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Contentschapter 13Group accounts: associatesIntroductionExamination contextTopic List1 Investment in an associate 2 Equity method: consolidated balance sheet 3 Equity method: consolidated income statement 4 Associate's losses 5 Transactions between a group and its associateSummary and Self-testTechn...

Description

chapter 13

Group accounts: associates

Contents Introduction Examination context Topic List 1

Investment in an associate

2

Equity method: consolidated balance sheet

3

Equity method: consolidated income statement

4

Associate's losses

5

Transactions between a group and its associate

Summary and Self-test Technical reference Answers to Self-test Answers to Interactive questions

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Introduction

Learning objectives 

Explain the relationship between a group and its associate



Explain the principles behind the treatment of the associate



Reflect an associate in group accounts by means of equity accounting



Deal with transactions between a group and its associate

Tick of

Specific syllabus references for this chapter are: 1g, 3c,d,e.

Practical significance In Chapters 10-12 we have seen that companies may acquire other entities as a means of achieving growth and meeting corporate objectives. We have been looking at situations where an investor obtains control of an investee through the ownership of a majority of the ordinary share capital. However, there are other ways in which an investment may be made. A minority stake could be obtained such that the investor can influence, rather than control, the key decisions made by the entity. This is normally achieved through the acquisition of 20% or more of the voting rights (normally attached to ordinary shares). This type of investment is referred to as an associate. But why would an entity wish to obtain a minority stake only? In many cases the acquisition of a minority stake is part of a wider plan. The investor is able to be involved in the strategy of the target company, through representation on the board whilst at the same time limiting its financial commitment. It is able to evaluate whether the target company would fit in with its existing activities and, if appropriate, to make initial plans for a merger. The target company may also benefit from this process as the investing entity can often provide expertise such as management and logistics services. This approach is common in high technology and developing industries. Typically these involve small, newly-established entities which require capital funding. If the readers of financial information are to understand the level of influence an entity can exercise it is essential that the method of reporting reflects this adequately. BAS 28 Investments in Associates aims to ensure that this is the case.

Stop and think? How do you think a simple trade investment differs from an investment in an associate?

Working context If you have worked on a client which involves a group of companies the investments made by the parent company may have included an associate. As we saw in Chapter 10 the subsidiaries in a group are normally consolidated by preparing a consolidation package. Typically the same type of procedure is used in respect of the associate. The key issues which would need to be addressed specifically include the correct identification of the investment as an associate and the appropriate accounting treatment in the financial statements.

Syllabus links More complex aspects of group financial statements will be examined in the Financial Reporting paper and at the Advanced stage. It is therefore important that you have a sound understanding of the accounting treatment of associates to carry forward to these other papers.

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Examination context

Examination commentary Associates could be examined in both the short-form question and written test sections of the paper. In the written test section it is likely that the associate will be examined in the context of the preparation of a consolidated balance sheet or income statement, within a group structure which includes at least one subsidiary. A written element of such a question could focus on an explanation of equity accounting by reference to the underlying principles or a comparison of the treatment of associates under BFRS. In the examination candidates could be required to: 

Incorporate the results of an associate in the consolidated financial statements using the equity method



Explain the equity method and the principles behind it

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1 Investment in an associate Section overview

1.1



An associate is an entity over which the parent exercises significant influence.



Significant influence is presumed where the parent holds 20% or more of the voting rights.



An associate is not part of the group.



An investment in an associate should be accounted for in the consolidated financial statements using the equity method of accounting.

Introduction In the previous chapters we have seen that where a parent entity controls another entity (normally by holding over 50% of the ordinary share capital) it is said to have a subsidiary. The results of the parent and subsidiary are consolidated in group accounts as if they were a single entity. However, investments can take a number of different forms. An investing entity may obtain sufficient shares such that the investment is of significant importance to it, without achieving control. This type of investment is referred to as an associate and is dealt with by BAS 28 Investments in Associates. In this chapter we will look at how to account for an associate. (The detailed provisions of BAS 28 are dealt with in Chapter 15.)

1.2

Associate Definition Associate: An entity, including an unincorporated entity such as a partnership, over which the investor has significant influence and that is neither a subsidiary nor an interest in a joint venture.

When deciding whether an investment should be treated as an associate the critical feature is whether the investing entity has significant influence over the investee.

Definition Significant influence: The power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies.

Significant influence can be determined by the holding of voting rights (usually attached to shares) in the entity. BAS 28 states that:

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

If an investor holds 20% or more of the voting power of the investee (directly or indirectly) it is presumed that the investor has significant influence; therefore associate status will be presumed unless it can be demonstrated otherwise.



If an investor holds less than 20% of the voting power of the investee (directly or indirectly) it is presumed that the investor does not have significant influence; therefore there is no associate status unless demonstrated otherwise.

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BAS 28 also states that significant influence can be shown by one or more of the following:     

Representation on the board of directors Participation in policy making decisions Material transactions between the investor and investee Interchange of managerial personnel Provision of essential technical information

Point to note For examination purposes you should assume that a holding of 20% or more of the ordinary share capital constitutes significant influence.

1.3

Relationship with the group An associate is not part of the group as a group comprises the parent and its subsidiaries only. In terms of the Financial Accounting syllabus, the group investment in the associate is always held by the parent company, not a subsidiary. So:

P Group 80% S

1.4

40% A

Treatment in investing company's own accounts The balance sheet of the investing company shows the investment in the associate in non-current asset investments, usually at cost. The investing company's income statement shows dividend income received and receivable from the associate as 'income from associates'. The question is whether this provides the shareholders of the parent company with sufficient information. It could be argued that to reflect fairly the nature of the investor's interest where it is in a position to exercise significant influence the group's interest in the net assets and results of the associate should be reflected. This is achieved by the use of the equity method of accounting.

1.5

Treatment in consolidated financial statements: accounting principles An investment in an associate should be accounted for in the consolidated financial statements using the equity method of accounting. This method reflects the substance of the relationship between the entities rather than their legal form. The group's share of the associate's profits, assets and liabilities are included in the consolidated financial statements rather than the cost of the investment and dividend income received. (Exceptions to the general requirement to apply the equity method of accounting are described in Chapter 15.) Point to note The equity method is only used in the group accounts i.e. the parent company holds investments in subsidiaries as well as associates. If the investor does not issue consolidated financial statements the investment will be shown in the investor's individual financial statements as described in section 1.4 above.

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2 Equity method: consolidated balance sheet Section overview

2.1



The investment in the associate is shown as a single line entry in the consolidated balance sheet.



If the carrying amount of the investment has suffered an impairment it should be written down to its recoverable amount.

Basic principle An associate is accounted for as follows: 

The interest in the associate is presented as a single line under non-current assets described as 'Investments in Associates'.



It is initially recognised at cost and is subsequently adjusted in each period for changes in the parent's share of the net assets.



In group reserves the parent's share of the associate's post-acquisition reserves are included (as for a subsidiary).

Point to note The assets and liabilities of the associate are not included on a line-by-line basis.

2.2

Calculation of balance sheet carrying amount The investment in the associate is calculated as follows: Original cost (in P's books) Share of post acquisition change in net assets Less: Impairment losses to date

CU X X X (X) X

Point to note If the parent company has made any long term loans to the associate which are not expected to be repaid in the foreseeable future these should be included as part of the investment in the associate.

2.3

Impairment losses At the date of acquisition the investment in the associate is recognised at cost (see section 2.1). This represents the parent's share of the fair value of the net assets acquired plus goodwill arising on acquisition. This goodwill is not separately calculated or disclosed (as with a subsidiary) but instead is included as part of the carrying amount of the investment. This presentation aims to avoid giving the misleading impression that the investor has acquired a goodwill asset through control over its share of the associate’ s individual assets, liabilities and contingent liabilities. It has only gained significant influence over the affairs of the associate so no goodwill is calculated at the date the investment is made. As a result impairment tests are performed in relation to the investment as a whole. If the investment has suffered an impairment it is written down to its recoverable amount (see section 2.2). Point to note If there is a discount on the purchase of the investment (i.e. the cost is less than the fair value of the net assets acquired) it must be recognised in profit or loss for the period in which the investment is made. In practice this is unlikely to occur.

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2.4

Application of the equity method in the consolidated balance sheet Remember that the equity method is only used in group accounts. This means that the parent has subsidiaries as well as an associate. In an examination question the practical implication of this is that you will need to produce the consolidation workings for the subsidiaries (See Chapter 11). These workings are adapted for the inclusion of the associate as follows: Working1: Group structure

 Include the associate in the group structure diagram

Working 2: Net assets

 Produce a net assets working for the associate (as for a subsidiary)  This should include any fair value or accounting policy adjustments to the associate's net assets  The post acquisition change in net assets will form part of the 'Investments in Associates' balance

Working 5: Consolidated retained earnings (reserves)

 Include the parent's share of the associate's post acquisition retained earnings

The calculation of the carrying amount of the investment in the associate will usually be Working 6.

Interactive question 1: Equity method (CBS)

[Difficulty level: Easy]

P Ltd owns 80% of S Ltd and 40% of A Ltd. Balance sheets of the three companies at 31 December 20X8 are as follows. P CU 800 600 6,600 8,000

Investment: shares in S Investment: shares in A Sundry assets Share capital –CU1 ordinary shares Retained earnings Equity Liabilities

1,000 4,000 5,000 3,000 8,000

S CU

– – 5,800 5,800

A CU – – 5,400 5,400

400 3,400 3,800 2,000 5,800

800 3,600 4,400 1,000 5,400

P acquired its shares in S when S's retained earnings were CU520, and P acquired its shares in A when A's retained earnings were CU400. In 20X7 an impairment loss of CU20 was recognised in relation to the investment in A. Requirement Prepare the consolidated balance sheet at 31 December 20X8. Fill in the proforma below.

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Solution P Ltd: Consolidated balance sheet as at 31 December 20X8 CU Intangibles (W3) Investments in associates (W6) Sundry assets Share capital Retained earnings (W5) Attributable to equity holders of P Ltd Minority interest (W4) Equity Liabilities WORKINGS (1) Group structure

(2) Net assets Balance sheet date CU

Acquisition CU

Post acquisition CU

S Ltd Share capital Retained earnings

A Ltd Share capital Retained earnings (3) Goodwill S Ltd Cost of investment Net assets acquired Balance c/f

CU

(4) Minority interest CU S Ltd (5) Retained earnings CU P Ltd S Ltd A Ltd Impairment to date

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(6) Investments in associates CU Original cost Share of post-acquisition change in net assets (W2) Impairment losses to date See Answer at the end of this chapter.

3 Equity method: consolidated income statement Section overview 

3.1

Share of profit of associates is recognised as a single line entry in the consolidated income statement.

Basic principle The associate is accounted for as follows: 

The group's share of the associate's profit after tax is recognised in the consolidated income statement as a single line entry.



This is disclosed immediately before the group profit before tax as 'Share of profit of associates'.



If the associate is acquired mid-year its results should be time-apportioned.

Points to note (1) It may seem odd to include an after tax balance in arriving at the profit before tax, but this is in line with the Guidance on Implementing BAS 1 Presentation of Financial Statements. (2) The revenues and expenses of the associate are not consolidated on a line-by-line basis.

3.2

Impairment review Where an impairment review in the current period has revealed an impairment loss to be charged to the income statement, the loss is deducted from the parent's share of the profit after tax of the associate (or added to the parent's share of a post-tax loss.)

3.3

Application of the equity method in the consolidated income statement An additional working will be required to calculate the parent's share of the associate's profit after tax. Point to note The consolidation schedule (Working 2) will only include the parent and any subsidiaries as the associate is not consolidated.

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Interactive question 2: Equity method (CIS)

[Difficulty level: Easy]

P Ltd has owned 80% of S Ltd and 40% of A Ltd for several years. Income statements for the year ended 31 December 20X8 are as follows. P Ltd CU 14,000 (9,000) 5,000 (2,000) 3,000 1,000 4,000 (1,000) 3,000

Revenue Cost of sales Gross profit Administrative expenses Profit from operations Investment income Profit before tax Income tax expense Profit after tax

S Ltd CU 12,000 (4,000) 8,000 (6,000) 2,000 – 2,000 (1,200) 800

A Ltd CU 10,000 (3,000) 7,000 (3,000) 4,000 400 4,400 (2,000) 2,400

An impairment loss of CU120 is to be recognised in 20X8 in relation to the investment in A Ltd. Requirement Prepare the consolidated income statement for the year ended 31 December 20X8. Fill in the proforma below.

Solution P Ltd: Consolidated income statement for the year ending 31 December 20X8 CU Revenue Cost of sales Gross profit Administrative expenses Profit from operations Investment income Share of profit of associates (W4) Profit before tax Income tax expense Profit after tax Attributable to: Equity holders of P Ltd ( ) Minority interest (W3) WORKINGS (1) Group structure

P Group 80%

40%

S

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(2) Consolidation schedule P Ltd CU

S Ltd CU

Adj CU

Consol CU

Revenue Cost of sales Admin expense Inv. income Tax (3) Minority interest CU S Ltd (4) Share of profit of associates CU A Ltd See Answer at the end of this chapter.

4 Associate's losses Section overview 

4.1

Losses recognised in respect of the associate are limited to the carrying amount of the associate.

Accounting treatment Where an associate makes a loss the following treatment should be adopted: Consolidated balance sheet

The group's share of the loss sho...