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IAS 28 Investments in Associates and Joint Ventures stipulates the key principles in accounting for associates and joint ventures. The standard also prescribes the requirements for applying the equity method. Investors account for their interest in both associates and joint ventures using the equity method, except where exemption applies.
This article will help you to answer the following questions:
- What is an associate?
- What is a joint venture?
- How does an associate different from a joint venture?
- What is equity method?
- How do we account for investments in associates and joint venture under the equity method?
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 control over the companies, investors only have significant influence in their invested associates.
A joint venture is a joint arrangement whereby the parties that have joint control of the arrangement. For a joint venture, the parties to the arrangement have rights to the net assets of the arrangement.
A significant influence
But what does it mean by “significant influence”? A significant influence is the power to participate in the financial and operating policy decisions of the investee. Importantly, this power does not constitute a control or joint control over those policies.
Our article Key Principles in the Preparation of Consolidated Financial Statements in IFRS 10 covers the discussion on how to determine if an investor controls an entity. Similarly, our article Accounting for Joint Arrangements in IFRS 11 discusses the concept of joint control.
Presumption of significant influence
IAS 28 includes a presumption relating to significant influence. The magic number for this presumption is 20%. If an entity holds, either directly or indirectly, 20% or more of the voting power of the investee, the entity can presume that it has significant influence unless the entity can clearly demonstrate that it is not the case. Conversely, if an entity holds less than 20% of the voting power, directly or indirectly, an entity presumes that it does not have significant influence, unless it can also clearly demonstrate otherwise.
IAS 28 further states the evidence on the existence of significant influence is:
- 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.
- Provision of essential technical information.
Entities should also consider the existence and effect of potential voting rights that are currently exercisable or convertible. This also includes potential voting rights held by other entities.
Accounting for investments in associates and joint ventures
IAS 28 requires entities to account for its investments in associates and joint ventures using the equity method. An exemption is available for investment that qualify the exemption criteria. We will explain in the later part of this article.
The equity method
The equity method is a method whereby entities measure and recognise the investment in associates and joint ventures initially at cost. Entities then adjust the amount 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. Similarly, the investor’s other comprehensive income includes its share of the investee’s other comprehensive income. An entity to account for distributions received from an investee as the reduction in the carrying amount of the investment.
When an entity’s share of losses of an associate or joint venture equal or exceeds its interest, the entity discontinues recognising its share of further losses. After the entity’s interest is reduced to zero, entity may need to provide and recognise a provision for additional losses. This is however, only to the extent that the entity has incurred legal or constructive obligations or made payments on behalf of the investee.
What happens 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.
Determining entities’ interest in associates and joint ventures
An entity determines its interest in an associate or a joint venture solely based on its existing ownership interests. The existing ownership interest does not reflect the possible exercise or conversion of potential voting rights and other derivative instruments.
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 entity determines its proportion of the allocation by considering 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.
Impairment of investments in associates and joint ventures
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 occurred 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.
Applicability of IFRS 9 to investments in associates and joint ventures
IFRS 9 Financial Instruments does not apply to associates and joint ventures that are accounted for using the equity method. However, entities account for instruments containing potential voting rights in an associate or a joint venture in accordance with IFRS 9 unless if such instruments, in substance, currently give access to the returns associated with an ownership interest in the investee.
It is also common for an investor to provide a long-term interest in an associate or a joint venture. A long-term interest that in substance form part of the net investment in the investee 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 to account for associates and joint ventures
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. Entities can elect each associate or joint venture separately from one another at the initial recognition of the investments.
Discontinuance of the equity method and change in ownership interest
What happen when there is a change in ownership interest in associates or joint ventures? Let’s explore the requirements in IAS 28 on this matter.
When do we discontinue the equity method?
Entities discontinue the use of the equity method 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.
How do we treat the change in ownership interest?
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, entities measure the retained interest at fair value. Entities recognise any difference between the fair value and the carrying amount of the investment in profit or loss.
What happened to the amount previously recognised in other comprehensive income when entities discontinue the equity method? In such a case, the entity reclassifies the gain or loss from equity to profit or loss when it discontinues the equity method.
Take note that entities do not need to remeasure the retained interest 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.
We will bring you discussion for other accounting requirements in our upcoming articles. Stay tuned for our upcoming articles by following us on social media. Meantime, enjoy other articles in Financial Accounting section or ask your queries by Joining on Community. It is free and open to join for all, now.