Accounting for Investments...Question 2 Entities will often invest in the equity of other businesses. The extent of the equity share-holding will determine how the investment should

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Accounting for Investments

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Accounting for Investments 1

LEARNING OUTCOMES

After studying this chapter students should be able to:

� explain the relationships between investors and investees;

� explain the different levels of investment and the conditions required for significant influence, control and joint control;

� explain the circumstances in which a subsidiary is excluded from consolidation;

� explain and apply the principles of recognition of goodwill based on the fair value of assets at the date of acquisition.

Accounting for investments

The accounting in the investees’ individual accounts for all investments and for simple invest-ments (commonly less than 20% of the total equity share capital of the entity invested in), the accounting treatment will be determined by applying the recognition, measurement and disclosure requirements of the accounting standards that specifically deal with investments:

• IAS 32 Financial instruments: presentation• IAS 39 Financial instruments: recognition and measurement• IFRS 7 Financial instruments: disclosure

The provisions of these standards are dealt with in more detail in Chapter 10.

Investment in associates

If an investor holds, directly or indirectly, 20% of the voting rights of an entity then it is normally considered an associated entity and is accounted for in accordance with IAS 28 Accounting for associates. IAS 28 states that there is a presumption that the investor has signif-icant influence over the entity, unless it can be clearly demonstrated that this is not the case.


4 Exam Practice Kit: Financial Management

The existence of significant influence by an investor is usually evidenced in one or more of the following ways:

• representation on the board of directors;• participation in policy-making processes;• material transactions between the investor and the entity;• interchange of managerial personnel;• provision of essential technical information.

The investment in the associate is equity accounted (given in greater detail in Chapter 4)and the investment shown in the statement of financial position will include the invest-ing entity’s share of the gains of the associate from the date the investment was made. The investing entity will show the share of realised and recognised gains it is entitled to by vir-tue of this investment rather than just the dividend received.

Investment in subsidiaries

The accounting standard that sets out the requirements for recognition of an entity as a subsidiary is IAS 27 Consolidated and separate financial statements. This standard was revised in January 2008, but its basic principles have been part of IFRS for many years.

First, some relevant definitions taken from the standard:

The key concept in determining whether or not an investment constitutes a subsidiary is that of control.

There is a presumption that control exists where the investor entity owns over half of the voting power of the other entity.

In most cases, control can be easily determined by looking at the percentage ownership of the ordinary share capital in the investee entity. However, there are exceptions. A parent/subsidiary relationship can exist even where the parent owns less than 50% of the voting power of the subsidiary since the key to the relationship is control. IAS 27 supplies the fol-lowing instances:

When there is:

(a) power over more than half of the voting rights by virtue of an agreement with other investors;

A parent is an entity that has one or more subsidiaries.A subsidiary is an entity, including an unincorporated entity such as a partner-

ship, which is controlled by another entity (known as the parent).

Control is the power to govern the fi nancial and operating policies of an entity so as to obtain benefi t from its activities.



(b) power to govern the financial and operating policies of the entity under a statute or agreement;

(c) power to appoint or remove the majority of the members of the board of directors or equivalent governing body and control of the entity is by that board or body; or

(d) power to cast the majority of votes at meetings of the board of directors or equivalent governing body and control of the entity is by that board or body.

The requirement to prepare consolidated financial statements

Where a parent/subsidiary relationship exists, IAS 27 requires that the parent should pre-pare consolidated financial statements.

Exclusion from preparing consolidated accounts

A full set of financial statements in addition to those already prepared is, of course, quite an onerous requirement. IAS 27 includes some exemptions, as follows:

A parent need not present consolidated financial statements if and only if:

(a) the parent is itself 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 parent not presenting consoli-dated financial statements;

(b) the parent’s debt or equity instruments are not traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets);

(c) the parent 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;

(d) the ultimate or any intermediate parent of the parent produces consolidated financial statements available for public use that comply with IFRS.

The only other exemption from the requirement to consolidate is in respect of an invest-ment in subsidiary that has been acquired exclusively with the intention of reselling it. The provisions of IFRS 5 Non-current assets held for sale and discontinued operations apply.

IFRS 3 Business combinations

IFRS 3 requires that entities should account for business combinations by applying the acquisition method of accounting. This involves recognising and measuring the identifi-able assets acquired, the liabilities assumed and any non-controlling interest in the acquiree entity (the recognition and measurement of non-controlling interests will be explained in

In the Financial Management examination, questions may be set that test understand-ing of the principle of control, and it is possible that you will be required to explain

these conditions in a written question.



Chapter 3). Measurement should be at fair value on the date of acquisition. Where 100% of the equity of a subsidiary is acquired, goodwill on acquisition is calculated as follows:

Goodwill on acquisition is the aggregate of:Consideration, measured at fair valueLESSNet assets acquired (the fair value of identifi able assets acquired less liabilities

assumed)

The goodwill arises at the date of acquisition and will not change unless impairment is identified, whereby it will be held net of impairment losses (which should be recognised in accordance with IAS 36 Impairment of assets).

Fair values in acquisition accounting

IFRS 3 requires that whenever a group entity is consolidated for the first time the purchase consideration and the group share of the net assets of the acquired entity are measured at fair values. The difference between these two figures is goodwill. The purpose of a fair-value exercise is to apportion the consideration given by the parent to purchase the shares in the newly acquired entity to the net assets of the newly acquired entity for consolidation purposes. Any difference between the fair value of the consideration given and the fair val-ues of the net assets acquired is goodwill on acquisition.

Fair value is defined in IFRS 3 as the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s-length transaction.

Investment in joint ventures

Where an entity enters into an arrangement whereby control over an economic activity is shared between it and other parties, a joint venture arrangement exists. A joint venture can take a number of forms (covered in depth in Chapter 4), however one of those is where a new entity is formed and since that entity is under joint control it will be consolidated.

Again the method of accounting reflects the level of the investment made – it is greater than significant influence (associate) but not as much as full control (subsidiary). The joint venture will be consolidated but not using the full consolidation method. Instead IAS 31 Interests in joint ventures requires that joint ventures be proportionally consolidated. This will involve only aggregating the parent’s share of the JV’s assets, liabilities, revenues and expenses.



Medium answer questions

Question 1

You are the chief accountant of XYZ Group responsible for production of the consolidated financial statements. The CEO has asked you to explain why another set of financial state-ments is necessary and whether XYZ Group could avoid the preparation of consolidated financial statements as it appears to be an expensive and time-consuming process.

Requirements

(a) Explain the main principles of the consolidation of a subsidiary and why it is necessary. (5 marks)

(b) Briefly explain the exclusions from the requirement to prepare consolidated accounts (5 marks) (Total � 10 marks)

Question 2

Entities will often invest in the equity of other businesses. The extent of the equity share-holding will determine how the investment should be accounted for. The accounting treat-ment applied for investments is intended to reflect the importance of the investment in the financial statements of the investee and how the future performance and financial position might be affected by these investments.

Requirement

Briefly describe the different levels of investment that an entity can make and how they would be accounted for. (10 marks)



Answer to medium answer questions

Answer 1

(a) There are two main reasons for the preparation of consolidated financial statements:(i) Reflecting the substance of the relationship between parent and subsidiary recog-

nising that although they may well be completely separate legal entities they are on single economic entity.

(ii) A regulatory requirement. IAS 27 requires that the parent should prepare consoli-dated financial statements where a parent/subsidiary relationship exists.

IFRS 3 requires that entities should account for business combinations by applying the acquisition method of accounting. This involves consolidating the income statement and statement of financial position of the parent and subsidiary, in effect adding them together line by line to reflect the single economic entity.

Where the cost of the investment in the subsidiary exceeds the fair value of the identifi-able net assets goodwill is created and recognised in the consolidated financial state-ment. The goodwill is reviewed for impairment where appropriate.

To reflect the single economic entity position all transactions and balances between group companies are eliminated before consolidation takes place (e.g. receivables and payables balances from intra-group trading).

(b) A parent need not present consolidated financial statements if and only if:(a) the parent is itself 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 parent not presenting consolidated financial statements;

(b) the parent’s debt or equity instruments are not traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets);

(c) the parent 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;

(d) the ultimate or any intermediate parent of the parent produces consolidated financial statements available for public use that comply with IFRS.

(e) The only other exemption from the requirement to consolidate is in respect of an investment in subsidiary that has been acquired exclusively with the intention of reselling it.

Answer 2

Simple Investments

This would commonly be a holding of less than 20% of the total equity share capital of the entity invested in. There would generally be no significant influence or control and so the accounting treatment will be determined by applying the recognition, measurement and disclosure requirements of the accounting standards that specifically deal with investments:

• IAS 32 Financial instruments: presentation• IAS 39 Financial instruments: recognition and measurement• IFRS 7 Financial instruments: disclosure



Investment in associate

If an investor holds, directly or indirectly, 20% of the voting rights of an entity then it is normally considered an associated entity and is accounted for in accordance with IAS 28 Accounting for associates. IAS 28 states that there is a presumption that the investor has signif-icant influence over the entity, unless it can be clearly demonstrated that this is not the case.

The key concept in the definition is ‘significant influence’. IAS 28 explains that significant influence is the power to participate in the financial and operating policy decisions of the entity but is not control over those policies.

The impact of this level of investment on the investing entity is likely to be greater than that of a simple investment. There is greater exposure to the results of the associate and a decline in its value will have a greater negative impact on the statement of financial posi-tion of the investing entity.

Investment in subsidiary

It is often the case that businesses conduct part of their operations by making investments in other business entities. In order to fulfil the needs of investors and other users, additional information is likely to be required, and therefore the IASB has in issue several accounting standards setting out the principles and practices that must be followed.

IAS 27 Consolidated and separate financial statements – sets out the requirements for recognition of an entity as a subsidiary. The key concept in determining whether or not an investment constitutes a subsidiary is that of control. Control is the power to govern the financial and oper-ating policies of an entity so as to obtain benefit from its activities. There is a presumption that control exists where the investor entity owns over half of the voting power of the other entity.

However, there are exceptions. A parent/subsidiary relationship can exist even where the parent owns less than 50% of the voting power of the subsidiary since the key to the rela-tionship is control.

IFRS 3 requires that entities should account for business combinations by applying the acquisition method of accounting. This involves adding together the parent and subsidi-ary’s financial statements.

Investment in joint ventures

Where an entity enters into an arrangement whereby control over an economic activity is shared between it and other parties, a joint venture arrangement exists. A joint venture can take a number of forms, however one of those is where a new entity is formed and since that entity is under joint control it will be consolidated.

Again the method of accounting reflects the level of the investment made – it is greater than significant influence (associate) but not as much as full control (subsidiary). The joint ven-ture will be consolidated but not using the full consolidation method. Instead IAS 31 Interests in joint ventures requires that joint ventures be proportionally consolidated. This will involve only aggregating the parent’s share of the JV’s assets, liabilities, revenues and expenses.

This answer is comprehensive and not representative of what is required from an exam standard 10 mark question.



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Accounting for Investments...Question 2 Entities will often invest in the equity of other businesses. The extent of the equity share-holding will determine how the investment should