Question

a) With relation to associate companies what do you understand to be significant influence and how would you identify it? Include in your answer illustrative examples.

b) How are inter-entity transactions dealt with when accounting for associate companies? Give examples.

c) How would an investor account for losses made by an associate company?

Answer 1

An associate is an entity over which an investor has significant influence, being the power to participate in the financial and operating policy decisions of the investee (but not control or joint control), and investments in associates are, with limited exceptions, required to be accounted for using the equity method.

Indicators of significant influence

When an investor exercises significant influence over the investee, one or more of the following indicators is usually present:

• Representation on the board of directors or equivalent governing body of the investee
• Participation in policy-making processes, including participation in decisions about dividends or other distributions
• Material transactions between the investor and the investee
• Interchange of managerial personnel
• Provision of essential technical information

Holding 20 per cent or more of voting power

As a general rule, significant influence is presumed to exist when an investor holds, directly or indirectly through subsidiaries, 20 per cent or more of the voting power of the investee.

This presumption relates to voting rights, which can arise not just in relation to an ordinary share holding. For example, when 50 per cent of the voting rights in an entity are held by the ordinary shareholders, and the other 50 per cent of the voting rights are attached to voting preferred shares, an investment in four per cent of the ordinary shares and thirty-six per cent of the voting preferred shares will result in a presumption that the four per cent ordinary share ownership will be accounted for under the equity method, provided that the voting preferred share investment is, with respect to voting rights, substantively the same as an investment in ordinary shares.

As with the classification of any investment, the substance of the arrangements in each case will need to be considered. If it can be clearly demonstrated that an investor holding 20 per cent or more of the voting power of the investee does not have significant influence, the investment will not be accounted for as an associate.

A substantial or majority ownership by another investor does not necessarily preclude an investor from having significant influence.

2)Accounting of transactions with associates

Equity method

An entity with significant influence over, or joint control of, an investee should account for its investment in an associate or a joint venture using the equity method except when the investment qualifies for exemption.IAS 28 defines 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 net assets of the investee.

The profit or loss of the investor includes the investor's share of the profit or loss of the investee, and the investor's other comprehensive income includes its share of the investee's other comprehensive income.IAS 28 justifies the use of the equity method by noting that the recognition of income on the basis of distributions received may not be an adequate measure of the income earned by an investor on an investment in an associate or a joint venture because the distributions received may bear little relation to the performance of the associate or joint venture.

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, as a result, the return on its investment. It is therefore appropriate for the investor to account 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.

3) When an associate or joint venture make losses and these losses exceed the carrying amount of the investment, investor cannot bring down the carrying amount of the investment below zero. Investor simply stops bringing in further losses.