ACF301 – Financial Accounting I

Week 5 – additional notes

Equity accounting
Equity accounting is sometimes called one-line consolidation (abbreviated consolidation).
Significant influence is the power to participate in the financial and operating policy
decisions of the investee but not control or joint control over those policies (IAS28).

 Does not require actual exercise of power, only potential power.

 Assumed more than 20% is significant influence, but less than 20% is not, but can be
overturned by the facts of the relationship.
Factors providing evidence of significant influence may include:
 Board representation
 Participation in policy making processes (e.g. dividends)
 Material transactions with or interchange of personnel or technical information
 Currently exercisable options or convertibles are also considered when determining
whether an entity has significance over another entity. Similar to the decision
around control, management intention are not taken into account. However one
difference when compared to the control decision is that financial ability to exercise
the potential rights does not form part of the consideration of significant influence
unlike with control where the financial ability does form part of the consideration
Equity accounting is similar to the consolidation workings except we do not consolidate on a
line by line basis – this is because we do not ‘control’ the investee. Instead, the Investment
in associate is prepared as follows:
Cost of investment
Plus: Share of post acquisition profits
Less: Share of dividends paid
Less: Impairment in value of the associate
Less: PURP (if the parent is the seller)
Less: Share of additional depreciation as a result of fair value adjustments

Note disclosure
A note disclosure of an associate’s proportionate assets and liabilities is required. For
associates, an associate note disclosure supplements the equity accounted investment in
the consolidated statement of financial position by disclosing the investee’s assets, liabilities
and goodwill as a note.
Issues associated with the equity method of accounting
 It is difficult to determine significant influence – significant is not particularly well
defined so it would be possible argue both for any against this were managers
particularly inclined to do so
 It is difficult to know whether the equity method of accounting is a one line
consolidation, a measurement basis or whether it is a hybrid of the two
 The cost is effectively a fair value at acquisition but it is not explicit in the standard
whether this ought to be at fair value unlike IFRS 3 for consolidation
 If a share of losses exceed the carrying value of the investment in associate then no
further losses would be recognised (unlike a subsidiary where a loss would continue
to be recognised)
 Whilst significant influence leads to use of the equity method of accounting because
“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”, significant influence
does not in itself guarantee that distributions will be received equal to the profits –
in fact dividends received often bear little resemblance to the profits being made
 Strictly speaking the associate is not really a measurement of an investment because
it then ought to follow the rules of IFRS 9 and potentially be valued at fair value
through SOPL
 Whilst the entity is not consolidated, there are many areas where consolidation type
techniques are required – which makes very little sense if we do not actually
consolidate the entity:
o Additional depreciation on fair value at acquisition => we are not including
the fair values of the associate assets anywhere so why should take
additional depreciation?
o Removal of a PURP => the associate is, for all intents and purposes, an
external party so any transactions with the party ought to be considered as
being realised and yet they are treated as unrealised
 This applies not just to transactions between the parent and associate but also
between the associate and other subsidiaries. Again implying that the associate is
part of a group
 Only the share of the PURP is removed which is inconsistent with consolidation
where the full amount is removed
 This creates internal inconsistencies within the accounts

An associate can be difficult to understand by users because it is, in essence, a hybrid

method of calculating the value of an investment. There is also potential for creative
accounting.
Joint Venture
Under IFRS 11 a joint venture is an investment over which the investor has joint control over
net assets of the investee. Under IFRS 11, the term ‘joint arrangement’ is used for all
arrangements over which the parties have ‘joint control’:
A ‘joint operation’ is where the parties with joint control have rights over individual assets,
and over obligations for individual liabilities of the arrangement => Fraction of item owned
included in separate company accounts
A ‘joint venture’ is where the parties have rights to the net assets as a whole of the
arrangement. IFRS 11 focuses on the economic substance of the arrangement and not its
legal form => Equity accounting plus asset and liability notes

Note, a joint venture is not necessarily 50% owned. It can be, say, 20%, 30% or 40% or 50%
owned. Unlike with an associate, there is a joint venture agreement (which is usually in
writing) which specifies how joint control is to be exercised. So ‘joint control’ is often
stronger than ‘significant influence’. Under IFRS 11, ‘joint control’ is defined as, ‘the
contractually agreed sharing of control….. which exists only when decisions about relevant
activities require the unanimous consent of the parties sharing control’. The parties must
have rights to the net assets of the arrangement. It is based upon the economic substance
of the arrangement and not its legal form (e.g. whether it is a company or not).
Joint ventures are reported separately from, but in the same way, as associates.

Creating accounting in structured entities

Enron transferred assets and loans transferred to off-balance sheet entities, hiding gearing.
Such off-balance sheet entities are now called ‘structured entities’ in IFRS 10 (2011). This
type of creative accounting reports what is really a controlled entity (a subsidiary) as an
associate or even as a passive investment. To counteract such creative accounting IFRS 10
refines the definition of ‘control’ to a more economic substance basis, to try to ensure all
controlled companies are consolidated.
The impact of accounting treatment is that gearing (debt/equity or debt/[debt + equity]) can
be different and impacts the interpretation of financial statements. Some analysts:
a) Leave NCI out in computing gearing: This measures gearing from a controlling
interests viewpoint. This is used by many financial analysts in assessing performance
from an investor perspective and is the gearing definition used on AcF 301. [Under
consolidation this gearing measure is always greater than under equity accounting]
b) Include NCI as a liability in computing gearing: Some analysts taking an investor
perspective do this as NCI don’t have much influence in practice and passively
receive their dividends. [Under consolidation this gearing measure is always greater
than under equity accounting]
c) Include NCI as part of equity in computing gearing: This tends not to be used by
analysts but follows the IASB’s wish to take an entity perspective, and to view NCI as
part of the group entity’s equity (particularly under the adjusted fair value approach
for NCI where NCI goodwill is included). [Under consolidation this gearing measure is
nearly always greater than under equity accounting except in certain unlikely
circumstances]