Ch31 sm loftus 2e - Textbook Solution for C31 PDF

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Solutions manual to accompany Financial reporting 2e by Loftus et al.

Solutions manual to accompany

Financial reporting 2nd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Noel Boys

© John Wiley & Sons Australia, Ltd 2018

© John Wiley and Sons Australia Ltd, 2018

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Chapter 31: Associates and joint ventures

Chapter 31:Associates and joint ventures Comprehension questions 1. What is an associate entity? Paragraph 3 of AASB 128/IAS 28 defines an associate as:  an entity over which the investor has significant influence. The key criterion is the existence of significant influence, also defined in para. 3 defined as:  The power to participate in the financial and operating policy decisions of the investee but is not control or joint control of those policies. Note that an investor does not have to necessarily hold shares in an associate – yet the application of the equity method depends on such a shareholding. However, refer to the presumptions in para 6 of AASB 128/IAS 28.

2. Why are associates distinguished from other investments held by the investor? The suite of accounting standards provides different levels of disclosure dependent on the relationship between the investor and the investee:  Subsidiaries: a control relationship (AASB 10).  Joint ventures: a joint control relationship (AASB 11).  Associates: a significant influence relationship (AASB 128).  Other investments: no relationship (AASB 9). The investor-associate relationship relates to the ability of the investor to influence the direction of the investee, in comparison to a simple holding of shares as an investment. Where such a relationship exists, it is argued that the investor is both accountable for and benefit from the financial performance and financial position of the investee [why have such an investment if there are no benefits to doing so?]. These effects result in the need for additional disclosure about the nature and the financial effects of that relationship.

© John Wiley and Sons Australia Ltd, 2018

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Solutions manual to accompany Financial reporting 2e by Loftus et al.

3. Discuss the similarities and differences between the criteria used to identify subsidiaries and those used to identify associates. A subsidiary is identified where another entity controls that entity. Control is defined in para 2 of AASB 128/IAS 28. An associate is identified where another entity has significant influence over that entity. Control Power over the investee

Significant influence Power to participate

Exposure or rights to variable returns from involvement in investee

To participate in the financial and operating policy decisions

Ability to affect returns through power

-----------

No ownership interest is necessary

No ownership interest is necessary

4. What is meant by ‘significant influence’? Para 3 of AASB 128/IAS 28 states:  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. Key features:  the power to participate  financial and operating policy decision.

© John Wiley and Sons Australia Ltd, 2018

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Chapter 31: Associates and joint ventures

5. What factors could be used to indicate the existence of significant influence? Note paras 5 and 6 of AASB 128/IAS 28: Para 5. 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 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. Para 6. The existence of significant influence by an investor is usually evidenced in one or more of the following ways: (a) representation on the board of directors or equivalent governing body of the investee; (b) participation in policy-making processes, including participation in decisions about dividends or other distributions; (c) material transactions between the investor and the investee; (d) interchange of managerial personnel; or (e) provision of essential technical information.

6. What is a joint venture? A joint arrangement is an arrangement of which two or more parties have joint control. Where a joint arrangement exists, the arrangement must be classified as either a joint operation or a joint venture. The classification depends on the rights and obligations of the parties to the arrangement. Joint ventures are accounted for under AASB 128/IAS 28 while joint operations are accounted for under AASB 11/IFRS 11. A joint venture is described as an arrangement where the investor has a right to an investment in the investee. The investee will have the following features:  the legal form of the investee and the contractual arrangements are such that the investor does not have rights to the assets and obligations for the liabilities of the investee; and  the investee has been designed to have a trade of its own and as such must directly face the risks arising from the activities it undertakes, such as demand, credit or inventory risks.

7. What is meant by joint control? Joint control is the contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. The key element of joint control is the sharing of control. In other words, there must be at least two investors who have shared control of the investee (AASB 128/IAS 28, para. 3) 8. How does joint control differ from control as applied on consolidation? Under AASB 10/IFRS 10: © John Wiley and Sons Australia Ltd, 2018

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Solutions manual to accompany Financial reporting 2e by Loftus et al.



An investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee.

There are three investor-investee relationships which are based on different levels of control: Relationship Parent - subsidiary Investor - associate Joint arrangement - investee

Level of control Dominant control Significant influence Joint control

With a subsidiary there can be only one parent. With joint control there needs to be at least 2 entities that share control.

9. Discuss the relative merits of accounting for investments by the cost method, the fair value method and the equity method. Cost method:  Advantages: - Simplicity. - Reliable measure.  Disadvantages: - No indication of changes in value since acquisition. - Revenue recognised only on dividend declared or received. Fair value method:  Advantages: - Up-to-date value, present information compared with past information. - Revenue recognised as value changes rather than waiting for dividends.  Disadvantages: - Reliability a function of how active the market is. - Costs associated with regular updating, extra costs for audit and valuation fees. Equity method:  Advantages: - Carrying amount related to change in net assets of the investee. - Share of profit seen as a more informative reflection of the performance of the investor’s investment.  Disadvantages: - Carrying amount reliant on validity of investee information rather than based on market value. - Recognition of revenue prior to associate declaring dividend; no transaction has occurred.

© John Wiley and Sons Australia Ltd, 2018

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Chapter 31: Associates and joint ventures

10. Outline the accounting adjustments required in relation to transactions between the investor and an associate/joint venture. Critically evaluate the rationale for these adjustments. Adjustments required:  Unrealised gains arising from inter-entity transfers of assets such as inventory or property, plant & equipment. Rationale:  Paragraph 11 of AASB 128/IAS 28 justifies the equity method on the basis that it provides more informative reporting of the investor’s net assets and profit or loss.  A key question is whether the equity method is used as a measurement technique to approximate fair value, or as a consolidation technique.  If it is a measurement technique, then why adjust for inter-entity transactions?  If it is a consolidation technique, then adjustments can be justified – however, does the method of adjustment proposed in para 22 conform with consolidation techniques? Debate:  Why should investor’s share of associate’s profits be adjusted if investor sells to associate as associate’s profits are unaffected by this transaction?  Should individual accounts such as “sales”, “cost of sales” and “inventories” be adjusted?  Should downstream transactions affect different accounts than upstream transactions? 11. Compare the accounting for the effects of inter-entity transactions for transactions between parent entities and subsidiaries and between investors and associates/joint ventures. See para 22 of AASB 128/IAS 28. Consolidation  Adjust for upstream & downstream.  Adjust for unrealised profits/losses.  Adjust for inter-entity balances.  Adjust for 100% of effect.  Adjust individual accounts such as sales. 

Transactions identified within group.

as

Equity method  Adjust for upstream & downstream.  Adjust for unrealised profits/losses.  No adjustment for inter-entity balances.  Proportionate adjustment.  Adjust share of profits/losses & investment account. occurring  No economic entity/group structure.

© John Wiley and Sons Australia Ltd, 2018

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Solutions manual to accompany Financial reporting 2e by Loftus et al.

12. Discuss whether the equity method should be viewed as a form of consolidation or a valuation technique. AASB 128/IAS 28 does not give a clear indication whether the equity method is a consolidation technique or a measurement technique similar to fair value. Note para 20: “Many of the procedures appropriate for the application of the equity method are similar to the consolidation procedures described in AASB 127/IAS 27.” If viewed as a measurement method, the equity method is an extension of the accrual process within the historical cost system. Revenue is recognised in relation to the investee as the investor records profits/losses, instead of merely when the investor pays dividends. The balance sheet is a one-line figure, being an alternative to fair value. If it is a measurement technique, why adjust for the effects of inter-entity transactions? Further, why not just use fair value if available, or if capable of being reliably measured, and only apply equity method as a default? Why use a criterion such as significant influence to determine associates – why not apply the equity method to all material investments? If viewed as a consolidation technique, there is an expansion of the group to include the investor’s share of the associate. The group then is more than just controlled entities.   

Why not use proportionate consolidation? Why not adjust fully for inter-entity transactions? Why expand the group beyond controlled entities in the first place?

It appears that equity accounting is a hybrid between a measurement technique and consolidation. It is argued that standard-setters should determine a conceptual basis for accounting for associates and apply an appropriate method.

© John Wiley and Sons Australia Ltd, 2018

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Chapter 31: Associates and joint ventures

13. Explain why equity accounting is sometimes referred to as ‘one-line consolidation’. Equity accounting is similar to consolidation in that:  both recognise the investor’s share of post-acquisition equity in the income statement. The consolidation method recognises the NCI share as well, but divides equity into parent and NCI share.  both adjust for the effects of unrealised gains or losses arising from inter-entity transactions  in the income statement, the share of profits/losses of an associate is similar to the parent’s share of the post-acquisition equity of a subsidiary – however, under the equity method this is not taken against individual accounts but there is a one-line disclosure.  in the balance sheet, the investment in the associate is adjusted for the increase in the investor’s share of the net assets of the associate – similar to the parent’s share of the net assets of a subsidiary. However, under equity accounting, there is no recognition of the individual assets and liabilities of the associate, rather, there is a one-line recognition.

14. Explain the differences in application of the equity method of accounting where the method is applied in the records of the investor compared with the application in the consolidation worksheet of the investor. There are 2 major differences when equity accounting is applied in the consolidation worksheet rather than in the accounts of the investor. First, in relation to past periods: If the adjustments are made in the records of the investor, then in any period, there is only a need to recognise the effects of the current period changes in share of the profit/losses and other comprehensive income of the associate. If the adjustments are made on consolidation, as the worksheet is only a temporary document and has no effect on the actual accounts, in periods subsequent to the date of acquisition, there needs to be a recognition, via retained earnings and reserves, of the investor’s share of prior period profits/losses and other comprehensive income of the associate. Second, in relation to dividend revenue: If the adjustments are made in the accounts of the investor, then on payment of a dividend by the associate, the adjustment is: Cash Investment in associate

Dr Cr

x x

If the adjustments are made on consolidation, the worksheet adjustment is: Dividend revenue Investment in associate

Dr Cr

x x

15. Explain the treatment of dividends from the associate under the equity method of accounting.

© John Wiley and Sons Australia Ltd, 2018

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Solutions manual to accompany Financial reporting 2e by Loftus et al.

Under the equity method, dividends are not recognised as revenue. To do so would be double counting as the investor’s share of profit from which such dividends are distributed have already been recognised. Instead, dividends are treated as a return of equity already recognised and so reduce the carrying amount of the investment in the associate. The treatment of dividends differs dependent on whether the equity method is applied in the accounts of the investor or applied on consolidation in the consolidation worksheet. Dividends paid In the accounts of the investor: On payment of the dividend by the associate, in the accounts of the investor, the following entry is made: Cash Investment in associate

Dr Cr

x x

As the investor recognises its share of the profits/losses of the associate as income, and this profit/loss is prior to the appropriation of dividends, then to recognise dividend revenue would double count the income recognised by the investor. The dividend is simply a receipt of equity already recognised via application of the equity method. Consolidation worksheet: In the year of payment of the dividend the consolidation adjustment entry is: Dividend revenue Investment in associate

Dr Cr

x x

When the dividend is paid the investor records the receipt of cash and recognises dividend revenue. The effect of the above entry is to eliminate the dividend revenue previously recognised by the investor. Because the investor recognises a share of the whole of the profit of the associate, the dividend revenue cannot also be recognised as income by the investor. Dividends declared Where revenue is recognised on declaration of the dividend, the effect is the same as for dividends paid. Where the investor does not recognise dividend revenue, then there is no entry in the investor’s accounts, nor is there any adjustment in the consolidation worksheet. In using the consolidation worksheet method, care must be taken in calculating the investor’s share of post-acquisition retained earnings where a dividend was declared at the end of the previous period. This must be added back to the closing balance of retained earnings, as the investor has not yet recognised the appropriation of profits.

© John Wiley and Sons Australia Ltd, 2018

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Chapter 31: Associates and joint ventures

Case studies Case study 31.1 Significant influences The accountant of Cornett Chocolates Ltd, Ms Fraulein, has been advised by her auditors that the entity’s investment in Concertina’s Milk Ltd should be accounted for using the equity method of accounting. Cornett Chocolates Ltd holds only 20.2% of the voting shares currently issued by Concertina’s Milk Ltd. Since the investment was undertaken purely for cash flow reasons based on the potential dividend stream from the investment, Ms Fraulein does not believe that Cornett Chocolates Ltd exerts significant influence over the investee. Required Discuss the factors that Ms Fraulein should investigate in determining whether an investor–associate relationship exists, and what avenues are available so that the equity method of accounting does not have to be applied

© John Wiley and Sons Australia Ltd, 2018

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Solutions manual to accompany Financial reporting 2e by Loftus et al.

The relevant paragraphs from AASB 128/IAS 28 are: Paragraph 3:  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. Paragraphs 5 and 6: 5. 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 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. 6. The existence of significant influence by an investor is usually evidenced in one or more of the following ways: (a) representation on the board of directors or equivalent governing body of the investee; (b) participation in policy-making processes, including participation in decisions about dividends or other distributions; (c) material transactions between the investor and the investee; (d) interchange of managerial personnel; or (e) provision of essential technical information. Points to discuss: 1. Why the investment is undertaken by Cornett Chocolates is irrelevant. The definition of significant influence is based on the capacity to participate, not the actual or intention to participate. 2. Whether Cornett Chocolates actually exerts influence is irrelevant. 3. The 20% is a guideline only. 4. Factors will include those in paragraph 6. Further an analysis of the 79.8% holding by other parties is very important. If it is closely held, then the ability for Cornett Choco...