The Equity Method in Financial Reporting for Associates and Joint Ventures

INTRODUCTION

Intercorporate investments, which refer to investments made by one company in another, can significantly influence the financial performance and overall position of the investing company. Such investments are typically made in the debt and equity securities of other firms for various strategic reasons, including diversification of asset bases, market entry, competitive advantage, deployment of excess cash, and enhanced profitability.

Types of Securities:

Debt Securities: These include various financial instruments such as:

• Commercial paper
• Corporate and government bonds and notes
• Redeemable preferred stock
• Asset-backed securities

Equity Securities: These consist primarily of:

• Common stock
• Non-redeemable preferred stock

The proportion of equity ownership acquired by a company in an investee can vary widely, influenced by factors such as available resources, the feasibility of share acquisition, and the desired level of influence or control.

Accounting Standards

The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) have collaborated to minimize discrepancies in the accounting standards related to the classification, measurement, and disclosure of inter-corporate investments. This effort has enhanced the relevance, transparency, and comparability of financial statement information.

Despite these efforts, complete convergence between International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP) has not been achieved in accounting for financial instruments, leading to some remaining differences. The terminology in this discussion is aligned with IFRS standards, although similar terms may exist under US GAAP.

Structure of the Reading

The following sections are structured as follows:

• Section 2: Explains the fundamental categorization of corporate investments.
• Section 3: Details the reporting standards under IFRS 9, which is the IASB standard for financial instruments.
• Sections 4–6: Discuss equity method reporting for investments in associates where significant influence exists, including the reporting for joint ventures.
• Sections 7–11: Cover reporting for business combinations, parent/subsidiary relationships, and variable interest entities.
• Conclusion: Summarizes the main points discussed.

BASIC CORPORATE INVESTMENT CATEGORIES

This section aims to:

Describe the Classification, Measurement, and Disclosure under IFRS:

• Investments in Financial Assets
• Investments in Associates
• Joint Ventures
• Business Combinations
• Special Purpose and Variable Interest Entities

Compare and Contrast IFRS and US GAAP: This will focus on the differences in classification, measurement, and disclosure of the aforementioned investment types.

Investment Categories

Investments in marketable debt and equity securities can generally be classified into four categories based on the level of influence or control:

1. Investments in Financial Assets: Where the investor holds no significant influence or control over the investee.
2. Investments in Associates: Where the investor can exert significant influence (but not control) over the investee.
3. Joint Ventures: Where control is shared among two or more entities.
4. Business Combinations: Including investments in subsidiaries where the investor obtains a controlling interest.

The classification is primarily determined by the degree of influence or control rather than solely by ownership percentage. Typically:

• Less than 20% ownership: Generally presumed to indicate no significant influence.
• 20% to 50% ownership: Generally presumed to indicate significant influence.
• Over 50% ownership: Generally presumed to indicate control.

Practical Example

An excerpt from GlaxoSmithKline’s 2017 Annual Report illustrates this categorization and disclosure:

“Entities over which the Group has the power to direct relevant activities to affect returns are accounted for as subsidiaries. Where the Group can exercise joint control, these entities are accounted for as joint ventures. Significant influence over entities results in their accounting as associates. The results of associates and joint ventures are incorporated into the consolidated financial statements using the equity method.”

Summary of Financial Reporting Standards

Exhibit 1 summarizes the financial reporting and relevant standards for various corporate investment types. The exhibit utilizes IFRS terminology, although US GAAP categorizes intercorporate investments similarly but with some differences.

Value Measurement

It is crucial to note that the value measurement and treatment of changes in value may vary depending on the classification and whether IFRS or US GAAP is employed. These alternative treatments are further discussed in subsequent sections of this reading.

INVESTMENTS IN FINANCIAL ASSETS: IFRS 9

Classification, Measurement, and Disclosure

Both the IASB and FASB have developed revised standards for financial investments. The IASB’s IFRS 9, which became effective on January 1, 2018, replaces the earlier standard IAS 39. The FASB’s guidance for investments in financial instruments is outlined in ASC 825, with updates made periodically.

Key Characteristics of IFRS 9:

• Focuses on contractual cash flows and the management of financial assets.
• The previous portfolio approach is replaced with clearer classifications of financial assets based on business objectives.

Criteria for Measurement at Amortized Cost

To qualify for amortized cost measurement, financial assets must meet the following two criteria:

1. Business Model Test: The financial assets must be held to collect contractual cash flows.
2. Cash Flow Characteristic Test: The cash flows must solely consist of principal and interest payments.

Classification and Measurement Categories

Under IFRS 9, financial assets are categorized into three measurement bases:

1. Amortized Cost
2. Fair Value Through Profit or Loss (FVPL)
3. Fair Value Through Other Comprehensive Income (FVOCI)

Initial and Subsequent Measurement

All financial assets are measured at fair value upon acquisition. Subsequently, the measurement basis will depend on the classification:

• Amortized Cost: For assets meeting both criteria.
• FVOCI: For assets held for both collecting cash flows and selling.
• FVPL: If an accounting mismatch would occur.

Debt Instruments are measured based on their respective business models, while Equity Instruments are categorized as either FVPL or FVOCI. Importantly, once an entity chooses the FVOCI option for equity instruments, this choice becomes irrevocable, with only dividend income recognized in profit or loss.

Investments in Associates and Joint Ventures: Equity Method of Accounting, Basis Principles

1. Classification, Measurement, and Disclosure under IFRS

• Investments in Financial Assets: Classified into categories such as financial assets at fair value through profit or loss (FVTPL), fair value through other comprehensive income (FVTOCI), and amortized cost.
• Investments in Associates: Investments where the investor has significant influence (typically 20% — 50% voting rights) are accounted for using the equity method, recognizing the investor’s share of profits and losses.
• Joint Ventures: Similar to associates, joint ventures are also accounted for using the equity method, reflecting shared control over the entity.
• Business Combinations: Acquisitions are accounted for using the acquisition method, recognizing identifiable assets and liabilities at fair value.
• Special Purpose and Variable Interest Entities: These are consolidated if the investor is the primary beneficiary, following IFRS 10.

2. Comparison of IFRS and US GAAP

• Investments in Financial Assets: IFRS has more categories for classification, while US GAAP has specific guidance for certain instruments.
• Investments in Associates: Both frameworks require the equity method for significant influence; however, US GAAP emphasizes control in determining consolidation.
• Joint Ventures: Both IFRS and US GAAP mandate the equity method, with IFRS allowing proportionate consolidation in limited circumstances.
• Business Combinations: Both use the acquisition method, but IFRS has a broader definition of control.
• Special Purpose Entities: IFRS focuses on the concept of control, while US GAAP specifies criteria for consolidation based on voting interest.

3. Analysis of Accounting Methods and Financial Impact

• Different accounting methods for intercorporate investments affect financial statements and ratios significantly. For example:
• Equity Method: Recognizes the investor’s share of the investee’s profits/losses, impacting net income and equity.
• Proportionate Consolidation: Directly combines the investee’s assets and liabilities, impacting the balance sheet ratios differently.

Key Considerations

• Significant Influence: Defined under IFRS (IAS 28) and US GAAP (FASB ASC Topic 323) by criteria including board representation, participation in policy-making, and significant transactions.
• Equity Method of Accounting: Under this method, investments are recorded at cost and adjusted for the investor’s share of profits or losses, with dividends treated as a return of capital.

Joint Ventures Characteristics

Joint ventures are defined as arrangements where two or more parties share control. Common characteristics include:

• A contractual arrangement between venturers.
• Establishment of joint control over the arrangement.

Accounting Treatment

Equity Method: Initially records the investment at cost; subsequent adjustments are made for the investor’s share of the investee’s earnings and losses.

Example Calculation: For Branch’s investment in Williams:

• Initial cost: €200,000
• Adjustments for income and dividends over three years lead to an investment balance of €310,000.

Summary of Deutsche Bank’s Accounting Treatment

Deutsche Bank’s annual report highlights that investments in associates are recorded under the equity method. The accounting reflects significant influence considerations, and any intercompany transactions are eliminated on consolidation. The investment value is tested for impairment, considering recoverable amounts against the carrying value.

Conclusion

In summary, the equity method of accounting for investments in associates and joint ventures plays a crucial role in providing a clear and accurate representation of financial performance and position. By recognizing the investor’s share of the investee’s profits or losses, this method offers a more integrated view of the relationship between entities, highlighting the impact of strategic partnerships on overall financial health.

Understanding the nuances of the equity method, including its application under both IFRS and US GAAP, is essential for financial professionals. The differences in classification, recognition, and measurement can significantly affect financial reporting and analysis. Furthermore, effective disclosure practices are vital for ensuring transparency and enabling stakeholders to make informed decisions.

As businesses increasingly engage in collaborative ventures, a thorough grasp of the equity method will empower investors to navigate the complexities of accounting for these investments. By adhering to the relevant standards and maintaining rigorous reporting practices, organizations can enhance their financial reporting quality and strengthen stakeholder confidence.

Ultimately, a well-implemented equity method not only reflects the economic realities of investments in associates and joint ventures but also supports the overarching goal of financial reporting: to provide clear and meaningful information that guides decision-making in an ever-evolving business landscape.