IAS 28 – Investments in Associates and Joint Ventures
Why do entities make strategic investments in other entities?
Business entities make strategic investments in the shares of other entities as part of business management, beyond their own direct operations. Such investments do not necessarily grant the investors control over the investees and often confer only significant non-controlling interests.
How do IFRS Accounting Standards classify investments in shares?
IFRS Accounting Standards distinguish between three types of investments in shares, according to the degree of influence of the reporting entity over the investee. The degrees are:
- No influence over the investee or insignificant influence (see A below).
- Control over the investee (see B below).
- Intermediate levels – between insignificant influence and control, including significant influence as well as joint control (see C below).A. Insignificant Influence
When the reporting entity has no influence over the investee or when its influence is insignificant, the investment is treated as a financial asset, accounted for according to the measurement principles for financial assets, similar to an investment in other securities (e.g., bonds). These investments are dealt with under IFRS 9 Financial Instruments.B. Control
When the reporting entity controls the investee (the subsidiary), the acquisition constitutes a business combination, and the reporting entity (the parent) is required to prepare consolidated financial statements. Such investments, constituting business combinations, are dealt with under IFRS 3 Business Combinations and IFRS 10 Consolidated Financial Statements.C. Intermediate Levels – Joint Control and Significant Influence
Investments that fall into the intermediate category are addressed under IAS 28 Investments in Associates and Joint Ventures or, alternatively, under IFRS 11 Joint Arrangements.
Under IAS 28, significant influence is defined as the power to participate in the financial and operating policy decisions of the investee, without constituting control or joint control over those policies. An associate is an entity over which the investor has significant influence.
Under IFRS 11, joint control is defined as the contractually agreed sharing of control over an arrangement, where decisions about the relevant activities require unanimous consent. Where joint control exists, the joint arrangement is classified as either a joint operation or a joint venture.
Why was an intermediate accounting method required for significant influence?
Significant Influence
Significant influence refers to cases where the reporting entity (the investor) has significant influence, rather than control, over the investee (an associate). Until the early 1960s, investments in entities that were not controlled (and therefore not consolidated) were accounted for using the cost method, with income recognised only when entitlement to dividends arose (i.e., when the investee declared dividends). Over time, it became clear that the cost method did not adequately measure the results of such investments, since entities typically do not distribute all of their profits as dividends. This led to the need for an intermediate method – one that did not consolidate the investee’s financial statements but at the same time did not restrict income recognition to dividends declared.
How are joint arrangements treated under IAS 28 and IFRS 11?
Investments in Joint Arrangements
The Standard addresses investments in associates as well as investments classified as joint ventures under IFRS 11 Joint Arrangements. Under IFRS 11, when a party determines that it has joint control over an arrangement, it must classify the arrangement as either a joint operation or a joint venture. This classification is based on the rights and obligations of the investor in the joint arrangement. Where the investor has rights to the net assets, the arrangement is classified as a joint venture and accounted for as an associate, i.e., using the equity method.
The rationale behind the use of the equity method for joint ventures is that the investor’s exposure is limited. Accordingly, the investor recognises rights in the net assets, rather than its share of each individual asset and liability, reflecting rights to net assets but not necessarily obligations for net liabilities. Thus, under the equity method losses of the investee are recognised only up to the carrying amount of the investment, unless there are obligations to fund the investee’s losses. This principle, limiting recognition of investee losses, supports the rationale for applying the equity method to joint ventures.
What is the equity method and how is it applied?
Equity Method
The intermediate accounting method required for investments in associates and joint ventures is the equity method. Under this method, the investment is initially recognised at cost and subsequently adjusted for the investor’s share of changes in the net assets of the investee after acquisition. Consequently, the investor’s comprehensive income includes its share in the profit or loss of the investee as well as its share in the investee’s other comprehensive income.
The equity method is conceptually based on the consolidation method of accounting. However, since the investor does not control the investee’s individual assets and liabilities but only its own investment, there are significant presentation differences between the equity method, full consolidation, and recognition of rights and obligations in a joint operation. Unlike the other methods, the equity method does not consolidate the investee’s assets, liabilities, income and expenses. Instead, a single-line entry is recorded for the investor’s share in the change in net assets and in the profit or loss of the investee. For this reason, the equity method is sometimes referred to as a “one-line consolidation” method. Nevertheless, there are still important differences between full consolidation under IFRS 10 and the equity method.
Why does the equity method provide more relevant information than the cost method?
The underlying principle of the equity method is that the involvement in the investee’s policy decisions (significant influence) reflects rights to its performance, both positive and negative, and justifies recognition of the investor’s share in the investee’s results. Recognition of the investor’s share in the investee’s profit or loss is appropriate even though the investor does not control the amount or timing of dividend distributions. The investor controls its investment and can derive economic benefits in other ways, e.g., by selling the investment or pledging it as collateral. Recognition of income only when dividends are declared does not properly measure the investor’s economic return, since dividend declarations may have little connection with the investee’s performance. The equity method therefore provides more relevant information regarding the investor’s profit or loss and net assets.
How is significant influence determined and are there exceptions to the equity method?
As noted, the Standard addresses the accounting treatment of associates and joint ventures. Determination of significant influence under the Standard is principle-based: holding 20% or more of the voting rights in another entity creates a presumption of significant influence, unless clearly demonstrated otherwise. Conversely, holding less than 20% creates a presumption of no significant influence, unless clearly demonstrated otherwise.
According to the Standard, venture capital organisations and mutual funds are not required to apply the equity method for associates or joint ventures, given the special nature of their operations, provided the investments are designated at initial recognition to be measured at fair value through profit or loss.
By way of comparison, under US GAAP (ASC 825, formerly FAS 159, on Financial Instruments), certain investments that would otherwise be accounted for under the equity method may be designated to be measured at fair value.
In which financial statements is the equity method applied?
Separate, Individual, and Consolidated Financial Statements
The equity method must be applied either in the individual financial statements or in the consolidated financial statements of the reporting entity, as follows:
- Where the reporting entity does not own any subsidiaries, the equity method is applied in the individual financial statements for associates and joint ventures.
b. Where the reporting entity owns one or more subsidiaries, the equity method is applied in the consolidated financial statements for associates and joint ventures. In this case, the equity method may also be applied in the separate financial statements (in which the subsidiaries are not consolidated) if such statements are issued alongside the consolidated statements.
The application of the equity method under the Standard is based, with necessary adjustments, on the guiding principles of IFRS 3 and IFRS 10, which address business combinations and consolidated financial statements. The Standard requires that the financial statements of the investee used in applying the equity method be adjusted to conform with the accounting policies of the investor. Although in the past it was argued that uniform accounting policies should not be required since there is no control and thus no single economic group exists, the change reflects the Standard’s objective of maintaining consistency in measuring the results of the reporting entity and its associates and joint ventures.