint venture might sell assets to its investor or to other parts of the investor’s consolidated group (that is, upstream transactions). Any unrealised profits and losses from upstream and downstream transactions are eliminated, to the extent of the entity’s interest in the associate.

Any assets in an upstream or downstream transaction that have been sold on to a third party have been realised, so the elimination relates to assets that are still held by the investor or the investee.

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 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.

Unrealised gain exceeds the carrying amount of the associate or the joint venture

An unrealised gain in a downstream transaction is eliminated against the investment in the associate or joint venture. If the unrealised gain in a downstream transaction exceeds the carrying amount of the investment, the carrying value of the investment is reduced to zero, and no adjustment is made for the remainder.

The investor might reduce the carrying value of the associate or joint venture to zero, through elimination of unrealised gains. If unrealised gains have exceeded the carrying amount of the investment and thus have not been eliminated, the investor has an accounting policy choice as to how to treat subsequent profits of the associate or joint venture. The investor can track unrealised gains that have not been eliminated and claw these back through non-recognition of profits from the associate or joint venture, until the unrealised gain has been fully eliminated.

Alternatively, the investor might continue to recognise its share of the associate’s or the joint venture’s profit. The investor should assess whether there is any objective evidence that its interests in the associate or the joint venture is impaired, and it should test for impairment (if appropriate).

Downstream transactions: accounting for unrealised gains Example 1 – Principles 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.

A downstream transaction might provide evidence of a reduction in net realisable value of the assets sold or contributed, or of an impairment loss. Those losses should immediately be recognised in full by the investor.

Inter-company trading transactions

Associates and joint ventures do not form part of the group. The procedures for eliminating intra-group balances, transactions, income and expenses are not appropriate under the equity method. Unsettled balances from normal trading transactions should be included as current assets or liabilities. These balances should not be eliminated.

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 associates or joint ventures

Distributions received from an associate or a joint venture reduce the carrying amount of the investment recorded by the investor.

An associate or joint venture might pay a dividend that is greater than the carrying amount of the investment in the investor’s books. The carrying amount is reduced to nil, but it does not become negative.

If the entity has no legal or constructive obligations to make payments on behalf of the associate or the joint venture, a gain is recognised in profit or loss for the remaining dividend. The investor has a policy choice, if the associate or joint venture makes profits in subsequent years. It can apply the ‘clawback’ approach, or it can recognise the profits immediately in its income statement

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.

Impairment

Investments in associates and joint ventures are assessed for impairment where indicators of impairment are present. Impairment indicators are as described in IAS 28 (previously IAS 39). The recoverable amount of the associate or joint venture is determined in accordance with IAS 36. The recoverable amount of an investment in an associate or a joint venture is assessed separately for each associate and joint venture unless it meets the unusual circumstances described.

Individual associates and joint ventures usually generate largely independent cash flows, and they are tested for impairment on an individual basis. Unusually, if an associate or joint venture does not generate largely independent cash flows and its fair value cannot be readily determined, the recoverable amount is determined for the cash-generating unit to which the associate or the joint venture belongs. This situation is likely to be rare in practice.

An associate or a joint venture that is making losses results in an ongoing reduction of the investor’s carrying amount. Losses, however, might be an indicator that there is further impairment that needs to be recognised.

Significant adverse changes in the technological, market, economic or legal environment in which the associate or the joint venture operates might provide objective evidence that the equity interest in the associate or the joint venture could be impaired. A significant or prolonged decline in the fair value of the associate or the joint venture below its cost is also objective evidence of impairment. There are also a number of potential indicators of impairment identified in the standard. Those indicators include:

1. significant financial difficulty;
2. a breach of contract, such as a default or delinquency;
3. the investor grants the associate or joint venture a concession that the entity would not otherwise consider because of the investee’s financial difficulty;
4. it appears probable that the associate or joint venture will enter bankruptcy or another financial reorganisation; or
5. the disappearance of an active market for the shares of the associate or joint venture.

If there is an indication that an investor’s interests in an associate or a joint venture might be impaired: The measurement rules in IAS 36 are applied to the entire carrying amount (including any notional goodwill) of the associate or the joint venture, to determine the amount of any impairment loss. The measurement rules in IFRS 9 (IAS 39) are applied to any other interests in the associate or the joint venture that do not form part of the net investment (for example, trade debtors or loans), to determine the amount of any impairment loss.

The entire carrying amount of the investment in the associate is compared to recoverable amount, which is the higher of value in use or fair value less costs of disposal.

Practical considerations in calculating recoverable amount The carrying amount of an investment in an associate or joint venture is not automatically written down to the current share price. The price decline is an indicator and also establishes the ‘fair value less costs of disposal’ of the associate or the joint venture. IAS 36 requires that the recoverable amount using the ‘value in use’ method should also be calculated before recording an impairment loss. If the value in use is higher than the carrying amount of the investment, there is no impairment to recognise. Calculating the value in use of an associate or a joint venture might entail obtaining cash flow forecasts from the associate’s or the joint venture’s management. The future expected dividend streams from the investment in the associate or the joint venture could also be used in measuring the associate’s or the joint venture’s value in use.

Any resulting impairment loss is not allocated against the notional goodwill and purchase price allocation, but against the investment as a whole. The normal rules in IAS 36 relating to impairment of goodwill do not apply to notional goodwill and therefore any previous impairment losses can be reversed.

The share of equity-accounted results might either continue to reflect adjustments for depreciation based on the original fair value of assets, or it might reflect depreciation based on an adjusted ‘impaired’ fair value. The notes should contain an explanation of the selected accounting policy.

An associate or a joint venture might have recognised an impairment charge in its own financial statements. The investor should account for its share of that impairment charge, adjusted for the effect of fair value differences from the notional purchase price allocation. The impairment charge recorded by the associate or joint venture is an indicator of impairment, and the investor should carry out an impairment review of the associate or the joint venture if it has not already done so.

An investor does not allocate an impairment loss on an associate or a joint venture to a particular asset (or assets) that forms the carrying amount of the joint venture. It is possible, therefore, for the entire impairment loss to be reversed, if the criteria in IAS 36 are met. Any reversal of this impairment loss is recognised as an adjustment to the investment in the associate or the joint venture to the extent that the recoverable amount of the investment increases.

There is no explicit guidance on where any impairment charge relating to associates or joint ventures is presented in profit or loss. The impairment charge is not as a result of applying the equity method, and so it does not form part of the share of results of associates and joint ventures. IAS 1 requires separate disclosure of the share of the profit or loss of associates and joint ventures accounted for using the equity method. Any material impairment loss should be presented adjacent to the share of the associate’s or joint venture’s results under the equity method.

Disposal

Loss of significant influence

Equity accounting ceases when significant influence or joint control is lost. An investor might lose significant influence or joint control through a change in its absolute or relative ownership levels, or when an associate becomes subject to the control of a government, court administrator or regulator or as a result of a contractual agreement. If an investor loses joint control but retains significant influence in an investment, this is a partial disposal, with no remeasurement to fair value of the retained interest.

Practical considerations regarding loss of significant influence 1.      Can an investor continue to have significant influence over an associate operating under restrictions? An associate might operate under the following restrictions: Insolvency or administration procedures in progress. Government restrictions on the transfer of currency out of the country. Significant international sanctions against the country that have a direct impact on the entity’s ability to trade and/or remit profits out of the country. Significant government regulation. In these circumstances, the entity might or might not continue to have significant influence. An investor entity might still have significant influence over an associate, despite restrictions on the associate’s ability to transfer funds to the investor entity. Such restrictions on the transfer of funds should be considered when assessing an investor entity’s ability to exercise significant influence over an entity. Such restrictions, independently, do not preclude the existence of significant influence. 2.      Can a contractual arrangement not to interfere in the associate’s ongoing business result in loss of significant influence? An entity that has significant influence over an associate might enter into a contractual agreement not to interfere with the associate’s ongoing business. It would be necessary to consider carefully the facts and circumstances to determine whether the contractual arrangement means that the entity has lost its significant influence over the associate. This would depend on, for example, the contract’s legal enforceability and how severe the penalty is for not meeting its contractual terms. It might also be a different situation where the contract is between the shareholders themselves rather than between the company and its shareholders.

Associate to an investment

An investor might lose significant influence or joint control but retain an investment in the entity. Any retained investment is measured at the fair value of the investment at the date when it ceases to be an associate or joint venture. This is its fair value on initial recognition as a financial asset in accordance with IFRS 9 (IAS 39). The investor recognises, in profit or loss, any difference between:

• “The fair value of any retained interest and any proceeds from disposing of the part interest in the associate or joint venture; and
• the carrying amount of the investment at the date the equity method was discontinued.”

The remeasurement to fair value requires the investor to account for all amounts recognised previously in other comprehensive income in relation to that associate or joint venture, as if the associate had disposed of the related assets or liabilities.

When the investor loses significant influence over the associate, any gains or losses that had previously been recognised in other comprehensive income arising from the investment in an associate or joint venture are reclassified to profit or loss if the gain or loss would be reclassified to profit or loss on the disposal of the related assets or liabilities.

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).

Dilution gains and losses

An associate might issue shares to other investors and dilute the investor’s interest. This is a partial disposal of an investor’s interest in an associate. The investment might remain an associate, or the investor might lose significant influence and have a financial asset.

A dilution gain or loss arising on a reduced stake in an associate or a joint venture should be recognised in the income statement. Any loss arising on dilution is an indicator of impairment, and the investor should test any remaining interest for impairment

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.