This series of blogs describes how SAP Financial Consolidation, Starter Kit for IFRS has been configured to meet International Financial Reporting Standards (IFRS).
In our previous blogs, we have covered the following topics:
- Brief overview of SAP Financial Consolidation starter kit for IFRS (blog #1)
- Presentation of consolidated financial statements according to IAS 1 and IAS 7
- Translation of a foreign entity’s financial statements as set out in IAS 21
- Consolidation, part 1: current consolidation process
- Consolidation, part 2: incoming entity
We will now focus on joint ventures and associates.
Definition of joint ventures and associates
From joint arrangements to joint ventures
IFRS 11 Joint Arrangements gives guidance to classify a joint arrangement either as a joint operation or a joint venture. Basically speaking any joint arrangement that is not structured as a separate entity is a joint operation. When the joint arrangement takes the form of a separate entity, further analysis is necessary to determine whether it has to be classified as a joint operation or a joint venture.
The following chart (extract from IFRS11 Application guidance) explains how this analysis should be carried out:
When a joint arrangement is classified as a joint operation, the joint operators should recognize their share in the joint operation in the separate statements as well as in the consolidated statements. Therefore it does not call for further comment in this document as it is not a consolidation issue.
Regarding joint ventures, IFRS 11 requires that they should be accounted for using the equity method in the consolidated statements referring to IAS 28. In the separate statements the investment in a joint venture is accounted for in accordance with IAS 27.
It is worth reminding that the option for proportionate consolidation (that currently exists in IAS 31) has been removed in IFRS 11 that becomes mandatory for annual periods beginning on or after 1 January 2013.
An associate is an entity over which the investor has significant influence (but does not control). According to IAS 28, associates should be accounted for using equity method in the consolidated statements.
Applying equity method
In the consolidated statements, an investment in an associate or a joint-venture must be accounted for using the equity method from the date on which it becomes an associate or a joint venture.
On acquisition, any difference between the cost of the investment and the entity’s share of the net fair value of the investee’s identifiable assets and liabilities is recognized as goodwill and included in the carrying amount of the investment or in profit or loss if negative amount (like a bargain purchase for subsidiaries). Amortization of goodwill is not permitted.
In the statement of financial position, the carrying amount of an investment accounted for using the equity method equals the initial cost of investment, increased or decreased to recognize any subsequent change in the investee’s equity to the extent of the investor’s interests (profit or loss, dividends paid, other comprehensive income…). In other words, the equity method consists in replacing the carrying amount of the shares held in the investee with the corresponding portion of equity, increased by the amount of goodwill recognized on acquisition if any. It should be classified as a non-current asset in the statement of financial position.
In the statement of profit and loss and other comprehensive income, the share of the net profit of entities accounted for using equity method and the share of their other comprehensive income must be disclosed on dedicated lines.
When an associate or a joint venture has subsidiaries, associates, or joint ventures, the profits or losses and net assets taken into account in applying the equity method are those recognized in the associate’s or joint venture’s consolidated statements.
In the starter kit
Reporting units consolidated using equity method can fill in a standard package or a more simplified one. The simplified package differs from standard package on the following points:
- It only includes information needed to automatically apply the equity method;
- It enables associates or joint ventures that hold subsidiaries, joint ventures or associates to enter consolidated data.
The equity method is automatically applied during the consolidation process.
Changes in ownership interests
Loss of significant influence or joint control
When an investment ceases to be an associate or a joint venture, the use of equity method should be discontinued (IAS 28.22). All amounts previously recognized in other comprehensive income in relation to that investment should be accounted for on the same basis as if the parent had directly disposed of the related assets or liabilities. For example, if an associate has cumulative exchange differences, these amounts previously recognized in other comprehensive income are reclassified to profit or loss when the equity method is discontinued.
In the starter kit, when the equity method is discontinued because the investment ceases to be an associate or a joint venture, the related entity accounted for using equity method leaves the consolidation scope. The principles are the same as with a subsidiary (see next blog).
Increase / decrease in interest rate
If a parent increases its interest in an associate (or a joint venture) without achieving control (which means that the acquiree remains an associate or a joint venture afterwards), IFRS do not specify how to deal with this operation in the consolidated financial statements. It does not meet the criteria of an equity transaction given that no NCI are recognized in the balance sheet. It does not meet either the definition of a business combination as no control is achieved after the transaction.
Many questions arise: should the acquisition method be applied? Should it be applied on the additional stake only or with remeasurement of the previously held interest? In this last case, should the remeasurement be recognized in profit or loss or directly to equity?
As regards partial disposals, IAS 28.25 is clearer: “if an entity’s ownership interest in an associate or a joint venture is reduced, but the entity continues to apply the equity method, the entity shall reclassify to profit and loss the proportion of the gain or loss that had previously been recognized in other comprehensive income relating to that reduction in ownership interest if that gain or loss would be required to be reclassified to profit or loss on the disposal of the related assets or liabilities”. It can be inferred that a gain or loss should be recognized in the income statement on a partial disposal of a joint-venture or an associate.
If an investment in an associate becomes a joint venture or a joint venture becomes an associate, the investor continues to apply the equity method and does not remeasure the retained interest (IAS 28.24).
In the starter kit, the new interest rate and the new integration rate (which changes as a consequence) in the associate or joint venture accounted for using equity method are taken into account with the impact of change posted on flow F04. Additional manual entries are left up to the user to, for example, enter a new goodwill or remeasure assets and liabilities acquired (in case of an increase) or to recognize a profit or loss on disposal in case of a partial disposal.
Associate / Joint venture becoming a subsidiary
According to IFRS 3, this operation is a business combination achieved in stages (also referred to as “step acquisition”). It should be similarly treated as if the interest in the associate / joint venture was disposed of and a controlling interest in a subsidiary was acquired.
Therefore, the different stages are the following:
- Other comprehensive income of the associate / joint venture that has been previously recognized is recycled on the same basis as would be required if the acquirer has disposed of its interest in the associate / joint venture
- The acquirer remeasures its previously held equity interest in the associate / joint venture at its acquisition-date fair value and recognize the resulting gain or loss in profit or loss
- The acquisition of a controlling interest is accounted for by applying the acquisition method (see previous blog)
In the starter kit, a change from equity method to full consolidation is handled as follows:
- The line “Investments accounted for using equity method” is reversed on the “old method” flow (F02) and “replaced” by the subsidiary’s assets and liabilities being loaded on the new method flow (F03).
- The equity accounts (the proportionate share of them that correspond to the consolidation rate) are reversed on the old method flow and reloaded at 100% on the new method flow; allocation between group and non-controlling interests is made on this flow according to the new interest rate.
Any goodwill existing at opening (and included in the carrying amount of the investment) is not reloaded on the new method flow. Indeed, it is part of the carrying amount of the previously held interest and is, therefore, taken into account to calculate the profit on “disposal”. A new goodwill has to be calculated as part of the acquisition method process and declared by a manual journal entry using the new method flow.
Accumulated other comprehensive income at opening is automatically reclassified to retained earnings on the new method flow, as with incoming entities. Reclassification adjustments displayed in the comprehensive income take into account the old method flow because change in consolidation method is handled as if the associate was disposed of.
Manual journal entries are necessary to:
- Recognize a gain or loss on “disposal” of the previously held interest (which means, in particular, remeasure the previously held shares to fair value)
- Remeasure net identifiable assets of the held company to fair value (as if it was an incoming entity)
- Declare goodwill
In our next blog, we will focus on changes in ownership interests in a subsidiary (loss of control, equity transactions).