Investments in Associates and

Investments in Jointly controlled entities

Presented by CPA Peter Njuguna+254 722 608 618

Investments in Associates

Introduction Definition Identifying associates Equity method Transactions between parent and associate Share of losses of the associates Impairments losses Dissimilar accounting policies Different reporting dates Main defects of equity accounting Disclosure

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Introduction

Companies may also have substantial investments in other entities without actually having control. Thus, a parent-subsidiary relationship does not exist between the two.

If the investing company can exert significant influence over the financial and operating policies of the investee company, it will have an active interest in its net assets and results.

The nature of the relationship differs from that of a simple investment, i.e. it is not a passive interest.

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Introduction

Including the investment at cost in the company's accounts would not fairly present the investing interest.

So that the investing entity (which may be a single company or a group) fairly reflects the nature of the interest in its accounts, the entity’s interest in the net assets and results of the company, the associate, needs to be reflected in the entity’s accounts.

This is achieved through the use of equity accounting An associate is an entity, including an unincorporated

entity such as a partnership, over which the investor has significant influence and that is neither a subsidiary nor an interest in a joint venture.

Significant Influence

If an investor holds, directly or indirectly (eg through subsidiaries), 20 per cent or more of the voting power of the investee, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case.

If the investor holds, directly or indirectly (eg through subsidiaries), less than 20 per cent of the voting power of the investee, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated.

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Significant Influence

The existence of significant influence by an investor is usually evidenced in one or more of the following ways: (a) representation on the board of directors or

equivalent governing body of the investee; (b) participation in policy-making processes,

including participation in decisions about dividends or other distributions;

(c) material transactions between the investor and the investee;

(d) interchange of managerial personnel; or (e) provision of essential technical information.

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Potential voting rights

The existence and effect of potential voting rights that are currently exercisable or convertible, including potential voting rights held by other entities, are considered when assessing whether an entity has significant influence. Potential voting rights are not currently exercisable or convertible when, for example, they cannot be exercised or converted until a future date or until the occurrence of a future event.

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Illustration 1

Z owns 15% of the voting rights of Y, and the remainder are dispersed among the public.

Z also is the sole supplier of raw materials to Y

and has a contract to supply certain expertise regarding the maintenance of Y’s equipment

What is the relationship between Z and Y ?

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Separate financial statements of the investor

An investments in an associate should be either

A) cost or in accordance with IAS 39. B) Under IFRS 5 if classified as held for sale;

Not issues consolidated accounts (e.g. no subsidiary) Equity method An associate is not part of a group as it is not a subsidiary, i.e.

it is not controlled by the group. As such, the accounting treatment of the associate is different to that of subsidiaries.

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Equity accounting

The investment in an associate is initially recognised at cost and the carrying amount is increased or decreased to recognise the investor’s share of the profit or loss of the investee after the date of acquisition.

This is equivalent to taking the investor’s share of the net assets of the associate at the date of the financial statements plus goodwill.

Distributions received from the associate reduce the carrying amount of the investment.

Adjustments to the carrying amount also necessary for changes in the investor’s proportionate interest in other comprehensive income. 10

Equity accounting

Other comprehensive income include those arising from the revaluation of property, plant and equipment, intangible assets, cash flow hedge and from foreign exchange translation differences on net investment in foreign operation.

Note The associate or joint venture is not consolidated line-by-line. Instead,

the group share of the associate’s net assets is included in the consolidated statement of financial position in one line, and share of profits (after tax) in the consolidated statement of comprehensive income in one line. And share of other comprehensive income in one line

the group’s share of the associate’s net assets at the end of the reporting period, Plus the goodwill arising on acquisition, less any impairment losses are report together. 11

Goodwill

Investment in associate in the individual company’s books is compared with the share of the associate’s fair value of net assets acquired.

The difference is goodwill.

The fair values of the associate’s assets and liabilities must be used in calculating goodwill.

Any change in reserves, depreciation charges etc due to fair value revaluations must be taken into account in subsequent accounting periods (as they are when dealing with subsidiaries).

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Goodwill computation

Fair value of consideration paid xxx Less Fair value of acquiree identifiable net assets

xxx

Goodwill (positive or negative) xxx Note If the goodwill is positive it is included as part of

investment in associate and not recognised separately as in the case of a subsidiary

Negative goodwill

Where the share of the associate’s net assets acquired at fair value are in excess of the cost of investment, the difference is negative goodwill

Negative goodwill is required to be taken to income in the period the associate was acquired and included in the investor’s share of the associate’s post acquisition after tax profit.

Investment in associate

Where the equity method is used for associates in a consolidated statement of financial position, the carrying value of the associate is made up as follows:

Either: share of equity at reporting date (plus fair value adjustments at acquisition) , PLUS any unimpaired goodwill remaining at that date,

Or: cost PLUS share of post-acquisition reserves at the reporting date LESS goodwill impaired and written off since acquisition.

As adjusted for intercompany unrealized profit/ excess depreciation

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Example of goodwill

P owns 80% of S and 40% of A. A statement of financial position of the three companies at 31December 2013 are:

P S A

Investment: shares in S 800 – –Investment: shares in A 600 – –Other non-current assets 1,600 800 1,400

Current assets 2,200 3,300 3,250 ——— ——— ——— 5,200 4,100 4,650

Ordinary shares – sh 1 1,000 400 800Retained earnings 4,000 3,400 3,600Liabilities 200 300 250

——— ——— ——— 5,200 4,100 4,650

P acquired its shares in S when S’s retained earnings were sh 520 and in A when A’s retained earnings were sh 400.

P Consolidated statement of financial position

Investment in associate 1,880goodwill 64Non-current assets (1,600 + 800) 2,400Current assets (2,200 + 3,300) 5,500

——— 9,844

Issued capital 1,000Retained earnings (W5) 7,584

——— 8,584

NCI (W4) 760Liabilities 500

——— 9,844 ———

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Net assets  Balance now Acquisition

Issued capital 400 400Retained earnings 3,400 520  ——— ——  3,800 920  ——— —— A Balance Acquisition now dateIssued capital 800 800Retained earnings 3,600 400 ——— ——— 4,400 1,200 ——— ———

GoodwillS Cost of investment 800

Net assets acquired (80% X 920 (W2)) (736) 64

A 

Cost of investment 600Net assets acquired (40% × 1,200 (W2)) (480)

120 

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Consolidated statement of comprehensive income

Treatment is consistent with consolidated statement of financial position and applies equally to a non-group company with an associate:

Include group share of the associate’s profits after tax in the consolidated statement of comprehensive income.

This replaces dividend income shown in the investing company’s own statement of comprehensive income.

Parent’s % the associate’s profit for the year X

Less: any impairment loss in the current year(X)

Less: the parent’s % of additional depreciation on fair value adjust. (X)

X

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Do not add in the associate’s revenue and expenses line-by-line as this is not a consolidation and the associate is not a subsidiary.

Time-apportion the associate’s results if acquired mid-year.

Note that the associate statement of financial position is NOT time apportioned as the statement of financial position reflects the net assets at the period end to be equity accounted.

Impairments losses

Impairment indicators in IAS 36 apply to investments in associates.

Because the goodwill that forms part of the carrying amount of the investment in an associate and is not separately recognzied, it cannot be tested for impairment separately by applying IAS 36.

Instead the entire carrying amount of the investment is tested for impairment under IAS 36 by comparing the recoverable amount with the carrying amount.

An impairment loss recognised in those circumstances is not allocated to any asset, including goodwill, that forms part of the carrying amount of the investment in the associate.

Accordingly, any reversal of that impairment loss is recognised in accordance with IAS 36 to the extent that the recoverable amount of the investment subsequently increases.

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Impairments losses

In determining the value in use of the investment, an entity estimates:

its share of the present value of the estimated future cash flows expected to be generated by the associate, including the cash flows from the operations of the associate and the proceeds on the ultimate disposal of the investment; or

the present value of the estimated future cash flows expected to arise from dividends to be received from the investment and from its ultimate disposal.

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Example

A acquired 30% of the issued capital of B for sh1 million on 31 Dec 2012. The accumulated profit and the share capital at that date were sh 2 million and sh 1 million (share capital @ sh1) respectively.

Financial information of B Ltd at 31 Dec 2013 is Share capital sh1 million Retained profit sh3 million

Recoverable amount is sh 4 million

Required: What amount should be shown in A’s consolidated

statement of financial position at 31 Dec 2013, for the investment in B ?

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Goodwill = 1 million – (30% X 3 million)=0.1 million.

Interest in associate at 31 Dec 2013Cost 1 Add: profit acq. Profits. ( 3-2)X 30% 0.3

1.3RA ( 4 X 30%) 1.2

An impairment test would prove that the carrying amount of the investment is impaired by 0.1.

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Inter- company items with associate

Inter-company trading Dividends Unrealised profit

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Inter-company trading

Members of the group can sell to or make purchases from the associate. This trading will result in the recognition of receivables and payables in the individual company accounts.

Do not cancel inter-company balances on the statement of financial position and do not adjust sales and cost of sales for trading with associate.

In consolidated statement of financial position, show balances with associate separately from other receivables and payables.

The associate is not part of the group. It is therefore appropriate to show amounts owed to the group by the associate as assets and amounts owed to the associate by the group as liabilities. 26

Dividends

Consolidated statement of financial position: Ensure dividends payable/receivable are fully

accounted for in individual companies’ books. Include receivable in the consolidated statement of

financial position for dividends due to group from associates.

Do not cancel inter-company balance for dividends. Consolidated statement of comprehensive

income: Do not include dividends from the associate in the

consolidated statement of comprehensive income. Parent’s share of the associate’s profit after tax (hence before dividends) is included under equity accounting in the income from associate.

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Unrealised profit

If parent sells goods to associate and associate still has these goods in stock at the year end, their carrying value will include the profit made by parent and recorded in its books. Hence, profit is included in inventory value in associate’s net assets (profit is unrealised); and parent’s revenue.

If associate sells to parent, a similar situation arises, with the profit being included in associate’s revenue and parent’s inventory.

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To avoid double counting when equity accounting for associate, this unrealised profit needs to be eliminated.

Unrealised profits should be eliminated to the extent of the investor’s interest in the associate.

To eliminate unrealised profit, deduct the profit from associate’s profit before tax and retained earnings in the net assets working before equity accounting for associate, irrespective of whether sale is from associate to parent or vice versa.

Unrealised profit

Unrealised inter-company profits and losses resulting from ‘upstream’ and ‘downstream’ transactions are to be eliminated, but on partial rather than full elimination basis, i.e. only the investor’s proportionate interest in the inter-company profit and losses is adjusted for.

‘Upstream’ transactions are, for example, sales of goods from an associate to the investor.

Dr. Retained earning Cr. Inventory

‘Downstream’ transactions are, for example, sales of goods from the investor to an associate.

Dr. Retained earning Cr. Investment in associate

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Example Company A sells inventory to its 30% owned

associate, B. The inventory had cost A sh 200,000 and was sold for sh 300,000 to B.

B also has sold inventory to A. The Cost of this inventory to B was sh 100,000, and it was sold for sh 120,000.

Required: How would the inter company profit on these

transactions be dealt with in the financial statements if none of the inventory had been sold at year-end ?

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Solution Company A to Company B 000 The inter group profit is (300 -200) 100 Unrealised Profits would be 100X 30/100 30

The unrealised profit would be deferred until the sale of the inventory Journal : Dr. Retained profits 30 Cr. Interest in Associate 30

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Company B to Company A 000 The inter group profit is (120 -100) 20 Unrealised Profit would be (20X 30/100) 6

The unrealised profit would be deferred until the sale of the inventory .

Journal : Dr. Retained profits 6 Cr. Inventory (B/S) 6

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Shares of losses of the associates

If the investor’s share of losses of an associate equals or exceeds its interest in the associate – i.e. the Carrying Value of the associate – the investor discontinues recognising its share of further losses.

Note that the Carrying Value of the associate for this purpose includes any long-term interests that, in substance form part of the investor’s net investment in the associate – for example, long-term receivables, loans (unless supported by adequate collateral) and preference shares.

If the associate subsequently reports profits, the investor resumes recognising its share of those profits only after its share of the profits equals the share of losses not recognzied.

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Dissimilar accounting policies

Adjustments shall be made to conform the associate’s accounting policies to those of the investor when the associate’s financial statements are used by the investor in applying the equity method.

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Different reporting dates

If the reporting dates of the investor and the associate are different, the associate prepares – for the use of the investor – financial statements as of the same date as the financial statements of the investor unless it is impractical to do so.

In any case, the difference between the reporting date of the associate and that of the investor should be no more than 3 months.

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An investor in a joint venture is a party to a joint venture and does not have joint control over that joint venture.

Joint control is the contractually agreed sharing of control over an economic activity, and exists only when the strategic financial and operating decisions relating to the activity require the unanimous consent of the parties sharing control (the venturers).

A joint venture is a contractual arrangement whereby two or more parties undertake an economic activity that is subject to joint control.

A venturer is a party to a joint venture and has joint control over that joint venture.

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Joint venture

Forms of Joint Ventures

A joint venture is a contractual arrangement whereby two or more parties undertake an economic activity that is subject to joint control. Consider three situations:

Jointly controlled operations involve the use of assets and other resources of the venturers rather than the establishment of an entity that is separate from the venturers themselves. The contractual agreement determines how the revenue and any expenses are shared among the venturers.

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Forms of Joint Ventures

Jointly controlled assets are where venturers control jointly, and often own jointly, an asset contributed to or acquired for the joint venture. No new entity, separate from the venturers, is formed. Each venturer takes a share of output or revenue from the asset and each bears an agreed share of the expenses incurred.

Jointly controlled entities involve the establishment of an entity in which each venturer has an interest. Separate financial statements will be prepared for the jointly controlled entity. Jointly controlled entities are either jointly controlled operations or jointly controlled assets – it is just that they are set up as separate entities – either as companies or as partnerships.

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Contractual arrangement

The contractual arrangement may be evidenced in a number of ways, for example by a contract between the venturers or minutes of discussions between the venturers. In some cases, the arrangement is incorporated in the articles or other by-laws of the joint venture. Whatever its form, the contractual arrangement is usually in writing and deals with such matters as:

the activity, duration and reporting obligations of the joint venture; the appointment of the board of directors or equivalent governing

body of the joint venture and the voting rights of the venturers; capital contributions by the venturers; and the sharing by the venturers of the output, income, expenses or

results of the joint venture.

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A JCOs is a JVs that involves the use of the resources of the

venturers (rather than the establishment of a separate financial structure)

each venturer uses its own PP&E, carries its own inventories, incurs its own expenses & liabilities & raises its own finance, which represent its own obligations

The JV activities may be carried out by the venturer’s employees alongside the venturer’s similar activities.

The JV agreement usually specifies how revenue from joint product & any expenses incurred in common are shared.

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A venturer recognises the assets that it controls & the liabilities

that it incurs the expenses that it incurs & its share of the

income that it earns from the sale of goods or services by the joint venture

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A & B successfully tendered jointly for a government contract to construct a motorway in return for 14 million. Contractual arrangement between A & B: each used their own equipment and

employees in the construction activity A constructs 3 bridges at a cost of 4 million B constructs all of the other elements of the

motorway at a cost of 6 million. A & B share equally in the 14 million billed &

received jointly to the government.

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Jointly controlled assets

JCAs are joint ventures that involve the joint control, & often the joint ownership, by the venturers of one or more assets contributed to, or acquired for the purpose of, the joint venture and dedicated to the purposes of the joint venture.

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A venturer recognises its share of the jointly controlled asset (JCA) any liabilities that it has incurred its share of any liabilities incurred jointly

with the other venturers any income from the sale or use of its share

of the output of the JV, together with its share of expenses incurred by the JV

any expenses that it has incurred in respect of its interest in the JV.

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A & B (independent oil producers) enter into a contractual arrangement to jointly control and operate an oil pipeline.

Each venturer uses the pipeline to transport its own product in return for which it bears an agreed proportion of the expense of operating the pipeline.

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