Associates and Joint Ventures

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Jagdish Kothari and Elisabetta Barone, Advanced Financial Accounting, 1st Edition, © Pearson Education Limited 2011

Chapter 20: Investments in associates (IAS 28) and

interestsin joint ventures (IAS 31)

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Objectives

When you have completed this chapter you should be able to:• Define an associate• Account for an associate in the consolidated financial statements using the equity method• Account for transactions between a group and its associate• Define a joint venture• Describe the different forms of a joint venture• Account for jointly controlled operations• Account for jointly controlled assets• Account for jointly controlled entities.

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Contents

• Investments in associates• Interests in joint ventures

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Definition of an associate

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 is the power to participate in the financial and operating policy decisions of

the investee but is not control or joint control over those policies.

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Definition of an associate (Continued)

Control is the power to govern the financial and operating policies of an entity so as to obtain

benefits from its activities.

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).

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Definition of significant influence

• ‘The power to participate in the financial and operating policy decisions of the investee but is

not control or joint control over those policies’ (IAS 28 para 2).

• If an investor holds, directly or indirectly (e.g. 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. Conversely, if the investor holds, directly or indirectly (e.g. through subsidiaries), less than 20

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Definition of significant influence(Continued)

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. A substantial or majority ownership by another investor does not necessarily preclude an investor from having significant influence (IAS 28 para 6).

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Demonstrating existence ofsignificant influence

• Representation on the board of directors or equivalent governing body of the investee;

• participation in policy-making processes, including participation in decisionsabout dividends or other distributions;

• material transactions between the investor and the investee;

• interchange of managerial personnel; or• provision of essential technical information.

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Figure 20.1 Associate relationship where investor has more than a 50 per cent interest but no controlSource: Groupe Danone Annual Report 2007

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The equity method

IAS 28 requires that an investment in an associate should normally be accounted for using the ‘equity method’. The equity method is defined 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 the investee’.

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Figure 20.2 Less than a 20 per cent interest but significant influenceSource: British Airways Plc Annual Report 2007–8

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Application of the equity method

Under the equity method of accounting, the investment made by the investing company is recorded initially at cost.

In subsequent years, the required accounting treatment is as follows:

(a)The investor’s share of the investee’s profit or loss for the year is recognised in the

investor’s income statement and is either added to or subtracted from the carrying amount of the investment in the investor’s balance sheet.

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Application of the equity method (Continued)

(b) Any dividends received from the investee are subtracted from the carrying amount of the investment.

(c) The carrying amount of the investment is also adjusted for the investor’s share of any changes in the investee’s equity (such as revaluation surpluses) that have not passed through the investee’s income statement.

The investor’s share of such items should be recognised in other comprehensive income.

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Example 20.2

Alpha plc is the parent of a group of companies. On 1 January 2009, Alpha plc acquired 25 per cent of the ordinary share capital of Beta Ltd at a cost of EUR 200,000. This was precisely equal to 25 per cent of the fair value of Beta Ltd’s identifiable net assets on that date. During the year ended 31 December 2009, Beta Ltd made a profit after tax of EUR 84,000 and paid an ordinary dividend of EUR 54,000. Explain how these transactions should be reflected in the consolidated financial statements of Alpha plc for the year ended 31 December 2009.

Equity method

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Example 20.2 (Continued)

In the consolidated income statement of Alpha plc, ‘share of profit of associates’ is shown as EUR 21,000 (25% × EUR 84,000). IAS 1 (revised) – Presentation of Financial Statements suggests that this amount should be shown just before the group’s pretax profit.

The investment is recognised initially at cost. The group’s share of the associate’s profit is added and the dividend of EUR 13,500 (25% × 54,000) is deducted. So in the consolidated balance sheet, the figure for ‘investments in associates’ is EUR 207,500 (200,000 + 21,000 − 13,500). This is shown as a non-current asset.

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Example 20.3

Gamma plc is the parent of several wholly-owned subsidiaries. On 1 July 2008, Gamma plc acquired 30 per cent of the ordinary shares of Delta Ltd at a cost of EUR 140,000. Delta Ltd had retained earnings of EUR 100,000 on that date and all of its assets and liabilities were carried at fair value. Delta Ltd has issued no shares since Gamma plc acquired its 30 per cent holding.

Equity method and consolidated financial statements

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The draft consolidated financial statements of Gamma plc for the year ended 30 June 2009 (before applying the equity method) and the financial statements of Delta Ltd for that year are shown in Tables 20.1–20.6.

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Delta Ltd is an associate of Gamma plc. The cost of the investment was EUR 140,000 and the fair value of 30% of the net assets of Delta Ltd on 1 July 2008 was 30% × EUR 300,000 = EUR 90,000. Therefore, there is a goodwill of EUR 50,000. This is not shown separately, but it was necessary to do this calculation so as to be sure that there was no negative goodwill.

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Table 20.1 Income statements for the year ended 30 June 2009

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Table 20.2 Balance sheets as at 30 June 2009

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Table 20.3 Statements of changes in equity (retained earnings only) for the year ended 30 June 2009

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Table 20.4 Consolidated income statement for the year ended 30 June 2009

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Table 20.5 Consolidated balance sheet as at 30 June 2009

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Table 20.6 Consolidated statement of changes in equity(retained earnings only) for the year ended 30 June 2009

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Upstream and downstream transactions

‘Upstream’ and ‘downstream’ transactions are transactions between an investor and an associate. An example of an upstream transaction is the sale of goods by the associate to the investor. An example of a downstream transaction is the sale of goods by the investor to the associate. IAS 28 requires that unrealised profits resulting from such transactions should be eliminated to the extent of the investor’s interest in the associate. This differs from the IAS 27 requirement that unrealised profits on intragroup transactions should be fully eliminated, whether or not the subsidiary concerned is wholly-owned.

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Accounting for upstream anddownstream transactions

Upstream. In the investor’s income statement, the unrealised profit on the transaction is deducted from the investor’s share of profit from associates. This automatically reduces the figure for the investment in associates shown in the investor’s balance sheet.

Downstream. The unrealised profit on the transaction is subtracted from the investor’s gross profit (usually by increasing cost of sales) and is also deducted from the figure for the investment in associates shown in the investor’s balance sheet.

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Example 20.4

Upstream and downstream transactionsAn investor company has a 25 per cent interest in an associate. During the year ended 31 December 2009, the investor bought goods from the associate on which the associate earned a profit of EUR 20,000. One-half of these goods remained unsold by the investor at the year-end.(a) Calculate the unrealised profit on this transaction and explain how this is eliminated from the investor’s financial statements.(b) Explain how the required accounting treatment would differ if the goods had been sold by the investor to the associate rather than the other way around.

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(a) The unrealised profit is EUR 2,500(25% × 50% × EUR 20,000). In the investor’s income statement, the share of profit from associate is reduced by EUR 2,500. In the investor’s balance sheet, the investment in associate is reduced by EUR 2,500.

(b) In the investor’s income statement, the cost of sales figure is increased by EUR 2,500. In the investor’s balance sheet, the investment in associate is reduced by EUR 2,500.

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Losses of an associate

The investor’s share of an associate’s loss is recognised in the investor’s income statement and is deducted from the carrying amount of the investment in the investor’s balance sheet. However, if the investor’s share of an associate’s loss is greater than the carrying amount of the investment, that amount is reduced to zero and the investor should normally recognise no further losses. But further losses should be recognised if the investor has incurred legal or constructive obligations on behalf of the associate. This situation might occur if the investor has guaranteed the associate’s debts.

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Losses of an associate (Continued)

If the carrying amount of the investment is reduced to zero but the associate then eventually returns to profit, the investor should not resume recognition of its share of the associate’s profits until after those profits have cancelled out all the losses which were not being recognised whilst the carrying amount of the investment was zero.

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Impairment losses

• Any goodwill which is included in the carrying amount of an investment in an associate is not separately recognised and is not separately tested for impairment. However, the entire carrying amount of the investment should be tested for impairment whenever there is an indication that impairment may have occurred.

• An impairment test involves comparing the carrying amount of the investment with the higher of its value in use and its fair value less costs to sell.

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Reporting dates and accounting policies

(a) If the reporting date of an investor and an associate are different, the associate should prepare additional financial statements for the use of the investor, using the same reporting date as the investor. If this is impracticable, the

financial statements of the associate should be adjusted to take account of any significant transactions or events between the associate’s

reporting date and the investor’s reporting date. In any case, the difference between the reporting date of the associate and that of the investor should not exceed three months.

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Reporting dates and accounting policies (Continued)

(b) The investor’s financial statements should be prepared using uniform accounting policies. If an

associate uses different accounting policies from those adopted by the investor, its financial

statements should be adjusted to conform with the investor’s accounting policies before the equity method is applied.

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Interests in joint ventures

The following are examples of joint ventures:• Shared distribution network;• consortia to jointly produce products (for example,

aircraft and ships);• property development;• property management;• property investment;• pharmaceutical companies sharing research;• shared use of an asset (such as an oil field or

pipeline or football teams sharing a ground).

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Definition of a joint ventureand joint control

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

• 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)

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Definition of a joint ventureand joint control (Continued)

The strategic financial and operating decisions relating to the activity to be agreed upon unanimously by the venturers. The standard does not give examples of the type of strategic decisions that require unanimous consent, but the decisions would include matters such as:

• issuing shares;

• capital expenditure;

• significant asset disposals;

• approving a business plan;

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Definition of a joint ventureand joint control (Continued)

• changing the strategic direction of the business such as changes in products, markets and activities;

• remuneration policy;

• major financing;

• distributions and investment;

• appointment, revocation of governing bodies’ members.

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Figure 20.3 Determining the existence of joint controlSource: Millicom International Cellular SA Annual Report 2008

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Forms of joint venture

• Jointly controlled operations;• jointly controlled assets;• jointly controlled entities.

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Jointly controlled operations and assets

• Jointly controlled operations or jointly controlled assets are somewhat similar in nature to jointly controlled entities in that two or more participants will form them and there will be an agreement covering the arrangement. But they differ in that these joint ventures do not involve the establishment of a corporation, partnership, entity or a financial structure that is separate from the venturers themselves.• Each venturer uses its own property, plant and equipment and carries its own inventories.

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Jointly controlled operationsand assets (Continued)

It also incurs its own expenses and liabilities and raises its own finance, which represent its own

obligations. The joint venture activities may be carried out by the venturer’s employees alongside

the venturer’s similar activities. The joint venture agreement usually provides a means by which

the revenue from the sale of the joint product and any expenses incurred in common are shared

among the venturers.(IAS 31 para 13)

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Jointly controlled entities

The standard defines a jointly controlled entity as:‘. . . a joint venture that involves the establishment of a corporation, partnership or other entity in which each venturer has an interest. The entity operates in the same way as other entities, except that a contractual arrangement between the venturers establishes joint control over the economic activity of the entity’.

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Measurement of Jointly controlled operations and assets

In respect of its interest in jointly controlled assets, A venturer recognises:• Its share of the jointly controlled assets, classified according to the nature of the assets rather than as an investment. For example, a share in a jointly controlled pipeline should be shown within plant property and equipment.• Any liabilities that it has incurred, for example, those

incurred to finance its share of the assets.• Its share of any liabilities incurred jointly with other venturers. For example, the decommissioning liability of a jointly controlled asset.

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Measurement of Jointly controlled operations and assets (Continued)

In respect of its interest in jointly controlled assets, A venturer recognises: (Cont’d)• Any income from its sale or use of its share of the output, together with its share of any expenses incurred by the joint venture.• Any expenses that it has incurred in respect of its interest in the venture, for example those related to financing the venturer’s interest in the assets and selling its share of the output (IAS 31 paras

21 and 22).

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Example 20.6

Jointly controlled operation

Entity A and entity B have entered into a joint operation to produce products for sale. Entity A manufactures the product and provides the day-to-day management of the production. Entity A makes a 10 per cent margin on the products it sells to the joint operation. Entity B identified the opportunity and contributed EUR 80,000. Entity A contributed EUR 20,000. Profits are shared 50/50.

During the joint operation’s first year, entity A incurred costs of EUR 140,000 in respect of work

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in progress, of which EUR 100,000 was charged to the joint operation at EUR 110,000. The joint operation made product sales to third parties of EUR 80,000 and the cost of those sales in the joint operation was EUR 60,000. There are no third party debtors or creditors at the year-end as all transactions have been settled.

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Table 20.7 Entity A’s adjusted balance sheet

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Measurement of jointly controlledentities

A venturer’s interest in a jointly controlled entity should be recognised using proportionate consolidation or the equity method.Proportionate consolidation is an accounting method whereby ‘a venturer’s shareof each of the assets, liabilities, income and expenses of a jointly controlled entity is combinedline by line with similar items in the venturer’s financial statements or reported as separate line items in the venturer’s financial statements’ (IAS 31 para 3).

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Measurement of jointly controlled entities: Application of proportionate consolidation

Table 20.8 Draft consolidated balance sheet of Theta Ltd and balance sheet of Iota Ltd as at 31 March 2010

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Additional information:(a) On 1 April 2007, Theta Ltd paid EUR 140,000 to

acquire 25 per cent of the shares in Iota Ltd. On that date, the retained earnings of Iota Ltd were EUR 144,000 and the fair value of the company’s non-current assets was EUR 80,000 more than their book value. This revaluation has not been reflected in the books of Iota Ltd.

(b) Iota Ltd has issued no shares since Theta Ltd acquired its holding and there have been no impairment losses in relation to goodwill.

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Table 20.9 Consolidated balance sheet of Theta Ltd as at 31 March 2010

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Figure 20.5 Trading transactions with jointly controlled entitiesSource: Millicom International Cellular SA Annual Report 2008

Documents

Associates and Joint Ventures