Equity – 2 understand it all at best

Equity

There are, at least, two ways to discuss equity:

  • Equity is the residual interest in the assets of the entity after deducting all its liabilities, or
  • An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

But also:

  • For the purposes of IFRS 3, equityinterests is used broadly to mean ownership interests of investor-owned entities and owner, member or participant interests of mutual entities.
  • The equity method is a method of accounting whereby the investment is initially recognised at cost and adjustedEquity 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.
  • An equity-settled share-based payment transaction is a share-based payment transaction in which the entity:
    1. receives goods or services as consideration for its own equity instruments (including shares or share options), or
    2. receives goods or services but has no obligation to settle the transaction with the supplier.

1. Equity the residual interest in the assets of the entity after deducting all its liabilities

1. Statement of Financial Position

Assets

Equity and liabilities

1. Non-current assets

2. Current assets

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A – TOTAL ASSETS [1 + 2] = B

3. Non-current liabilities (including Provisions)

4. Current liabilities (including Provisions)

5. Equity [1 + 2 -/- 3 -/- 4]

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B – TOTAL EQUITY AND LIABILITIES [3 + 4 + 5] = A

2. Equity instrument is the contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities

2. Statement of Financial Position

Assets

Equity and liabilities

1. Non-current assets

– Equity instruments (is investment in part of or all of #5 Equity in 1. Statement of Financial Position, above)

2. Current assets

– Equity instruments (is current portion of non-current equity instruments (if any))

A – TOTAL ASSETS

3. Non-current liabilities (including Provisions)

4. Current liabilities (including Provisions)

5. Equity

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B – TOTAL EQUITY AND LIABILITIES

3. Equity interests

Equity interests is a special label for equity instruments in the investment industry (in IFRS terms the above mentioned investor-owned entity and mutual entity vehicles). The investment industry is a subset of the financial services industry. It comprises all the participants that are instrumental in helping savers invest their money and helping spenders raise capital in financial markets.

The investment industry plays an important role in providing and processing information about investment opportunities. It helps investors collect and analyse data about economies and information about individuals, companies, and governments. It also assists investors in determining the value of real and financial assets.

Investment industry participants package investment opportunities so that they satisfy the needs of investors. In particular, the investment industry offers a wide range of services and products that makes it easier for savers to invest.

The investment industry also provides liquidity. Liquidity refers to the ease of buying or selling an asset without affecting its price. Some assets, such as real estate (land and buildings), are inherently illiquid. For example, if youequity want to sell your house, it will likely take some time to sell, even if it is priced fairly compared with other houses in your neighborhood.

If you want to sell your house quickly, you may have to sell it at a lower price than you think is fair. Other assets are more liquid, such as shares that trade actively. But an investor may hold a large number of shares and selling all the shares quickly could have a negative effect on the share price.

For example, if an investor owns 100 shares in a company with actively traded shares, she will likely be able to sell her shares quickly and not affect the share price. But if she owns 100,000 shares, she may not be able to sell her shares quickly without affecting the share price. As a result, she may have to accept a lower price for some or all of the shares she wants to sell.

Liquidity is a very important aspect of well-functioning financial markets. Highly liquid markets allow investors to complete a transaction quickly (and to reverse it quickly if they change their minds) and to have confidence that they are getting a fair price at that particular moment.

All of these benefits increase the willingness of savers to supply funds to those who need them. Capital that is put to more productive use fosters economic growth, which ultimately benefits society.

4. The equity-method

This method is a rather simple ‘one-line consolidation’ method.

A simple example with different scenarios to show how it works:

4.1 Cost

An investor buys a 15% share in investee A for 10,000 (cost). The net equity of 100% of investee A is 45,000.

So the net equity value of the 15% investment is 45,000 * 15% = 6,750 (net equity), the difference between the cost (10,000) and net equity (6,750) is a premium or goodwill (3,250).

However under the equity method goodwill is not separately recognised for investments in other companies representing less than a 51% share of share capital issued (see control over an investee LLIIINNK).

Under the equity method investments (lower than a 51% share) are value at cost (10,000).

4.2 Profit for the year

Investee A records a net profit attributable to 100% of the owners of investee A of 1,500. So our investor’s share is 15% of 1,500 = 225.

Movement schedule of the 15% investment in investee A:

Opening balance

10,000

Share of profit for the year in investee A

225

Closing balance

10,225

4.3 Loss for the year

Investee A records a net loss attributable to 100% of the owners of investee A of 2,500. So our investor’s share is 15% of -/-2,500 = -/-375.

Movement schedule of the 15% investment in investee A:

Opening balance

10,225

Share of loss for the year in investee A

-/-375

Closing balance

9,850

4.4 Impairment

The investment may be impaired and the investor is required to test the carrying amount for impairment if objective evidence of impairment exists. IAS 28 identifies situations that may trigger the impairment test and refers to IAS 36 for recognition and measurement. Impairment testing for associates and joint ventures also requires significant judgments and estimates to be made.

Further complications arise when the investor not only has equity interests in the investee, but has also made loans to the investee, for example, or when the investee is loss-making.

Step 1 Determine the net investment in the investee

The net investment in an equity-method investee comprises two main components.

  • First, the carrying amount of the investor’s equity interest in the investee that will be equity accounted.
  • Second, any long-term interests (LTIs), such as preferred shares or loans to the investee for which settlement is neither planned nor likely in the foreseeable future. Those are common financing structures in the extractive and real estate sectors. The net investment excludes trade receivables and payables, or other long-term receivables for which collateral exists.

OR

Assets

1. Non-current assets

Equity accounted investment

– Long term loan

Step 2: Apply IFRS 9 to LTI component of net investment in the investee

The investor applies IFRS 9 to financial instruments included in the net investment to which the equity method is not applied (i.e. the LTIs). This requirement may sound obvious because IFRS 9 provides measurement guidance, including the expected credit loss impairment model for loans. However, it creates a loss-recognition ordering challenge in certain situations, which is illustrated in the example below.

Step 3: Apply the equity method to the equity interest in the investee

The investor applies the equity method in the usual way, but complications arise when the investee is loss-making. In that case, the investor recognizes its share of the losses until its equity interest is reduced to zero. Any further share of losses is allocated to the LTIs in the investee in the reverse order of seniority (after applying IFRS 9 in Step 2).

Case: Interaction of Steps 2 and 3 for a loss-making investee

The following table shows how IFRS 9 and IAS 28 apply to the same instrument. Here is a simplified example, in which an investor has a 40% interest in the investee, and has also given investee a long-term loan that is not collateralised.

In italics the assumptions applied are provided

Net investment in investee (EUR)

IAS 28

IFRS 9

Total

Disclose

Carrying amount of 40% equity interest (equity accounted)

140

140

Carrying amount of of loan (amortised cost)

70

70

Position at the end of year 1

140

70

210

Year 2 accounting:

Step 2: IFRS 9 applied to LTI and ECL allowance recognised (ECL is 20)

-20

-20

Step 3 Investor 40% share of loss in investee (500 * 40% – 200) recognised in part against 40% equity interest (investee’s loss as per separate FS is -/-500)

-140

-140

Step 2/3 combination: Unrecognised share of loss in investee (200 total loss -/- 150 = 60), but recognised only in part against remaining book value of the LTI = 50 (70 -/- 20)

-50

-50

Unrecognised share of loss of 10 has to be disclosed (200 -/- 140 -/- 50)

-10

Position at the end of year 2

-10

Year 3 accounting:

Step 2: IFRS 9 applied to LTI of 50 (ignoring year 2 loss allocation of 50) and the year 1 impairment loss is reversed (new amortised cost net of loss allowance is 70)

20

20

Step 3: Investee has zero profit or loss for year 2 therefore no share for investor to record

Step 2/3 combination: Recognise previously unrecognised loss because now there is a balance against which it can be recognised^1

-10

-10

Position at the end of year 3

10

10

Note:

1. In this case, the previously unrecognised loss is recognised. If the facts were different, this adjustment might result in previously allocated losses being reversed or losses being reallocated between different LTIs

Step 4 Test net investment in investee for impairment

An investor assesses whether there is an indication that its net investment in the associate or joint venture is impaired. IAS 28 provides potential indicators, including significant financial difficulty of the investee, and significant adverse changes in the technological, market, economic or legal environment in which the investee operates.

If objective evidence of impairment exists, the investor performs an impairment test. The net investment (as determined in Steps 1 to 3) is tested as one single asset under IAS 36, by comparing its carrying amount to the recoverable amount. This includes any fair value adjustments and goodwill arising from the acquisition of the investment – i.e. the goodwill is not allocated to a larger cash-generating unit.

Recoverable amount is the higher of value in use and fair value less costs to sell. An investor may determine the value in use of the investment by calculating either:

  • its share of the present value of the estimated future cash flows that the investee is expected to generate, including cash flows from the operations of the investment and any proceeds from its ultimate disposal; or
  • the present value of the expected future dividend cash flows, together with any proceeds from the ultimate disposal of the investment.

If the carrying amount of an investment in an associate or joint venture exceeds its recoverable amount, an impairment loss is recognized. The loss is allocated to the investment as a whole and not to the underlying assets of the investee that make up the carrying amount of the investment.

Any reversal of that impairment loss is recognized to the extent that the recoverable amount of the investment subsequently increases. Impairment losses are not reversed simply because of a future reduction in the carrying amount of the investment due, for example, to the investor recognizing its share of additional investee losses.

5. An equity-settled share-based payment transaction

Employee services are recognised as expenses, unless they qualify for recognition as assets, with a corresponding increase in equity.

  • Employee service costs are recognised over the vesting period from the service commencement date until vesting date.
  • Employee services are measured indirectly with reference to the fair value of the equity instruments granted; this equityis done by applying the modified grant-date method. If, in rare circumstances, the fair value of the equity instruments granted cannot be measured reliably, then the intrinsic value method is applied.
  • Under the modified grant-date method, the grant-date fair value of the equity instruments granted is determined once at grant date, which may be after the service commencement date.
  • If a market price is not available, then the grant-date fair value of the equity instruments granted is determined using a valuation technique.
  • The grant-date fair value of the equity instruments granted takes into account the impact of any market conditions and non-vesting conditions and does not take into account service and/or non-market performance conditions.
  • The grant-date fair value is not adjusted for subsequent changes in the fair value of the equity instruments and differences between the estimated and actual outcome of market or non-vesting conditions.
  • Recognition is initially based on the number of instruments for which any required service and non-market performance conditions are expected to be met.
  • Subsequently, recognition of the share-based payment cost is trued up for changes in estimates regarding the achievement of any service and non-market performance conditions, so that ultimately the share-based payment cost is based on the number of instruments for which any service and non-market performance conditions are met.
  • Failure to meet a non-vesting condition that either the entity or the employee can choose to meet results in accelerated recognition of any unrecognised grant-date fair value of the equity instruments granted based on the amount that otherwise would have vested (cancellation accounting).
  • Grants in the form of shares may be in substance grants of share options, which will affect the valuation of the equity instruments.

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2 thoughts on “Equity – 2 understand it all at best”

    • Hi Mark,

      Profit is always added to equity. In most countries this year’s profit/net income is part of equity as a separate line, and it is distributed by the shareholders in general meeting while ‘approving’ the financial statements. Distribution means allocation of all net income for the year to reserves or pay a part of profit as dividend to the shareholders and part of profit allocated to reserves. Instead of paying dividend an entity can also issue bonus shares (these are an entity’s fully paid shares held by that entity itself also called treasury shares) at no costs to existing shareholders.

      Hope this helps…

      Kind regards,

      Henk

      Reply

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