W9 Chapter 31 Associates and joint ventures) PDF

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CHAPTER 31

Associates and joint ventures 

CHA PT ER A IM This chapter discusses the application of AASB 128/IAS 28 Investments in Associates and Joint Ventures. The objectives of this standard are to prescribe the accounting for investments in associates and to set out the requirements for the application of the equity method when accounting for investments in associates and joint ventures.

LEA RNING OBJECT IVES After studying this chapter, you should be able to: 31.1 explain the nature of associates and joint ventures 31.2 discuss the concepts of significant influence and joint control 31.3 explain the rationale for the equity method and the different sets of financial statements in which it may be applied 31.4 apply the equity method to an investment in an associate 31.5 adjust the application of the equity method for fair value/carrying amount differences of identifiable assets and liabilities at acquisition date and account for goodwill or gain on bargain purchase at acquisition 31.6 account for the effects of inter‐entity transactions 31.7 account for associates and joint ventures where these entities incur losses 31.8 discuss the disclosures required in relation to associates and joint ventures.

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CONCEPT S F OR REVIEW Before studying this chapter, you should understand and, if necessary, revise: • the nature of goodwill or gain on bargain purchase in a business combination including fair value increments at acquisition • incremental and decremental revaluations of non‐current assets • accounting for unrealised gains arising from intragroup transactions between entities within a group • the criteria for identifying parent entities and subsidiaries and the requirement to prepare consolidated financial statements.

31.1 Introduction and scope LEARNING OBJECTIVE 31.1 Explain the nature of associates and joint ventures.

An equity investment is where one entity holds shares in another entity. Where such an investment exceeds 50% we generally identify that the investor has control over the investee, giving rise to a parent–subsidiary relationship. As we saw in chapters 26–30 of this text, the parent entity is required to prepare consolidated financial statements under AASB 10/IFRS 10 Consolidated Financial Statements (i.e. a set of financial statements of the parent and its subsidiaries presented as those of a single economic entity). Other equity investments may be relatively insignificant and simply carried at either cost or fair value under AASB 9/IFRS 9 Financial Instruments. Other investments may involve less than 50% ownership and yet still be significant. For example, in the disclosure note reproduced in figure 31.1, one of Australia’s largest listed companies, Wesfarmers Limited, lists its interests in a diverse range of associates. These investments are in the range of 20% to 50%, below the level indicative of control yet they are not insignificant. All are accounted for using the equity method of accounting. FIGURE31.1

Investments in associates and joint ventures, Wesfarmers

18. Associates and joint arrangements CONSOLIDATED

Investments in associates Interests in joint ventures

2016 $m

2015 $m

588 17

545 17

605

562

Net profits from operations of associates Other comprehensive income of associates Profit/(loss) from operations of joint venture Other comprehensive income of joint venture

111 15 3 (7)

83 — (1) (13)

Total comprehensive income

122

69

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Investments in associates Recognition and measurement The Group’s investments in its associates, being entities in which the Group has significant influence and are neither subsidiaries nor jointly controlled assets, are accounted for using the equity method. Under this method, the investment in associates is carried in the consolidated balance sheet at cost plus post‐acquisition changes in the Group’s share of the associates’ net assets. Goodwill relating to associates is included in the carrying amount of the investment and is not amortised. After application of the equity method, the Group determines whether it is necessary to recognise any additional impairment loss with respect to the Group’s investment. The Group’s income statement reflects the Group’s share of the associate’s result. Where there has been a change recognised directly in the associate’s equity, the Group recognises its share of any changes and discloses this in the consolidated statement of comprehensive income. Where the reporting dates of the associates and the Group vary, management accounts of the associate for the period to the Group’s balance date are used for equity accounting. The associates’ accounting policies are consistent with those used by the Group for like transactions and events in similar circumstances. Investment properties owned by associates are initially measured at cost, including transaction costs. Subsequent to initial recognition, investment properties are stated at fair value, which reflects market conditions at the balance sheet date. Gains or losses arising from changes in the fair values of investment properties are recognised in profit or loss of the associate, in the year in which they arise. This is consistent with the Group’s policy.

CHAPT ER 31 Associates and joint ventures

1261

Interests in joint arrangements Recognition and measurement The Group recognises its share of the assets, liabilities, expenses and income from the use and output of its joint operations. The Group’s investment in joint ventures is accounted for using the equity method of accounting. Key judgement: control and significant influence The Group has a number of management agreements with associates and joint ventures it considers when determining whether it has control, joint control or significant influence. The Group assesses whether it has the power to direct the relevant activities of the investee by considering the rights it holds to appoint or remove key management and the decision‐making rights and scope of powers specified in the contract. Where the Group has the unilateral power to direct the relevant activities of an investee, the Group then assesses whether the power it holds is for its own benefit (acting as principal) or for the benefit of others (acting as agent). This determination is based on a number of factors including an assessment of the magnitude and variability of the Group’s exposure to variable returns associated with its involvement with the investee. In an agency capacity, the Group is considered to be acting on behalf of other parties and therefore does not control the investee when it exercises its decision‐making powers. Interests in associates and joint arrangements 2016 %

2015 %

Australia

27.4

27.4

31 December

Australia

—

40.0

Sales agent

31 December

Australia

40.0

40.0

Management company Property investment Investment banking Private equity fund Information technology

31 December 30 June 30 September 30 June 31 December

Australia Australia Australia Australia USA

40.0 24.8 50.0 (a) 20.0

40.0 24.8 50.0 (a) 20.0

Chemical manufacture Chemical manufacture Pine sawmillers

30 June 30 June 30 June

Australia Australia Australia

50.0 50.0 50.0

50.0 50.0 50.0

Joint operations

Principal activity

Reporting date

Country of incorporation

%

%

Sodium Cyanide Bengalla ISPT

Sodium cyanide manufacture Coal mining Property ownership

30 June 31 December 30 June

Australia Australia Australia

75.0 40.0 25.0

75.0 40.0 25.0

Joint ventures

Principal activity

Reporting date

Country of incorporation

%

%

BPI NO 1 Pty Ltd

Property management

30 June

Australia

Associates

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Australian Energy Consortium Pty Ltd1 Bengalla Agricultural Company Pty Limited Bengalla Coal Sales Company Pty Limited Bengalla Mining Company Pty Limited BWP Trust Gresham Partners Group Limited Gresham Private Equity Funds iCiX International, Inc. Queensland Nitrates Management Pty Ltd Queensland Nitrates Pty Ltd Wespine Industries Pty Ltd

1

Principal activity

Reporting date

Country of incorporation

Oil and gas

31 December

Agriculture

(b)

(b)

Australian Energy Consortium Pty Ltd has a 50.0 per cent interest in Quadrant Energy Holdings Pty Ltd. (a) Gresham Private Equity Funds: Whilst the Group’s interest in the unit holders’ funds of Gresham Private Equity Fund No. 2 amounts to greater than 50.0 per cent, it is not a controlled entity as the Group does not have the practical ability to direct their relevant activities. Such control requires a unit holders’ resolution of 75.0 per cent of votes pursuant to the Funds’ trust deeds. (b) BPI NO 1 Pty Ltd: Whilst the Group owns the only equity share in BPI NO 1 Pty Ltd, the Group’s effective interest approximates 50.0 per cent and joint control is effected through contractual arrangements with the joint venture partner.

Source: Wesfarmers Limited (2016, p. 120). 1262 Financial reporting in Australia

The purpose of this chapter is to detail the nature of associates and joint ventures and to set out how they are accounted for. The appropriate accounting standard is AASB 128/IAS 28 Investments in Associates and Joint Ventures. Under AASB 128/IAS 28, the equity method is applied to both associates and joint ventures. Accounting for joint arrangements is covered by AASB 11/IFRS 11 Joint Arrangements (see chapter 32). LEARNING CHECK

■ An equity investment refers to an entity’s investment in shares of another entity. ■ An equity investment may result in the investee being deemed an associate or a joint venture. ■ AASB 128/IAS 28 Investments in Associates and Joint Ventures requires the equity method to be applied to both associates and joint ventures.

31.2 Identifying associates and joint ventures LEARNING OBJECTIVE 31.2 Discuss the concepts of significant influence and joint control.

31.2.1 Associates An associate is defined in paragraph 3 of AASB 128/IAS 28 as: an entity over which the investor has significant influence.

The same paragraph goes on to define significant influence 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.

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The key features of this definition are as follows. • The investor has the power or the capacity to affect the decisions made in relation to the investee. As with the concept of control used in determining the parent–subsidiary relationship, an investor is not requiredto actually exercise this power to influence. It is only necessary that an investor has the ability to do so. • The specific power is that of being able to participate in the financial and operating policy decisions ofthe investee but significant influence falls short of control over such decisions. The preparer is required to exercise judgement in determining the existence of significant influence over another entity. Paragraphs 5 to 9 of AASB 128/IAS 28 provide guidance to assist in this determination. Specifically, paragraph 5 states: If an entity 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 entity has significant influence, unless it can be clearly demonstrated that this is not the case. Conversely, if the entity 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 entity does not have significant influence, unless such influence can be clearly demonstrated.

The distinction between a direct and an indirect holding in an associate is depicted in figure 31.2. So, while 20% of the voting power over an investee is the quantitative indicator, there is scope for other factors to override this determination either side of this threshold. For example, an entity may have 25% of the voting power in an investee while another entity holds 60%. Despite their voting power exceeding 20%, the fact that another entity has control may lead the preparer to the conclusion that they do not have significant influence over the investee. There is no requirement that the investor holds any shares, or has any beneficial interest in the associate. However, as discussed later, the application of the equity method is possible only where the investor holds shares in the associate. In other cases, the investor is required to make specific disclosures in its financial statements. CHAPT ER 31 Associates and joint ventures

1263

FIGURE31.2

Direct and indirect associate relationships Direct

Investor

25%

Associate

Indirect

Parent

100%

25%

Subsidiary

Associate

According to paragraph 6 of AASB 128/IAS 28, the existence of significant influence by an entity 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 entity and its investee; (d) interchange of managerial personnel; or (e) provision of essential technical information.

Due to the voting power the investor typically has in the investee, the most common form of participation is that of representation on the board of directors.

31.2.2 Joint ventures A joint arrangement is defined in paragraph 3 of AASB 128/IAS 28 as an arrangement of which two or more parties have joint control. The key feature of a joint arrangement is that of joint control. The most obvious example of joint control is where two entities each hold 50% of the shares of a third entity as shown in figure 31.3. FIGURE31.3

Example of joint control of a joint venture

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Investor A

Investor B

50%

50%

Joint venture

Joint control is defined in paragraph 3 of AASB 128/IAS 28 as the contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the 1264 Financial reporting in Australia

unanimous consent of the parties sharing control. The key element of joint control is there must be at least two investors who have shared control of the investee. In summary then, 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

According to paragraph 14 of AASB 11/IFRS 11, an investor in a joint arrangement must determine whether the arrangement is a joint operation or a joint venture. This 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. This distinction is covered in detail in chapter 32. In this chapter, it is sufficient to note that a joint venture is 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. • 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 inventories risks. In the examples used in this chapter, an investor will hold between 20% and 50% of the shares in an investee. The classification of that investment as an investor–associate relationship or a joint venture will depend on whether the investor has significant influence over or joint control of the investee. The subsequent accounting for either structure is the same. LEARNING CHECK

■ The key criterion for identifying an investor–associate relationship is that the investor

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■ Significant influence is the power to participate in the policy decisions of the investee, but it does not extend to control as required for a parent–subsidiary relationship. ■ ■ AASB 128/IAS 28 provides guidelines to help determine the existence of significant influence, including the ability to influence the investee’s board of directors, and the existence of material transactions between the investor and the investee. ■ The key criterion for identifying a joint arrangement is that two or more parties have joint control over the investee. ■

31.3 The equity method of accounting: rationale and application LEARNING OBJECTIVE 31.3 Explain the rationale for the equity method and the different sets of financial statements in which it may be applied.

The method of accounting used to account for an investor’s interest in an associate or joint venture is known as the equity method of accounting. CHAPT ER 31 Associates and joint ventures

1265

Paragraph 3 of AASB 128/IAS 28 describes the equity method as: a method of accounting whereby the investment is initially recognised at cost and adjusted thereafter for the post‐acquisition change in the investor’s share of the investee’s net assets. The investor’s profit or loss includes its share of the investee’s profit or loss and the investor’s other comprehensive income includes its share of the investee’s other comprehensive income.

31.3.1 Rationale for the equity method Paragraph 11 of AASB 128/IAS 28 provides an insight into the standard setters’ rationale for the equity method by making the following points. • The recognition of income on the basis of dividends earned by an investor from investments in an associate or joint venture may not adequately reflect the performance of the investee. • Because the investor has joint control of, or significant influence over, the investee, the investor has an interest in the associate’s or joint venture’s performance and return on investment. • The equity method requires the investor to include its share of the profit or loss of such an investee in its own financial statements thereby providing more informative reporting of the investor’s net assets and profit or loss. Under the cost method, the only information provided about the associate’s performance would be in relation to dividends received or receivable from the associate. The equity method is designed to provide more information than that provided by the cost method, but less than that given under the consolidation method. However, as stated in paragraph 26 of AASB128/ IAS 28: Many of the procedures that are appropriate for the application of the equity method are similar to the consolidation procedures described in AASB 10 [IFRS 10]. Furthermore, t...