Accounting for Associates and Joint Ventures: Unit of Account and Transaction Elimination, Study notes of Accounting

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ASBJ Short Paper Series No. 3

Equity Method of Accounting

September 2021

Perspectives on

the Equity Method of Accounting

Accounting Standards Board of Japan

Introduction

1. The question of whether the equity method of accounting should be viewed as one- line consolidation or a measurement basis 1 has been a long-standing question. Because the International Accounting Standards Board (IASB) has not directly addressed this question, diversity exists under IFRS Standards in practice and questions continue to be submitted to the IFRS Interpretations Committee.
2. This paper proposes principles that would clarify when to focus on the aspect of one- line consolidation and when to focus on the aspect of a measurement basis to address the current practical issues arising from applying the equity method of accounting, with the understanding that the existing requirements in IAS 28 Investments in Associates and Joint Ventures have both aspects of one-line consolidation and a measurement basis. Constituents in our jurisdiction note that the equity method of accounting provides useful information but there are practical issues that cannot be resolved under existing guidance. Accordingly, this paper is not intended to discuss whether the equity method of accounting should be viewed as one-line consolidation or a measurement basis, but rather to propose principles that would address the current practical issues. Some of the existing requirements in IAS 28 would need to be amended to incorporate the principles we propose.
3. This paper is structured as follows:

Part A: The Three Main Approaches In Part A, we describe and present our views on the three main approaches regarding the equity method of accounting: (1) one-line consolidation, (2) a measurement basis and (3) a hybrid of the two approaches. Part B: Our Proposed Principles in Applying the Hybrid Approach

(^1) The term ‘measurement basis’ used in this paper does not refer to that term as defined in paragraph 6. of the IASB’s Conceptual Framework for Financial Reporting but refers to that term as used by European Financial Reporting Advisory Group (EFRAG) in EFRAG Short Discussion Series The Equity Method: A Measurement Basis or One-Line Consolidation? issued in 2014. Paragraph 29 of the EFRAG paper describes this view as “the equity method is about measurement of an asset rather than being a one-line consolidation”.

The Equity Method of Accounting as One-Line Consolidation

7. If the equity method of accounting were to be viewed as one-line consolidation, applying the equity method of accounting to an associate or joint venture should have the exact same effect on total net assets and profit or loss as if the associate or joint venture were consolidated. In other words, the difference between consolidations and the equity method of accounting can be viewed as a matter of presentation, where consolidated entities would present their assets, liabilities, income and expenses on a gross basis, and entities accounted for under the equity method of accounting would present their assets, liabilities, income and expenses on a net basis.
8. The current requirements under IAS 28 are inconsistent with this view in its purest form. Under consolidations, the parent would absorb losses beyond the carrying value of the investment for its share in the subsidiary^2. However, under IAS 28, the investor would not recognise losses in excess of the carrying value of the investment unless the investor has legal or constructive obligations to absorb the losses.

The Equity Method as a Measurement Basis

9. If the equity method of accounting were to be viewed as a measurement basis, the unit of account would be the investment itself, that is, the entire carrying amount of the net investment would be accounted for as a single asset^3. The asset may be impaired and written down to zero, but the investor would not recognise any further losses unless the investor has obligations to absorb such losses.

(^2) If non-controlling shareholders exist, those non-controlling shareholders absorb the losses for their share in the subsidiary. 3 We use the term 'single asset' in this paper to indicate that the equity method of accounting is applied with an asset representing the share of the net assets of the associate or jointly venture as a unit. We acknowledge the following:  an interest in the associate or joint venture may comprise more than one type of equity instruments and potential voting rights may be taken into account.  long-term interests that, in substance, form part of the entity's net investment in an associate or joint venture are taken into account in determining the amounts to recognise losses of an associate or joint venture; however, the financial instruments are accounted for in accordance with IFRS 9 Financial Instruments.

10. The current accounting requirements in IAS 28 are inconsistent with this view in its purest form. Paragraph 26 of IAS 28 states that many of the procedures that are appropriate for the application of the equity method are similar to the consolidation procedures described in IFRS 10 Consolidated Financial Statements , and a typical example would be the elimination of unrealised profits or losses from upstream and downstream transactions. If the investment were to be viewed as a single asset, the elimination of such profits or losses would not be required.

The Equity Method as a Hybrid of the Two Approaches

11. The previous paragraphs illustrate how the two views, in their purest forms, are inconsistent with the current requirements in IAS 28. The question is whether IAS 28 should be amended so that the accounting would be consistent with one of the two approaches mentioned above, or whether IASB should accept the fact that the equity method of accounting is neither of the two views in their purest forms but a hybrid of the two approaches.
12. We believe that the equity method of accounting is neither of these two approaches in their purest forms but a hybrid of the two approaches. Moreover, within the hybrid approach, we believe that the equity method of accounting is based on one- line consolidation, with a few exceptions. Our reasons include the following: (a) Neither significant influence nor joint control constitutes control of an investee. Accordingly, requiring the equity method of accounting to have the same effect on total net assets and profit or loss as if the investor controlled the investee may not result in a faithful representation of the investment. (b) However, significant influence or joint control is not obtained by accident. Management makes deliberate decisions to obtain significant influence or joint control, taking into account the accounting that will follow. While significant influence or joint control does not constitute control of an investee, associates and joint ventures accounted for using the equity method of accounting are closer to the investor compared to investments accounted for in accordance with IFRS 9 and thus warrant accounting that is closer to consolidation.

the interest may be written down to zero, and no additional liabilities would be recognised unless: (a) the investor has legal or constructive obligations to absorb the losses; or (b) the amounts that would otherwise be eliminated (in the case of gains from downstream transactions or dividends) exceed the carrying amount of the interest. Principle 3 : Neither significant influence nor joint control constitutes control of an investee. Accordingly, the accounting requirements related to consolidations for the investor’s ownership interests based on the concept of a group (a parent and its subsidiaries) shall not be carried over to the accounting requirements related to the equity method. Principle 4: For issues that are not covered by Principles 1 to 3, the accounting requirements related to the equity method shall follow the accounting requirements related to consolidations.

16. The following paragraphs discuss each Principle in detail.

Principle 1

Principle 1 : The unit of account for the interest in an associate or a joint venture is the interest itself (that is, an investment in a single asset), rather than the assets and liabilities of the associate or joint venture. The investor shall recognise an asset representing its share of the net assets of the associate or joint venture, and income or expense representing its share of the net profit or loss of the associate or joint venture.

Rationale for this Principle

17. Neither significant influence nor joint control constitutes control of an investee. Accordingly, unlike consolidation, it would be inappropriate to recognise the full amount of the individual assets and liabilities of the associate or joint venture.
18. Proportionate consolidation may be one alternative; however, it is questionable whether it is appropriate for the investor to recognise its proportionate share of the assets and liabilities of the associate or joint venture that it does not control. On the other hand, it is clear that the investor controls an interest in the associate or joint venture. Accordingly, such interest in an associate or joint venture should be recognised as an asset of the investor.
19. The asset that the investor recognises represents the investor’s share of the net assets of the associate or joint venture, and the related income or expense that the investor recognises represents the investor’s share of the net profit or loss of the associate or joint venture. Accordingly, the gains or losses that would be eliminated from upstream and downstream transactions would be the investor’s share of the gains or losses.

Implications of this Principle

20. The implications of Principle 1 can be summarised as follows:

(a) The interest in the associate or joint venture would be recognised as a single asset; the assets and liabilities of the associate or joint venture would not directly be recognised by the investor. The recognised asset represents the investor’s share of the net assets of the associate or joint venture. (b) The income or expense from the investment represents the investor’s share of the net profit or loss of the associate or joint venture. Gains or losses that would be eliminated from upstream and downstream transactions would be the investor’s share of such gains or losses.

Potential Changes to IFRS Standards

21. The implications of Principle 1 are fairly consistent with the current requirements in IAS 28.

24. We observe that diversity exists in the accounting for the amounts in the preceding paragraph^7 : (a) When unrealised gains from downstream transactions exceed the carrying amount of the interest in the associate or joint venture: (i) some entities reduce the carrying amount to zero and recognise a liability for the amount that could not be eliminated; (ii) other entities reduce the carrying amount to zero but do not recognise a liability; if the investee earns a profit in subsequent periods, the carrying amount would be increased only after adjusting for the gain that had not been eliminated; and (iii) yet other entities reduce the carrying amount to zero but do not recognise a liability; any profit the investee earns in subsequent periods is recognised without adjusting for the gain that had not been eliminated. (b) When dividends from the investee exceed the carrying amount of the investment: (i) some entities reduce the carrying amount to zero and recognise a liability for the amount that could not be eliminated; (ii) other entities reduce the carrying amount to zero and do not recognise a liability but a gain for the amount that could not be eliminated; if the investee earns a profit in subsequent periods, the carrying amount would be increased only after adjusting for the gain that had not been eliminated; and (iii) yet other entities reduce the carrying amount to zero and do not recognise a liability but a gain for the amount that could not be eliminated; any profit the investee earns in subsequent periods is recognised without adjusting for the gain that had not been eliminated.

(^7) In September 2014, the IASB amended IFRS 10 and IAS 28. That amendment would have required any gain or loss resulting from a downstream transaction involving assets that constitute a business between the investor and the associate or joint venture be recognised in full in the investor’s financial statements (paragraph 31A of IAS 28). However, in December 2015, the IASB decided to defer the effective date of this amendment indefinitely.

25. We think a liability should be recognised for both cases for the following reasons:

(a) In the case of gains from downstream transactions, recognising a liability would enable the entity to fully eliminate the gains from downstream transactions. If a liability is not recognised, profit or loss will be reduced in the subsequent period(s). From the perspective of faithfully representing the income from the equity method investment, a liability should be recognised. (b) In the case of dividends, recognising a gain is inconsistent with the notion that dividends from equity method investments are returns of investments rather than returns on investments. From the perspective of faithfully representing the income from the equity method investment, a liability should be recognised.

26. We note that in July 2013, the IASB agreed with the IFRS Interpretation Committee’s recommendation that the entity should eliminate the gain from a downstream transaction to the extent of related investors’ interest in the associate or joint venture, even if the gain to be eliminated exceeds the carrying amount of the entity’s investment in the associate or joint venture, and that the remaining gain in excess of the carrying amount of the entity’s investment in the associate or joint venture should be presented as a deferred gain^8. However, in June 2015, the IASB decided to defer further work on this topic to the Equity Method research project.
27. We also note that those who are against recognising a liability argue that the gains from downstream transactions would not meet the definition of a liability as defined in the IASB’s Conceptual Framework.

Implications of this Principle

28. The implications of Principle 2 can be summarised as follows:

(a) Impairment would be tested against the interest in the associate or joint venture in its entirety (that is, the single asset). (b) A liability should be recognised when, and only when: (i) the investor has legal or constructive obligations to absorb the losses; or

(^8) IASB Update July 2013

Implications of this Principle

32. The implications of Principle 3 can be summarised as follows:

(a) When control of an investee is obtained in steps, the investments previously made (regardless of whether IFRS 9 or IAS 28 had been applied) would be remeasured at fair value at the date control is obtained, with any difference recognised in profit or loss^9. However, when significant influence or joint control is obtained in steps, the investments previously made may not be measured at fair value at the date significant influence or joint control is obtained^10. (b) When the parent increases its interest in the subsidiary and that parent continues to control the subsidiary, the transaction would be viewed as a transaction with owners, and any difference between the consideration paid and the non- controlling interests reduced would be recognised in equity. However, when the investor increases its interest in the associate or joint venture and that investor continues to have significant influence or joint control over the associate or joint venture, the transaction would not be viewed as a transaction with owners. (c) When the parent reduces its interest in the subsidiary and yet that parent continues to control the subsidiary, the transaction would be viewed as a transaction with owners, and any difference between the consideration received and the increase in non-controlling interests would be recognised in equity. However, when the investor reduces its interest in the associate or joint venture and yet that investor continues to have significant influence or joint control

(^9) For our view regarding the accounting for consolidations, refer to Part C of this paper. (^10) When significant influence or joint control is obtained in steps, our understanding is that more than one approach, including (1) the accumulated cost approach and (2) the fair value as deemed cost approach, is currently acceptable. Under (1) the accumulated cost approach, the investments previously made would have been measured at fair value in accordance with IFRS 9, and the changes from the initial cost would be reversed to measure the investments previously made at their initial costs. Under (2) the fair value as deemed cost approach, the investments previously made also would have been measured at fair value in accordance with IFRS 9, but the fair value when significant influence or joint control is obtained is deemed to be the cost of the investment previously made for the initial application of the equity method of accounting. Our understanding is that (1) and (2) represent different views on how to carry over the costs of the investments previously made when significant influence or joint control is obtained, and do not represent a remeasurement of the previously held investments at the acquisition date fair value as required by paragraph 42 of IFRS 3.

over the associate or joint venture, the transaction would not be viewed as a transaction with owners. (d) When the parent’s interest changes without any acquisitions or sales of interests by the parent (for example, when the subsidiary issues new shares to third parties) and the parent continues to control the subsidiary, any change in the parent’s interest would be recognised in equity. However, when the investor’s interest changes without any acquisitions or sales of interests by the investor (for example, when the associate or joint venture issues new shares to third parties) and the investor continues to have significant influence or joint control over the associate or joint venture, any increase in the interest would be accounted for in a manner consistent with acquisitions ((b) above) and any decrease in the interest would be accounted for in a manner consistent with sales ((c) above). (e) A group’s share in an investment is the aggregate of the holdings in that investment by the parent and its subsidiaries (that is, the group). The holdings in that investment by associates and joint ventures would be ignored. The same thinking applies to investments in the entity’s own shares. When a parent has a subsidiary and that subsidiary holds an interest in the parent, such interest would be accounted for as treasury shares when the parent prepares consolidated financial statements. However, when the investor has an associate or joint venture and that associate or joint venture holds an interest in the investor, such interest would not be accounted for as treasury shares when the investor prepares consolidated financial statements.

Potential Changes to IFRS Standards

33. Paragraph 26 of IAS 28 states that many of the procedures that are appropriate for the application of the equity method are similar to the consolidation procedures described in IFRS 10. However, it is unclear which procedures should follow the procedures in IFRS 10. Principle 3 would clarify the guidance in IAS 28 by focusing on the accounting requirements for the investor’s ownership interests that refer to the concept of a group.

(OCI)) and thus the equity method of accounting may not necessarily result in recognising income or expense from equity investments earlier. However, because of the investor’s involvement in the management of the associate or joint venture, we are of the view that the equity method of accounting continues to be relevant even after the adoption of IFRS 9.

Implications of this Principle

37. The implications of Principle 4 can be summarised as follows^11 :

(a) The investor’s share of profit or loss and OCI of the associate or joint venture would be recognised in the investor’s profit or loss and OCI, respectively. (b) The measurement of identifiable net assets of the associate or joint venture would follow the requirements in IFRS 3. Accordingly, the general principle on initial recognition would be to use fair value for measurement and the exceptions to recognition and measurement will be those prescribed in IFRS 3. This would include the requirement to measure contingent consideration at fair value. (c) The concept of “measurement period” in IFRS 3 would also apply to associates and joint ventures. (d) Unrealised gains and losses from upstream and downstream transactions would be eliminated. (e) Receivables and payables (including loans and borrowings) between the investor and the associate or joint venture would be eliminated. (f) Income and expenses that do not involve the transfer of assets between the investor and the associate or joint venture would be eliminated. (g) When eliminating the unrealised gains from upstream transactions, the carrying amount of the asset (and not the carrying amount of the equity method investment) that is held by the investor would be adjusted.

(^11) For simplicity, the following discussions ignore any tax effects that may arise from the transactions.

(h) When Entity A holds an interest in Entity B and Entity B concurrently holds an interest in Entity A, such reciprocal interests would be eliminated when the equity method of accounting is applied to either Entity A or Entity B.

38. Regarding paragraph 37(d) of this paper, in the case of upstream transactions, the effects on profit or loss attributable to the parent would be the same for consolidations and the equity method of accounting. However, in the case of downstream transactions, the effects on profit or loss attributable to the parent would be different.
39. Regarding paragraph 37(e) of this paper, we observe that the guidance provided by large accounting firms suggest that receivables and payables (including loans and borrowings) between the investor and the associate or joint venture should not be eliminated. Some note that associates and joint ventures do not form part of the group and thus balances against entities outside of the group should not be eliminated.
40. However, we are of the view that the investor’s share of the loans or borrowings should be eliminated against the carrying amount of the investment in the associate or joint venture. If we follow the argument in the previous paragraph, transactions with associates and joint ventures that give rise income and expenses also should not be eliminated, which would be inconsistent with the view that many hold, including the large accounting firms.
41. Consider the following example. The net assets of the associate are valued at CU1,000. The investor holds a 30% interest in the associate, valued at CU300. The investor also has a loan to the associate, valued at CU100.
42. For those entities that eliminate the receivables and payables between the investor and the associate or joint venture, the loan balance would be reduced by CU (CU100x30%). Because this would increase the net assets of the associate, the carrying amount of the associate would increase by CU30.
43. When an entity eliminates the receivables and payables between the investor and the associate or joint venture, the investor’s receivables (payables) will decrease

50. For those entities that adjust the carrying amount of the asset that the investor purchased from the associate or joint venture , the carrying amount of the property is reduced by CU30 (CU100x30%). For those entities that adjust the carrying amount of the investment in the associate or joint venture, the carrying amount is reduced by CU30.
51. Applying the principles we propose in this paper, the carrying amount of the asset purchased from the associate or joint venture will be adjusted.

Potential Changes to IFRS Standards

52. Principle 4 would clarify the guidance in IAS 28 by stating that, unless Principles 1 to 3 apply, the equity method of accounting should follow the accounting requirements related to consolidations. While many entities currently may not eliminate the investor’s share of the loans or borrowings against the carrying amount of the investment in the associate or joint venture, elimination would be consistent with our view.

Part C: Accounting for Consolidations

53. In Parts A and B of this paper, we have taken the requirements related to the accounting for consolidations as granted. However, in Part C, we present our views on the current requirements related to the accounting for consolidations.
54. As noted in paragraph 30 of this paper, the requirements in IFRS 10 and IFRS 3 are based on the notion that obtaining control of another entity (that is, the investee becoming a subsidiary) is a significant economic event that warrants a change in accounting such that all of the investments previously made would be remeasured at fair value at the acquisition date, with any difference recognised in profit or loss.
55. We do not believe this accounting treatment represents the event faithfully, because the required accounting would have the same effect as if the entity sells the investments previously made at fair value at the acquisition date. The fact is that the investments previously made have not been sold. It would be difficult to say

that the faithful representation of an additional purchase of shares would involve the accounting for the sales of the previously held shares.

56. Accordingly, in the case of step acquisitions, we are of the view that investments previously made should not be remeasured when the investor obtains control. Instead, we think that the carrying amounts of the investments should be carried over.

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