Completely understand 1 consolidated and 2 separate financial statements

Last update

Completely understand 1 consolidated and 2 separate financial statements is a summary of the requirements of IFRS 10 Consolidated financial statements, IFRS 11 Joint Arrangements, IFRS 12 Disclosure of Interests in Other Entities and IAS 28 Investments in Associates and Joint ventures and IAS 27 Separate financial statements.

Major topics discussed are:

  • The single control model in IFRS 10 that applies to all entities (including ‘structured entities’ or ‘variable interest entities’ as they are referred to in US GAAP). The changes introduced by IFRS 10 require continuous management to exercise significant judgement to determine which entities are controlled, and therefore are required to be consolidated by a parent. IFRS 10 may periodically change which entities are within a group or not (any-more).
  • IFRS 11 capitalises on single control model in IFRS 10 to define joint control, the determination of whether joint control exists. In addition, jointly controlled entities (JCEs) that meet the definition of a joint venture must be accounted for using the equity method. For joint operations (which includes former jointly controlled operations, jointly controlled assets, and potentially some former JCEs), an entity recognises its assets, liabilities, revenues and expenses, and/or its relative share of those items, if any. In addition, IFRS 11 focuses on the nature of the rights and obligations arising from the arrangement.
  • IFRS 12 incorporates the disclosure requirements from IAS 27, IAS 31 and IAS 28. These disclosures relate to an entity’s interests in subsidiaries, joint arrangements, associates and structured entities. A number of new disclosures are also required. An entity (parent/investing company) is now required to disclose the judgements made to determine whether it controls another entity.Even if management concludes that it does not control an entity, the information used to make that judgement has to be transparently disclosed to users of the financial statements. These disclosures should assist users of the financial statements to make their own assessment of the financial impact were management to reach a different conclusion regarding consolidation — by providing more information about unconsolidated entities), such as firm commitments and/or guarantees to an entity’s interests in subsidiaries, joint arrangements, associates and structured entities. Completely understand 1 consolidated and 2 separate financial statements
  • IAS 28 introduces the concept of significant influence as the power to participate in the financial and operating policy decisions of the investee but not to control or joint control those policies. In addition, the equity method is defined 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.
  • IAS 27 prescribe the accounting and disclosure requirements for investments in subsidiaries, joint ventures and associates when an entity (investor) prepares separate financial statements. Separate financial statements are those presented by an entity in which the entity could elect, subject to the requirements in this Standard, to account for its investments in subsidiaries, joint ventures and associates either at cost, in accordance with IFRS 9 Financial Instruments, or using the equity method as described in IAS 28 Investments in Associates and Joint Ventures.

OR

Completely understand 1 consolidated and 2 separate financial statements

IFRS 10 — Consolidated Financial Statements

All elements in assessment of control:

An investor controls an investee (in such cases normally called a subsidiary) when it 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. This principle applies to all investees, including structured entities. Consequently, for an investor to control an investee, the investor must possess all of the following elements:

  • Power over the investee, which is described as having existing rights that give the current ability to direct the activities of the investee that significantly affect the investee’s returns (such activities are referred to as the ‘relevant activities’)
  • Exposure, or rights, to variable returns from its involvement with the investee
  • Ability to use its power over the investee to affect the amount of the investor’s returns

– What are relevant activities?

Where it is not clear that control is through voting rights, a crucial step in assessing control is to identify the relevant activities i.e., those activities of the investee returns. Examples of relevant activities mentioned in IFRS are:

  • Determining operating policies  Completely understand 1 consolidated and 2 separate financial statements
  • Making capital decisions Completely understand 1 consolidated and 2 separate financial statements
  • Appointing key management personnel Completely understand 1 consolidated and 2 separate financial statements
  • Management of underlying investments Completely understand 1 consolidated and 2 separate financial statements

However, the identification of relevant activities is not limited to these activities, it is not a coincidence that they are called examples.

– Evaluating power or rights to…..

IFRS 10 also includes application guidance on evaluating whether various types of rights (such as voting rights, potential voting rights (e.g., options or convertible instruments), rights to appoint key personnel, decision making rights within a management contract, or removal or ‘kick-out’ rights) give an investor power.

Where management concludes that an entity does not have control, the requirements of IFRS 11 and IAS 28 must still be considered to determine whether an investor has joint control, significant influence or none of these three governance themes over an investee. Completely understand 1 consolidated and 2 separate financial statements

– Assessing the nature of investor returns

To control an investee, an investor must be exposed, or have rights, to variable returns from its involvement with the investee. Returns can be positive, negative or both. Examples of returns include: Completely understand 1 consolidated and 2 separate financial statements

  • Dividends, other distributions of economic benefits (e.g., interest on debt securities) and changes in the value of the investment in the investee
  • Remuneration for servicing an investee’s assets or liabilities, fees and exposure to loss from providing credit or liquidity support, residual interests in the investee’s assets and liabilities on liquidation of that investee, tax benefits, and access to liquidity that an investor has from its involvement with an investee
  • Returns that are not available to other interest holders (e.g., economies of scale, cost savings, scarce products, proprietary knowledge, or synergies)

Returns are often an indicator of control. This is because the greater an investor’s exposure to the variability of returns from its involvement with an investee, the greater the incentive for the investor to obtain rights that give the investor power. However, the magnitude of the returns is not determinative of whether the investor holds power.

The link between power over an investee and returns is essential to having control. An investor that has power over an investee, but cannot benefit from that power, does not control that investee. An investor that receives a return from an investee, but cannot use its power to direct the activities that significantly affect the returns of that investee, does not control that investee.

– Minority owned subsidiaries

Although a consolidation group owns less than half of entity A (45% ownership) and entity B (48% ownership) and has less than half of their voting power, management has determined that the consolidation group controls these two entities. Completely understand 1 consolidated and 2 separate financial statements

The consolidation group controls entity A by virtue of an agreement with its other shareholders; the consolidation group has control over entity B, on a de facto power basis, because the remaining voting rights in the minority owned subsidiary are widely dispersed and there is no indication that all other shareholders exercise their votes collectively. (IFRS 12 7(a), IFRS 12 9(b), IAS 1 122)

IFRS 11 — Joint Arrangements

Joint control is defined as, “the contractually agreed sharing of control of an arrangement which exists only when the decisions about the relevant activities require the unanimous consent of the parties sharing control.” IFRS 11 describes the key aspects of joint control as follows: Completely understand 1 consolidated and 2 separate financial statements

  • Contractually agreed — contractual arrangements are usually, but not always, written, and provide the terms of the arrangement.
  • Control and relevant activities — IFRS 10 describes how to assess whether a party has control, and how to identify the relevant activities (see above)
  • Unanimous consent — exists when the parties to an arrangement have collective control over the arrangement and no single party has control

It may require judgment to identify at which level to assess whether joint control exists — that is, the unit of account. In many cases, this assessment is made at the contract level. However, some contracts may contain more than one joint arrangement. For example, a master agreement may contain the terms and conditions for numerous entities that each constitute a joint arrangement.

The contractual arrangement sets out the terms upon which the parties participate in the arrangement. It generally addresses matter such as:

  • the objective and duration of the joint arrangement, Completely understand 1 consolidated and 2 separate financial statements
  • the specific activities undertaken by the joint arrangement, Completely understand 1 consolidated and 2 separate financial statements
  • how the members of the governing body are appointed and how decisions are made, Completely understand 1 consolidated and 2 separate financial statements
  • the capital or other contributions required of the parties, and Completely understand 1 consolidated and 2 separate financial statements
  • how the parties will share assets, liabilities, revenues, expenses or profits or losses. Completely understand 1 consolidated and 2 separate financial statements

Food for thought

An entity is not automatically a joint arrangement because two or more parties hold equal shares in the arrangement. From this it is important to make a distinction between joint control and collective control.

Joint control only exists when there is a contractual agreement requiring two or more parties to unanimously agree on decisions about the relevant activities of the arrangement and the parties together control the arrangement.

Joint control does not arise where decisions on relevant activities only require the consent of a majority or super-majority of owners. Here, the control is contractually shared; however the same group of investors does not need to agree to the relevant activities, as the arrangement only requires a majority to agree.

In SUMMARY, this is the decision tree for identifying a joint arrangement (or not): Completely understand 1 consolidated and 2 separate financial statements

Once a joint arrangement is identified, it is then classified as either a joint venture or a joint operation. Here is the decision tree in this situation (the starting point is the joint arrangement box in the above decision tree): Completely understand 1 consolidated and 2 separate financial statements

All elements in assessment of the type of joint arrangement: Completely understand 1 consolidated and 2 separate financial statements

IFRS 11

Joint operation

IFRS 11 15 A joint operation is a joint arrangement whereby the parties that have joint control of the arrangement have rights to the assets, and obligations for the liabilities, relating to the arrangement. Those parties are called joint operators.

For example, the contractual arrangement gives the parties an interest in individual assets and liabilities and obligations for liabilities of the arrangement.

Joint venture

IFRS 11 16 A joint venture is a joint arrangement whereby the parties that have joint control of the arrangement have rights to the net assets of the arrangement. Those parties are called joint venturers.

For example, the contractual arrangement only gives the parties rights to a share of the net outcome generated by an economic activity.

Completely understand 1 consolidated and 2 separate financial statements

Terms or the arrangement

The parties have rights to the assets and obligations for the liabilities, relating to the arrangement.

The parties have rights to the net assets of the arrangement.
Completely understand 1 consolidated and 2 separate financial statements

Rights to assets

The parties share all interests in the assets in a specified proportion.
Completely understand 1 consolidated and 2 separate financial statements

The assets belong to the arrangement. The parties to the arrangement do not have direct rights, title or ownership of the assets.

Obligations for liabilities

The parties share all liabilities, obligations, costs and expenses in a specified proportion.

The parties are all liable for claims on the arrangement raised by third parties of the arrangement.

Completely understand 1 consolidated and 2 separate financial statements

The joint arrangement is liable for the debts and obligations of the arrangement. The parties are liable to the arrangement only to the extent of their respective investments in the arrangement or their respective obligations to contribute any unpaid or additional capital to the arrangement, or both.

Creditors of the arrangement do not have any right of recourse against the parties in respect of debts or obligations of the arrangements.

Revenue

Expenses

Profit or loss

The arrangement establishes an allocation of revenue and expenses based on the relative performance of each party (for example, the basis of capacity used by each party). This could differ from their ownership interest in the arrangement.

The arrangement establishes each party’s share in profit or loss of the arrangement.

Completely understand 1 consolidated and 2 separate financial statements

Completely understand 1 consolidated and 2 separate financial statements

Guarantees

The provision of guarantees by parties to a joint arrangement (or a commitment to provide guarantees) does not by itself result in the classification of an arrangement as a joint operation. Completely understand 1 consolidated and 2 separate financial statements

Classifying a joint arrangement

When classifying a joint arrangement as either a joint operation or a joint venture, several issues should be considered, as shown in the illustration above.

The structure (i.e., legal form) of a joint arrangement is only one element to be considered in classifying a joint arrangement as either a joint operation or a joint venture. IFRS 11 focuses primarily on the nature and substance of the rights and obligations arising from the arrangement. Completely understand 1 consolidated and 2 separate financial statements

Nevertheless, the structure of the joint arrangement is still very important. As shown in the illustration above, a joint arrangement that is not structured through a separate vehicle (such as a partnership, corporation, or other financial structure) is classified as a joint operation.

However, if there is a separate vehicle, the joint arrangement is not necessarily a joint venture. The contractual terms of the joint arrangement itself, as well as other facts and circumstances, impact its classification.

Joint arrangement accounting consolidated and separate financial statements

Consolidated financial statements

Separate financial statements

Parties that share joint control

Joint operations

Joint operators recognise their interest in the direct rights and obligations of the arrangement, and their share of those assets, liabilities and transactions incurred jointly.

Any gains or losses should only be recognised to the extent of the other parties’ interest in that joint operation.

Proportional (or line-by-line) consolidation

N/A

Joint ventures

Accounted for in accordance with the equity method (one line consolidation), unless the joint venture classifies as held by venture capital organisation, mutual fund, unit trust or similar entity, or as a joint venture held for sale.

Investment is measured at costs or fair value (IFRS 9 see below)

Parties that do not share joint control Completely understand 1 consolidated and 2 separate financial statements

Joint operations

Follows the accounting of parties that share joint control, or where the party does not have direct rights or obligations, then in accordance with other applicable IFRSs.

An example of the latter point may arise where a party has contributed funding to a joint operation in return for a right to the share of the output from the joint operation, as opposed to direct rights to assets or obligations for liabilities.

This party will account for this right applying IAS 38 Intangible assets.

Joint ventures

Where the party significantly influences the arrangement:

Accounted for in accordance with the equity method (one line consolidation), unless the joint venture classifies a held by venture capital organisation, mutual fund, unit trust or similar entity, and joint ventures held for sale.

Investment is measured at costs or fair value (IFRS 9 see below)

Where the party does not significantly influence the arrangement:

It is accounted for in accordance with IFRS 9 (see below)

IAS 28 Associate

This type of investment is something less than a subsidiary, no joint venture but more than a simple investment.

The definition of an associate is based on ‘significant influence’, which is the ‘power to participate’ in the financial and operating policy decisions of an associate but is not in ‘control’ or ‘joint control’ of those decisions. (IAS 28 Definitions)

Significant influence can be determined by the holding of voting rights (usually attached to shares) in the entity. IAS 28 states that if an investor holds 20% or more of the voting power of the investee, it can be presumed that the investor has significant influence over the investee, unless it can be clearly shown that this is not the case. [IAS 28 Definitions].

IFRS 10 puts an upper limit to this definition in that if an investor holds over 50% and more of the voting rights of the investee the investment is a subsidiary.

Significant influence can be presumed not to exist if the investor holds less than 20% of the voting power of the investee, unless it can be demonstrated otherwise.

These presumptions may be overcome in circumstances in which an ability, or lack of ability, to exercise significant influence can be demonstrated clearly. [IAS 28 5]

An associate may also be created if the nomination or appointment power is used in conjunction with a formal or informal agreement to exercise significant influence through direct involvement in setting the associate’s financial and operating policy decisions.

The existence of significant influence is evidenced in one or more of the following ways.

  • Representation on the board of directors (or equivalent) of the investee Completely understand 1 consolidated and 2 separate financial statements
  • Participation in the policy making process Completely understand 1 consolidated and 2 separate financial statements
  • Material transactions between investor and investee Completely understand 1 consolidated and 2 separate financial statements
  • Interchange of management personnel Completely understand 1 consolidated and 2 separate financial statements
  • Provision of essential technical information Completely understand 1 consolidated and 2 separate financial statements

Potential voting rights that are currently exercisable are considered in assessing significant influence.

An entity loses significant influence over an investee when it loses the power to participate in the financial and operating policy decisions of that investee. The loss of significant influence can occur with or without a change in absolute or relative ownership levels.

It could occur, for example, when an associate becomes subject to the control of a government, court, administrator or regulator. It could also occur as a result of a contractual arrangement.

IFRS 12 — Disclosure of Interests in Other Entities

for an entity’s interests in subsidiaries, joint arrangements, associates and structured entities into one comprehensive disclosure standard. Many of the disclosure requirements were previously included in IAS 27, IAS 31, and IAS 28, while others are new. Completely understand 1 consolidated and 2 separate financial statements

The objective of IFRS 12 is for an entity to disclose information that helps users of its financial statements evaluate:

  • The nature of, and risks associated with, its interests in other entities
  • The effects of those interests on its financial position, financial performance and cash flows

One of the new requirements of IFRS 12 is that an entity discloses the significant judgements and assumptions it has made ( and changes thereto) in determining:

  • Whether it has control, joint control or significant influence over another entity Completely understand 1 consolidated and 2 separate financial statements
  • The type of joint arrangement (i.e., joint operation or joint venture) when the joint arrangement is structured through a separate vehicle

IFRS 12 expands the disclosure requirements for subsidiaries with non-controlling interests (NCI), joint arrangements and associates that are individually material. For example, a parent is now required to disclose summarised financial information for each subsidiary that has non-controlling interests that are material. The required disclosures with respect to summarised financial information for joint arrangements and associates are also expanded.

IFRS 12 introduces a new term ‘structured entity,’ which replaces and expands upon the concept of a ‘special-purpose entity’ that was previously used in SIC-12. The required disclosures for the interests in such entities have been significantly expanded. An entity is now required to disclose the nature and extent of, and changes in, the risks associated with its interests in both its consolidated and unconsolidated structured entities. Completely understand 1 consolidated and 2 separate financial statements

For example, an entity is required to disclose the terms of any arrangement that could require the entity to provide financial support. If an entity provides financial or other support to a structured entity without being obliged to do so, it is required to disclose the type and amount of support, the situation, and reasons for providing the support, any change in control that resulted there from, and whether there is any current intention to provide support.

 IFRS 9/IFRS 7  (Passive) Investments

IFRS 9 requires all equity investments to be measured at fair value. The default approach is for all changes in fair value to be recognised in profit or loss.

However, for equity investments that are neither held for trading nor contingent consideration recognised by an acquirer in a business combination, entities can make an irrevocable election at initial recognition to classify the instruments as at FVOCI, with all subsequent changes in fair value being recognized in other comprehensive income (OCI). This election is available for each separate investment. Completely understand 1 consolidated and 2 separate financial statements

Under this FVOCI category, fair value changes are recognized in OCI while dividends are recognized in profit or loss (unless they clearly represent a recovery of part of the cost of the investment). Although it might appear similar to the ‘Available-for-Sale’ category in IAS 39, it is important to note that this is a new measurement category which is different.

In particular under the new category, on disposal of the investment the cumulative change in fair value is not recycled to profit or loss. However entities have the ability to transfer amounts between reserves within equity (i.e. between the FVOCI reserve and retained earnings).

Ownership of less than 20% of a company’s shares dictates that the investor is not able to exercise significant influence in the company or participate in shareholder meetings where business decisions affecting the company are made. Ownership of this quantity of shares is recorded using the cost method.

The following is an example of how to report investments of less than 20% of shares — assume ABC Corporation purchases 10% of XYZ’s Corporation’s common shares, or 50,000 shares. The market price of the shares is USD 1. When purchasing less than 20% of a company’s shares, the cost method is used to account for the investment.

ABC records a journal entry for the purchase by debiting Investment in XYZ Corp. for USD 50,000 and crediting Cash for USD 50,000. The investment in XYZ Corporation is reported at cost in the asset section of the balance sheet.

If the investee declares dividends, the investor records a journal entry for their share of the investment. Assume XYZ Corporation declares a dividend of USD 1 per share. ABC records a journal entry debiting Dividends Receivable for USD 50,000 and crediting Dividend Income for USD 50,000. The Dividend Receivable is reported on the balance sheet under current assets and Dividend Income is reported on the income statement under a section for other income.

IFRS 12 Structured entities

A structured entity is one that has been designed so that voting or similar rights are not the dominant factor in deciding who controls it (IFRS 12 Appendix A). For such entities, the criteria in IFRS 10.B51 to B54 should be applied in order to determine which investor, if any, has power.

Many structured entities may run on ‘auto-pilot’ such that no ongoing decisions need to be made after the structured entity has been set up. The assessment of power may be challenging for such entities, as there appear to be no significant decisions over which power is required. Completely understand 1 consolidated and 2 separate financial statements

IFRS 10.10 requires an investor to have the current ability to direct the relevant activities of the investee in order to have control. If there are truly no decisions to be made after an entity has been set up, none of the investors have such a ‘current ability to direct’ and so no one would consolidate the investee. However, this assessment must be made carefully after considering all relevant factors including those set out below. Completely understand 1 consolidated and 2 separate financial statements

The purpose and design of the structured entity should be considered when assessing control. Involvement in the purpose and design of a structured entity does not of itself convey power; it may indicate who is likely to have power (IFRS 10.B17 and IFRS 10.B51).

If decisions that significantly affect returns are required only if some trigger event happens (for example, default of receivables or downgrade of collateral held by the structured entity), these should be looked to in determining who has power, no matter how remote the triggering event is. These decisions should be considered in light of the purpose and design of the entity and the risks that it was intended to pass on.

For example, decisions regarding the management of defaulting bonds are more likely to be relevant activities when the structured entity was set up to expose investors to the bonds’ credit risk, no matter how remote default might be at inception of the vehicle.

The possibility that non-contractual power may exist should also be considered. It will be important to assess how any decisions over any relevant activities are actually made in practice (IFRS 10.B18). Completely understand 1 consolidated and 2 separate financial statements

If the investee has some form of ‘special relationship’ with the investor, the existence of such a relationship could also suggest that the investor may have power (IFRS 10.B19).

Contractual arrangements such as call rights, put rights and liquidation rights established at the investee’s inception should also be assessed. When these contractual arrangements involve activities that are closely related to the investee, these activities should be considered as relevant activities of the investee when determining power over the investee (IFRS 10.B52).

If an investor has an explicit or implicit commitment to ensure that an investee continues to operate as designed, this may also indicate it has power over relevant activities. Such a commitment may increase the investor’s exposure to variability of returns and thus give it an incentive to obtain rights sufficient to give it power (IFRS 10.B54).

Finally, if an investor has disproportionately large exposure to variability of returns, it has an incentive to obtain power to protect its exposure; the facts and circumstances should therefore be closely examined to determine if it has power (IFRS 10.B20).

Consolidated Structured entities

The consolidation group does not hold any ownership interests in two structured entities, entity C and entity D. However, based on the terms of agreements under which these entities were established, the consolidation group receives substantially all of the returns related to their operations and net assets (these entities perform research activities exclusively for the consolidation group) and has the current ability to direct these entities’ activities that most significantly affect these returns. (IFRS 12 7(a), IFRS 12 9(b), IFRS 12 10(b)(ii))

The owners’ interests in these structured entities are presented as liabilities of the consolidation group, and as such there are no non-controlling interest for these structured entities in the consolidation group’s equity. Completely understand 1 consolidated and 2 separate financial statements

IAS 27 Separate financial statements

Recognition and measurement

When an entity prepares separate financial statements, it shall account for investments in subsidiaries, joint ventures and associates either (IAS 27 10):

  1. at cost; Completely understand 1 consolidated and 2 separate financial statements
  2. in accordance with IFRS 9 Financial Instruments; or Completely understand 1 consolidated and 2 separate financial statements
  3. using the equity method as described in IAS 28 Investments in Associates and Joint Ventures. Completely understand 1 consolidated and 2 separate financial statements

The entity shall apply the same accounting for each category of investments. Investments accounted for at cost or using the equity method shall be accounted for in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations when they are classified as held for sale or for distribution (or included in a disposal group that is classified as held for sale or for distribution). The measurement of investments accounted for in accordance with IFRS 9 Financial Instruments is not changed in such circumstances.

Dividends

Dividends from a subsidiary, a joint venture or an associate are recognised in the separate financial statements of an entity when the entity’s right to receive the dividend is established. The dividend is recognised in profit or loss unless the entity elects to use the equity method, in which case the dividend is recognised as a reduction from the carrying amount of the investment.

Presentation and disclosure

An entity shall present and disclose information that enables users of the financial statements to evaluate the financial effects of investments in subsidiaries, joint ventures and associates when an entity prepares separate financial statements: Completely understand 1 consolidated and 2 separate financial statements

In the Notes to the (separate) financial statement:
An entity shall apply all applicable IFRSs when providing disclosures in its separate financial statements, including the requirements below:
  1. When a parent elects not to prepare consolidated financial statements and instead prepares separate financial statements,
    1. it shall disclose in those separate financial statements: Completely understand 1 consolidated and 2 separate financial statements
      • the fact that the financial statements are separate financial statements;
      • that the exemption from consolidation has been used; Completely understand 1 consolidated and 2 separate financial statements
      • the name and principal place of business (and country of incorporation, if different) of the entity whose consolidated financial statements that comply with International Financial Reporting Standards have been produced for public use; and Completely understand 1 consolidated and 2 separate financial statements
      • the address where those consolidated financial statements are obtainable; Completely understand 1 consolidated and 2 separate financial statements
      • a list of significant investments in subsidiaries, joint ventures and associates, including: Completely understand 1 consolidated and 2 separate financial statements
        • the name of those investees. Completely understand 1 consolidated and 2 separate financial statements
        • the principal place of business (and country of incorporation, if different) of those investees.
        • its proportion of the ownership interest (and its proportion of the voting rights, if different) held in those investees;
  2. a description of the method used to account for the investments listed under (i).

Cost method for (Passive) investments

Ownership of less than 20% of a company’s shares dictates that the investor is not able to exercise significant influence in the company or participate in shareholder meetings where business decisions affecting the company are made. Ownership of this quantity of shares is recorded using the cost method. These comprise investments to receive income in addition to the regular income of the business. Completely understand 1 consolidated and 2 separate financial statements

Cost method for subsidiaries, joint ventures and associates

Under IFRS 9 there are no possibilities to value subsidiaries, joint ventures and associates at cost. As stated above IAS 27 10 allows the costs valuation method for subsidiaries, joint ventures and associates in its separate financial statements. Completely understand 1 consolidated and 2 separate financial statements

IFRS 9 Fair value for subsidiaries, joint ventures, associates and other (passive) investments (<20%)

IFRS 9 requires all equity investments to be measured at fair value, even if those instruments are not quoted in an active market. The default approach is for all changes in fair value to be recognised in profit or loss. There is no ‘cost exception’ for unquoted equities. Completely understand 1 consolidated and 2 separate financial statements

However, for equity investments that are neither held for trading nor contingent consideration recognised by an acquirer in a business combination, entities can make an irrevocable election at initial recognition to classify the instruments as at FVOCI (use this link for more explanations), with all subsequent changes in fair value being recognised in other comprehensive income (OCI). This election is available for each separate investment. Completely understand 1 consolidated and 2 separate financial statements

The unit of account for investments in subsidiaries, joint ventures and associates is the investment as whole, and not the individual financial instruments (i.e., shares) that constitute the investment (this is to distinguish subsidiaries, joint ventures, associates, structured entities and other (passive) investments (<20%) in IFRS 10, IFRS 11, IFRS 12IAS 27 and IAS 28 from investments in equity instruments in IFRS9). Completely understand 1 consolidated and 2 separate financial statements

When a quoted price in an active market is available for the individual financial instruments that comprise the entire investment, the fair value measurement would be the product of the quoted price of the financial instrument (P) multiplied by the quantity (Q) of instruments held (i.e., price x quantity, P × Q).

However, when an entity holds an investment in a subsidiary, joint venture or associate, current valuation techniques sometimes include an adjustment (e.g., a control premium) to reflect, for example, the value of the investor’s control, joint control or significant influence over the investee.

IFRS 13 requires entities to select inputs that are consistent with the characteristics of the asset or liability being measured and that would be considered by market participants when pricing the asset or liability. Apart from block discounts (which are specifically prohibited), determining whether a premium or discount can be included in a particular fair value measurement requires judgement and depends on specific facts and circumstances. Completely understand 1 consolidated and 2 separate financial statements

IFRS 13 states that premiums or discounts should not be incorporated in fair value measurements unless all of the following conditions are met:

  • The application of the premium or discount reflects the characteristics of the asset or liability being measured
  • Market participants, acting in their economic best interest, would consider that premium or discount when pricing the asset or liability
  • The inclusion of the premium or discount is not inconsistent with the unit of account in the IFRS that requires or permits the fair value measurement

Therefore, if the unit of account is deemed to be the investment as a whole, it would be appropriate to include, for example, a control premium when determining fair value, provided that market participants take this into consideration when pricing the asset. Completely understand 1 consolidated and 2 separate financial statements

However, if a quoted price in an active market is available for individual shares in the subsidiary, joint venture or associate, should the requirement to use P x Q without adjustment to measure the fair value override the requirements relating to premiums or discounts? This question is applicable even when the unit of account is the entire investment.

For investments that are comprised of financial instruments for which a Level 1 price is available, the requirement to use P x Q takes precedence irrespective of the unit of account. Therefore, for all such investments, the fair value measurement is the product of P x Q, even when the reporting entity has an interest that gives it control, joint control or significant influence over the investee.

Performing fair value measurements

IFRS 13 states that, when measuring fair value, the objective is to estimate the price at which an orderly transaction to sell an asset or to transfer a liability would take place between market participants at the measurement date under current market conditions (ie to estimate an exit price). In many cases, a fair value measurement will involve uncertainty about the timing and/or amount of the future cash flows and other factors. Completely understand 1 consolidated and 2 separate financial statements

Measuring unquoted equity instruments at fair value
There are a range of valuation techniques that can be used when measuring the fair value of unquoted equity instruments. Judgement is involved not only when applying a valuation technique, but also in its selection of the valuation technique. This includes consideration of the information available to an investor.

As being said valuation involves significant judgement and it is likely that different valuation techniques will provide different results. This is because the inputs used, and any adjustments to those inputs, may differ depending on the technique used. The existence of such differences does not mean that any of the techniques are incorrect.

Although IFRS 13 does not explicitly require an investor to use a variety of valuation techniques, the selection of the most appropriate valuation technique, depending on the facts and circumstances, will require the consideration of more than one technique so that the results from applying multiple techniques can be compared. In such situations, the investor must understand the reasons for the differences in valuation and select the amount within the ranges of values that is most representative of the fair value of the unquoted equity instrument.

When carrying out this exercise, the investor must determine how much weight to give to the results of each valuation technique by considering the reasonableness of the ranges of the values indicated by the different techniques and the relative subjectivity of the inputs used (IFRS 13 61 and IFRS 13 74) as well as the specific facts and circumstances.

For example, when determining how much weight to give to the results obtained from the comparable company valuation multiples technique, an investor would consider, along with the degree of subjectivity of the inputs used in that valuation technique, the degree of comparability between the comparable company peers and the investee being valued and whether there are any differences left unexplained between the relative values of the investee and those of the comparable company peers, on the basis of the specific facts and circumstances.

When assessing the price that is most representative of fair value, an investor must consider: Completely understand 1 consolidated and 2 separate financial statements

  1. which valuation technique makes the least subjective adjustments to the inputs used (ie which technique maximises the use of relevant observable inputs and minimises the use of unobservable inputs); Completely understand 1 consolidated and 2 separate financial statements
  2. the ranges of values indicated by the techniques used and whether they overlap; and Completely understand 1 consolidated and 2 separate financial statements
  3. the reasons for the differences in value arising from applying different techniques. Completely understand 1 consolidated and 2 separate financial statements
Fair value of subsidiaries

The fair value measurement of subsidiaries is not frequently used in IFRS reporting. The most common valuation is using the equity method in the separate financial statement of the parent company. In rare case subsidiaries are valued at costs (mostly on a temporary basis, due to the start-up of a new subsidiary and lack of timely and reliable information or because the investment in the subsidiary is ignored based on immateriality). Completely understand 1 consolidated and 2 separate financial statements

Fair value of joint ventures

The fair value measurement of joint ventures is not frequently used in IFRS reporting. The most common valuation is using the equity method in the separate financial statement of the parent company. In rare case joint ventures are valued at costs (mostly on a temporary basis, due to the start-up of a new subsidiary and lack of timely and reliable information or because the investment in the subsidiary is ignored based on immateriality). Completely understand 1 consolidated and 2 separate financial statements

Fair value of associates

Associates for which there are price quotations publicly available are valued at this fair value. Completely understand 1 consolidated and 2 separate financial statements

Fair value of (passive) investments

Ownership of less than 20% of a company’s shares dictates that the investor is not able to exercise significant influence in the company or participate in shareholder meetings where business decisions affecting the company are made. These comprise investments to secure trade/production/R&D ties with the invested companies. Ownership of this type of investments where some kind of (in)formal influence exists are valued at fair value using fair value techniques (comparable quotes or so).

IAS 28 Equity method for subsidiaries, joint ventures and associates

The investor accounts for this interest by extending the scope of its financial statements to include its share of the profit or loss of such an investee. As a result, application of the equity method provides more informative reporting of the investor’s net assets and profit or loss. Completely understand 1 consolidated and 2 separate financial statements

Under the equity method, Completely understand 1 consolidated and 2 separate financial statements

  • on initial recognition, the investment in an associate or a joint venture is recognised at cost, and the carrying amount is increased or decreased to recognise the investor’s share of the profit or loss of the investee after the date of acquisition and the investor’s share of the investee’s profit or loss is recognised in the investor’s profit or loss.
  • distributions received from an investee reduce the carrying amount of the investment.
  • adjustments to the carrying amount may also be necessary for changes in the investor’s proportionate interest in the investee arising from changes in the investee’s other comprehensive income such as changes arising from the revaluation of property, plant and equipment and from foreign exchange translation differences and the investor’s share of those changes is recognised in the investor’s other comprehensive income,

IAS 28 Equity method for (Passive) investments (<20)

In case fair value measurement of such an investment is only possible at significant costs or is not considered reliable enough to provide useful information and costs is also not providing useful information, the equity method can be used as a matter of last resort.

Summary of the different measurement bases for  associates

In its consolidated financial statements, an investor should use the equity method of accounting for investments in associates, other than in the following three exceptional circumstances:

  • An investment in an associate held by a venture capital organisation or a mutual fund (or similar entity) and that upon initial recognition is designated as held for trading under IAS 39. Under IAS 39, those investments are measured at fair value with fair value changes recognised in profit or loss.
  • An investment classified as held for sale in accordance with IFRS 5. Completely understand 1 consolidated and 2 separate financial statements
  • A parent that is exempted from preparing consolidated financial statements may prepare separate financial statements as its primary financial statements. In those separate statements, the investment in the associate may be accounted for by the cost method or under IAS 39. Completely understand 1 consolidated and 2 separate financial statements
  • An investor need not use the equity method if all of the following four conditions are met: Completely understand 1 consolidated and 2 separate financial statements
    1. the investor 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 investor not applying the equity method; Completely understand 1 consolidated and 2 separate financial statements
    2. the investor’s debt or equity instruments are not traded in a public market; Completely understand 1 consolidated and 2 separate financial statements
    3. the investor 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; and Completely understand 1 consolidated and 2 separate financial statements
    4. the ultimate or any intermediate parent of the investor produces consolidated financial statements available for public use that comply with International Financial Reporting Standards. Completely understand 1 consolidated and 2 separate financial statements

(Continious) Assessment of control

In many cases, when decision-making is controlled by voting rights, and those voting rights entitle an entity to returns (e.g., voting shares), it is clear that whoever holds a majority of those voting rights controls the investee. However, in other cases (such as for structured entities, or when these are potential voting rights, or less than a majority of voting rights), it may not be so clear. In those instances, further analysis is needed and each of the factors above needs to be considered in more detail to determine which investor controls an investee (if any).

Diagram 1 illustrates this assessment.

– Reassessments of (joint) control and significant influence

An investor is required to reassess whether it controls (or jointly controls) an investee if the facts and circumstances indicate that there are changes to one of the three elements of control (and therefore to the control aspect of ‘joint control’). Therefore, it is possible that an investee could ‘flip in and out’ of the consolidated group, or into or out of joint control between reporting periods, as facts and circumstances change. Completely understand 1 consolidated and 2 separate financial statements

For example, if a fund manager provides all of the seed money for a fund upon inception, it is possible that the fund manager controls (and therefore consolidates) the fund at inception, but this conclusion may change as third parties invest in the fund and dilute (or eliminate) the fund manager’s interest.

See also: The IFRS Foundation

Completely understand 1 consolidated and 2 separate financial statements

Leave a comment