Once a year, I teach students the basics of consolidated financial statements. The first element that usually surprises them is when we bring in acquisitions by well-known companies. It’s not uncommon for a student to completely doubt me when I hit them with the news that Coca-Cola owns Costa Coffee (the UK’s largest coffee chain), often leading to some furious Google searching to confirm I’m not a liar.
After I have won their trust (verified by Google), students are generally comfortable with the principles of control, ownership and the single entity concept when accounting for a subsidiary. But things get a little more complicated when we bring in the concept of an associate or joint venture.
I often have students wondering why we account for things this way
First, students don’t necessarily appreciate the slightly unclear situation of what can constitute ‘significant influence’ in an entity. Secondly, I often have students wrinkle their noses when I explain the equity method, often wondering why we account for things this way.
By questioning the common sense of this treatment, these students are closer than they realise to being financial reporting nerds. It enters their mental list of their least favourite accounting treatments/standards, even if they believe they are too cool to acknowledge that they could have such a list (and, if they did, IAS 8 should be top of it).
Equity method
The equity method is required in consolidated financial statements for associates and joint ventures. Additionally, entities are permitted to use the method in separate financial statements for subsidiaries, joint ventures and associates.
The equity method remains as one of the more contentious areas of accounting treatment
The principles of the equity method are covered in IAS 28, Investments in Associates and Joint Ventures. The main element is that one line will be included in a statement of financial position representing the value of the investment. This is often shown as cost plus/minus the investor’s share of post-acquisition profits or losses. In the statement of profit or loss, one line is shown which reflects the investor’s share of the investee’s profit or loss.
Arguments
The equity method remains as one of the more contentious areas of accounting treatment, as discussed in a previous AB article. A common criticism raised is the question of how including a share of profit is relevant, as the investor will only get that in the form of dividends.
Other criticisms question how useful showing simply one line is if the associate is a key part of the entity’s business, and the judgments around how entities can interpret the ‘significant influence’ principle. Sadly, these criticisms are likely to rumble on, with the focus on more technical aspects of the equity method.
Entities will be required to include any previously held ownership at fair value
The International Accounting Standards Board (IASB) has recently issued an exposure draft setting out proposed amendments to IAS 28. Some of the early proposals have previously been discussed here and this article will cover the other major elements of the exposure draft.
Presentation
The exposure draft doesn’t discuss one of the most contentious issues, which is where to present the investor’s share of profit or loss in the statement of profit or loss. This isn’t something that has been ignored, but is covered by the release of IFRS 18, Presentation and Disclosure in Financial Statements. To eliminate the discrepancy in practice, IFRS 18 will mandate that entities show this in the investing category in the statement of profit or loss.
Cost of investment
There were a couple of issues regarding the cost of investment calculation under the equity method. IAS 28 doesn’t specifically address what happens with regards to previously held ownership interest in the associate or with contingent consideration.
Bringing this in line with IFRS 3, Business Combinations, entities will be required to include any previously held ownership at fair value. This is also the case regarding contingent consideration.
Transactions
Among the other changes that stand out will be one that is a joy to both lecturers and students alike. Currently, IAS 28 states that gains or losses from transactions with associates held under the equity method (whether ‘upstream’ or ‘downstream’) are recognised only to the extent of unrelated investors’ interests.
In the exam world this would be cause for great celebration
The excellent news is that this is no more. Under the proposals, there will no longer be these adjustments and any gains or losses arising from transactions with an associate or joint venture will be recognised in full. This may seem niche, but in the exam world this would be cause for great celebration, particularly with one lecturer who found it so confusing that they incorrectly claimed for years that it was a quirk that led to financial statements simply not balancing.
The exposure draft can be found on the IFRS website and comments can be made until 20 January 2025. I have suggested to my students that they write comment letters simply saying ‘thank you’, but they seemed remotely unimpressed by that idea. Maybe they are still a little too cool.
Watch and learn
See Adam Deller’s series of videos explaining the fundamentals of IFRS Accounting Standards
