The key principles in accounting for associates and joint ventures are stipulated in IAS 28 Investments in Associates and Joint Ventures. IAS 28 also prescribes the requirements for the application of the equity method. Associates and joint ventures are accounted for by the investor using the equity method, except where exemption applies.
What is an associate? What is a joint venture? And what is the equity method? How does it work? You will find the answers to these questions in this article. Let us now dive into the details.
What are an associate and a joint venture?
Let us first understand the term ‘associate’ and ‘joint venture’. IAS 28 defines an associate as an entity over which the investor has significant influence. Unlike subsidiaries where the investors have controls over the companies, investors only have significant influence in their invested associates. What does it mean by significant influence over an investee? 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. Discussion on how to determine if an investor controls an entity is covered in Key Principles in the Preparation of Consolidated Financial Statements in IFRS 10.
There is a presumption in IAS 28 whereby if an entity holds, either directly or indirectly, 20% or more of the voting power of the investee, the entity has significant influence over it unless it can be clearly demonstrated that it is not the case. Conversely, if an entity holds less than 20% of the voting power, directly or indirectly, it is presumed that the entity does not have significant influence over the investee – unless it can be clearly demonstrated that it is also not the case. IAS 28 further states that the existence of significant influence is usually evidenced in one of the following ways:
- Representation on the board of directors or equivalent governing body of the investee;
- Participation in the policy-making processes, including participation in decisions about dividends or other distributions;
- Material transactions between the entity and its investee;
- Interchange of managerial personnel; or
- Provision of essential technical information.
In assessing significant influence, IAS 28 states that entities should also consider the existence and effect of potential voting rights that are currently exercisable or convertible including potential voting rights held by other entities.
A joint venture, on the other hand, is a joint arrangement whereby the parties that have joint control of the arrangement, have rights to the net assets of the arrangement. Further discussion on the determination of whether a joint arrangement constitutes a joint venture will be covered in our upcoming article.
Accounting for investments in an associate and a joint venture
IAS 28 requires entities to account its investments in associates and joint ventures using the equity method unless the investments qualify for exemption. This will be further explained in the later part of this article. The equity method is a method whereby the investment is initially recognised at cost and adjusted thereafter for the post-acquisition change in the investor’s share of the investee’s net assets. Under this method, the investor’s profit or loss includes its share of the investee’s profit or loss and the investor’s other comprehensive income includes its share of the investee’s other comprehensive income. The equity method also requires an entity to account for distributions received from an investee as the reduction in the carrying amount of the investment.
Where the entity’s share of losses of an associate or joint venture equal or exceeds its interest in the investee, the entity should discontinue recognising its share of further losses. However, after the entity’s interest is reduced to zero, any additional losses are provided for and a liability is recognised only to the extent that the entity has incurred legal or constructive obligations or made payments on behalf of the associate or joint venture. And what happen if the associate or joint venture makes profits subsequently? In this situation, the entity resumes recognising its share of those profits only after its share of the profit equals to the share of losses not recognised.
It is also important to take note that an entity’s interest in an associate or a joint venture is determined solely based on existing ownership interests and does not reflect the possible exercise or conversion of potential voting rights and other derivative instruments. Nevertheless, in certain 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. Accordingly, the proportion allocated to the entity is determined by taking into account the eventual exercise of those potential voting rights. This area, in fact, requires entities to apply significant judgment to determine the allocation belongs to the investor.
Another area to remember is relating to the impairment of the investments in associates and joint ventures. The net investment in an associate or joint venture is impaired if, and only if, there is objective evidence of impairment that occured after the initial recognition of the net investment and that loss event has an impact on the estimated future cash flows from the net investment that can be reliably estimated.
IFRS 9 Financial Instruments does not apply to associates and joint ventures that are accounted for using the equity method. However, instruments containing potential voting rights in an associate or a joint venture are accounted for in accordance with IFRS 9 unless if such instruments, in susbstance, currently give access to the returns associated with an ownership interest in the investee. It is also common, for an investor to provide long-term interest in an associate or a joint venture. Such long-term interests that in substance form part of the entity’s net investments in the investee is, however, is subject to IFRS 9. Lastly, investment in an associate or a joint venture should be classified as a non-current asset unless that investment is classified as held-for-sale.
Exemptions from the equity method
As an exemption to the general rule to account for the investments in associates and joint ventures using the equity method, an entity do not need to apply the equity method if:
- The entity is a parent that is exempt from preparing consolidated financial statements; or
- If all of the following conditions apply:
- The entity is a wholly-owned subsidiary or is a partially-owned subsidiary of another entity and its other owners, including those not otherwise entitled to vote, 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.
- The entity did not file nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation, for the purpose of issuing any class of instruments in a public market.
- The ultimate (Malaysian) or any intermediate parent of the entity produces financial statements available for public use that comply with the International Financial Reporting Standards (“IFRSs”), in which subsidiaries are consolidated or are measured at fair value through profit or loss in accordance with IFRS 10 Consolidated Financial Statements.
IAS 28 further states that when investments in associates or joint ventures are held directly or indirectly through, a venture capital organisation or a mutual fund, unit trust and similar entities, the entity can elect to measure that investments at fair value through profit or loss in accordance with IFRS 9. Each associate or joint venture can be elected separately from one another at the initial recognition of the investments.
Discontinuance of the equity method and change in ownership interest
The use of the equity method is discontinued from the date the investment ceases to be an associate or a joint venture. The investment ceases to be an associate when the entity loses significant influence over it – i.e., the entity loses its power to participate in the financial and operating policy decisions of that investee. This can happen with or without a change in absolute or relative ownership levels.
If the investment becomes a subsidiary, the entity must account for its investment in accordance with IFRS 3 Business Combinations and IFRS 10. However, if the retained interest in the former associate or joint venture is a financial asset, the retained interest is measured at fair value. Any difference between the fair value and the carrying amount of the investment is recognised in profit or loss. What happened to the amount previously recognised in other comprehensive income when the equity method is discontinued? In such a case, the entity reclassifies the gain or loss from equity to profit or loss when the equity method is discontinued.
Take note that no re-measurement of retained interest is required if an investment in an associate becomes an investment in a joint venture or vice versa, as the entity will continue to apply the equity method. In the situation where the entity’s ownership interest is reduced, it must reclassify to profit or loss the proportion of the gain or loss previously recognised in other comprehensive income relating to that reduction of ownership interest.
Although the above discussion summarises the key focus to account for investments in associates and joint ventures, IAS 28 further provides comprehensive guidance on the equity method procedures. This guidance is rather more complex for the purpose of this article. Hence, they are not included here.
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