Accounting, Financial, Taxation

INVESTMENT IN ASSOCIATES

Definition

IFRS: An associate is an entity over which the investor has significant influence – that is, the power to participate in, but not control, an associate’s financial and operating policies. Participation by an investor in the entity’s financial and operating policies via representation on the entity’s board demonstrates significant influence. A 20% or more interest by an investor in an entity’s voting rights leads to a presumption of significant influence.

US GAAP: Similar to IFRS, although the term ‘equity investment’ rather than ‘associate’ is used. US GAAP does not include unincorporated entities, although these would generally be accounted for in a similar way.

Equity Method

IFRS: An investor accounts for an investment in an associate using the equity method. The investor presents its share of the associate’s post-tax profits and losses in the income statement. The investor recognizes in equity its share of changes in the associate’s equity that have not been recognized in the associate’s profit or loss.

The investor, on acquisition of the investment, accounts for the difference between the cost of the acquisition and investor’s share of fair value of the net identifiable assets as goodwill. The goodwill is included in the carrying amount of the investment. The investor’s investment in the associate is stated at cost, plus its share of post-acquisition profits or losses, plus its share of post-acquisition movements in reserves, less dividends received.

Losses that reduce the investment to below zero are applied against any long-term interests that, in substance, form part of the investor’s net investment in the associate – for example, preference shares and long-term receivables and loans. Losses recognized in excess of the investor’s investment in ordinary shares are applied to the other components in reverse order of priority in a winding up. Further losses are provided for as a liability only to the extent that the investor has incurred legal or constructive obligations to make payments on behalf of the associate.

Disclosure of information is required about the revenues, profits or losses, assets and liabilities of associates. Investments in associates held by venture capital organizations, mutual funds, unit trusts and similar entities including investment-linked insurance funds can be carried at fair value through profit or loss.

US GAAP: Similar to IFRS if the equity method is applied. In addition, an entity can elect to adopt the fair value option for any of its equity method investments. If elected, equity method investments are presented at fair value at each reporting period, with changes in fair value being reflected in the income statement.

Accounting Policies

IFRS: An investor’s financial statements are prepared using uniform accounting policies for like transactions and events; adjustments are made to the associate’s policies to conform to that of the investor.

US GAAP: The investor’s financial statements do not have to be adjusted if the associate follows an acceptable alternative US GAAP treatment, although it would be acceptable to do so.

Impairment

IFRS: If the investor has objective evidence of one of the indicators of impairment set out in IAS 39.59 for example, significant financial difficulty impairment is tested as prescribed under IAS 36, Impairment of Assets. The entire carrying amount of the investment is tested by comparing its recoverable amount (higher of value in use and fair value less costs to sell) with its carrying amount. In the estimation of future cash flows for value in use, the investor may use either: its share of future net cash flows expected to be generated by the investment (including the cash flows from its operations) together with the proceeds on ultimate disposal of the investment; or the cash flows expected to arise from dividends to be received from the associate together with the proceeds on ultimate disposal of the investment.

US GAAP: The impairment test under US GAAP is different to IFRS. Equity investments are considered impaired if the decline in value is considered to be other than temporary. As such, it is possible for the fair value of the equity method investment to be below its carrying amount, as long as that decline is temporary. If an other-than-temporary impairment is determined to exist, the investment is written down to fair value.

Investments in Joint Ventures

Definition

IFRS: A joint venture is defined as a contractual agreement whereby two or more parties undertake an economic activity that is subject to joint control. Joint control is the contractually agreed sharing of control of an economic activity. Unanimous consent of the parties sharing control is required.

US GAAP: A corporate joint venture is defined as a corporation owned and operated by a small group of businesses as a separate and specific business or project for the mutual benefit of the members of the group.

Types of Joint Venture

IFRS: Distinguishes between three types of joint venture:

1. jointly controlled entities – the arrangement is carried on through a separate entity (company or partnership);
2. jointly controlled operations – each venturer uses its own assets for a specific project;
3. jointly controlled assets – a project carried on with assets that are jointly owned.

US GAAP: Only refers to jointly controlled entities, where the arrangement is carried on through a separate corporate entity.

Jointly Controlled Entities

IFRS: Either the proportionate consolidation method or the equity method is allowed. Proportionate consolidation requires the venturer’s share of the assets, liabilities, income and expenses to be either combined on a line-by-line basis with similar items in the venturer’s financial statements, or reported as separate line items in the venturer’s financial statements.

US GAAP: Prior to determining the accounting model, an entity first assesses whether the joint venture is a VIE. If the joint venture is a VIE, the accounting model discussed in the above section, “Special purpose entities”, is applied. If the joint venture is not a VIE, venturers apply the equity method to recognize the investment in a jointly controlled entity. Proportionate consolidation is generally not permitted except for unincorporated entities operating in certain industries.

Contributions to a Jointly Controlled Entity

IFRS: A venturer that contributes non-monetary assets, such as shares or non-current assets, to a jointly controlled entity in exchange for an equity interest in the jointly controlled entity recognises in its consolidated income statement the portion of the gain or loss attributable to the equity interests of the other venturers, except when:

1. the significant risks and rewards of the contributed assets have not been transferred to the jointly controlled entity;
2. the gain or loss on the assets contributed cannot be measured reliably; or
3. the contribution transaction lacks commercial substance.

US GAAP: As a general rule, an investor (venturer) records its contributions to a joint venture at cost (i.e.: the amount of cash contributed and the book value of other non-monetary assets contributed). Sometimes, appreciated non-cash assets are contributed to a newly formed joint venture in exchange for an equity interest when others have invested cash or other ‘hard assets’. It is sometimes argued that the investor contributing appreciated non-cash assets has effectively realized part of the appreciation as a result of its interest in the venture to which others have contributed cash and that immediate recognition of a gain would be appropriate. Practice and existing literature vary in this area. As a result, the specific facts and circumstances affect gain recognition and require careful analysis.

Jointly Controlled Operations

IFRS: Requirements are similar to jointly controlled entities without an incorporated structure. A venturer recognises in its financial statements:

1. the assets that it controls;
2. the liabilities it incurs;
3. the expenses it incurs;
4. its share of income from the sale of goods or services by the joint venture.

US GAAP: Equity accounting is appropriate for investments in unincorporated joint ventures. The investor’s pro-rata share of assets, liabilities, revenues and expenses are included in their financial statements in specific cases where the investor owns an undivided interest in each asset of a non-corporate joint venture.

Jointly Controlled Assets

IFRS: A venturer accounts for its share of the jointly controlled assets, liabilities, income and expenses, and any liabilities and expenses it has incurred.

US GAAP: Not specified. However, proportionate consolidation is used in certain industries to recognize investments in jointly controlled assets.(REFERENCES: IFRS: IAS 1, IAS 28, IAS 31, SIC-13, IAS 36, IAS 39. US GAAP: APB 18, FAS 153, FIN 35).

CONSOLIDATED FINANCIAL STATEMENT

Preparation

IFRS: Parent entities prepare consolidated financial statements that include all subsidiaries. An exemption applies to a parent:

1. that is itself wholly owned or if the owners of the minority interests have been informed about and do not object to the parent not presenting consolidated financial statements;
2. the parent’s securities are not publicly traded nor is it in the process of issuing securities in public securities markets; and
3. the immediate or ultimate parent publishes consolidated financial statements that comply with IFRS.

US GAAP: There is no exemption for general purpose financial statements. Consolidated financial statements are presumed to be more meaningful and are required for SEC registrants. Specific rules apply for certain industries.

Consolidation Model and Subsidiaries

The definition of a subsidiary, for the purpose of consolidation, is an important distinction between the two frameworks.

IFRS: Focuses on the concept of control in determining whether a parent/subsidiary relationship exists. Control is the parent’s ability to govern the financial and operating policies of a subsidiary to obtain benefits. Control is presumed to exist when a parent owns, directly or indirectly through subsidiaries, more than one half of an entity’s voting power. Control also exists when a parent owns half or less of the voting power but has legal or contractual rights to control the majority of the entity’s voting power or board of directors. A parent could have control over an entity in circumstances where it holds less than 50% of the voting rights of an entity and no legal or contractual rights by which to control the majority of the entity’s voting power or board of directors (de facto control). Currently exercisable potential voting rights should also be considered to determine whether control exists. Entities acquired (disposed of) are included in (excluded from) consolidation from the date on which control passes.

US GAAP: Uses a bipolar consolidation model. All consolidation decisions are evaluated first under the variable interest entity (VIE) model. If the entity is a VIE, management should follow the US GAAP guidance below, under ‘Special purpose entities’. The second model looks to voting interest. Under this model, control can be direct or indirect and may exist with less than 50% ownership. ‘Effective control’, which is a similar notion to de facto control under IFRS, is very rare if ever employed in practice under US GAAP. Accordingly, there could be situations in which an entity is consolidated under IFRS based on the notion of de facto control. However, it would not be consolidated under US GAAP under the concept of effective control.

Special Purpose Entities

IFRS: Special purpose entities (SPEs) are consolidated where the substance of the relationship indicates that an entity controls the SPE. Control may arise through the predetermination of the activities of the SPE (operating on ‘autopilot’) or otherwise. Indicators of control arise where:

1. the SPE conducts its activities on behalf of the entity;
2. the entity has the decision-making power to obtain the majority of the benefits of the SPE;
3. the entity has other rights to obtain the majority of the benefits of the SPE; or
4. the entity has the majority of the residual or ownership risks of the SPE or its assets.

Post-employment benefit plans or other long-term employee benefit plans to which IAS 19, Employee Benefits, applies are excluded from this requirement.

US GAAP: The consolidation of an SPE is required by its primary beneficiary when the SPE meets the definition of a VIE and the primary beneficiary has a variable interest in the entity that will cause it to absorb a majority of the VIE’s expected losses, receive a majority of the VIE’s expected residual returns, or both. There are several scope exceptions to this rule (such as pension, post-retirement or post-employment plans). Specific criteria also permit the transfer of financial assets to an SPE that is not consolidated by the transferor. The SPE should be a qualifying SPE (QSPE, as defined),
and the assets should be financial assets (as defined).

Uniform Accounting Policies

IFRS: Consolidated financial statements are prepared using uniform accounting policies for like transactions and events in similar circumstances for all of the entities in a group.

US GAAP: Similar to IFRS, with certain exceptions. Consolidated financial statements are prepared using uniform accounting policies for all of the entities in a group except when a subsidiary has specialized industry accounting principles. Retention of the specialized accounting policy in consolidation is permitted in such cases.

Reporting Periods

IFRS: The consolidated financial statements of the parent and the subsidiary are usually drawn up at the same reporting date. However, the consolidation of subsidiary accounts can be drawn up at a different reporting date provided the difference between the reporting dates is no more than three months. Adjustments are made for significant transactions that occur in the gap period.

US GAAP: Similar to IFRS, except that adjustments are generally not made for transactions that occur in the gap period (REFERENCES: IFRS: IAS 27, SIC-12, IFRS 5. US GAAP: ARB 51, FAS 94, FAS 144, SAB 51, SAB 84, EITF 96-16, FIN 46).

Cash flow statement

Exemptions

IFRS: No exemptions.

US GAAP: Limited exemptions for certain investment entities and defined benefit plans.

Direct/indirect method

IFRS: Inflows and outflows of ‘cash and cash equivalents’ are reported in the cash flow statement. The cash flow statement may be prepared using either the direct method (cash flows derived from aggregating cash receipts and payments associated with operating activities) or the indirect method (cash flows derived from adjusting net income for transactions of a non-cash nature such as depreciation). The indirect method is more common in practice. Non-cash investing and financing transactions are to be disclosed.

US GAAP: The cash flow statement provides relevant information about ‘cash receipts’ and ‘cash payments’. Similar to IFRS, either the direct method or indirect method may be used. The latter is more common in practice. A reconciliation of net income to cash flows from operating activities is disclosed if the direct method is used.  Significant non-cash transactions are disclosed.

Definition of cash and cash equivalents

IFRS: Cash is cash on hand, and demand deposits and cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and are subject to an insignificant risk of changes in value. An investment normally qualifies as a cash equivalent only when it has a maturity of three months or less from its acquisition date. Cash may also include bank overdrafts repayable on demand but not short-term bank borrowings; these are considered to be financing cash flows.

US GAAP: The definition of cash equivalents is similar to that in IFRS, except bank overdrafts are not included in cash and cash equivalents; changes in the balances of overdrafts are classified as financing cash flows, rather than being included within cash and cash equivalents.

Format

IFRS: Cash flows from operating, investing and financing activities are classified separately.

US GAAP: Whilst the headings are the same as IFRS, there is more specific guidance on items that are included in each category as illustrated in the below table.

Classification of specific items

IFRS and US GAAP require the classification of interest, dividends and tax within specific categories of the cash flow statement.

Changes in accounting policy

IFRS: Changes in accounting policy are accounted for retrospectively. Comparative information is restated, and the amount of the adjustment relating to prior periods is adjusted against the opening balance of retained earnings of the earliest year presented. Effect of retrospective adjustments on equity items is presented separately in this SoRIE and SoCIE (Statements of Changes in Equity) (see ‘Statements of recognised income’). An exemption applies when it is impracticable to change comparative information. Policy changes made on the adoption of a new standard are accounted for in accordance with that standard’s transition provisions. The method described above is used if transition provisions are not specified.

US GAAP: Similar to IFRS.

Correction of errors

IFRS: The same method as for changes in accounting policy applies.

US GAAP: Similar to IFRS, reported as a prior-period adjustment; restatement of comparatives is mandatory.

Changes in accounting estimates

IFRS: Changes in accounting estimates are accounted for in the income statement when identified.

US GAAP: Similar to IFRS.

Recent proposals – US GAAP

In July 2007, the SEC issued a proposed rule that would allow foreign private issuers that prepare financial statements in accordance with the English-language version of IFRS as published by the IASB to file those financial statements with the SEC without reconciling them to US GAAP. The proposed amendments state that such financial statements would need to include an explicit statement asserting that they are in compliance with IFRS as published by the IASB. The proposed amendment would not apply to issuers that use a jurisdictional or other variation of IFRS in which the financial statements would be different compared to financial statements prepared under IFRS as published by the IASB. The comment period on the proposed rule ended on 24 September 2007.

Recent proposals – US GAAP

In August 2007, the SEC issued a concepts release to gauge the extent and nature of the public’s interest on allowing US issuers the option to prepare their financial statements in accordance with IFRS. The concepts release poses specific questions around the impact on the US capital markets, standard setting, education and training as well as encouraging constituents to raise any other relevant issues. The comment period on the concepts release ends on 13 November 2007. REFERENCES: IFRS: IAS 1, IAS 7, IAS 8, IAS 21, IAS 29, IAS 32, SIC-30. US GAAP: CON 1-7, FAS 16, FAS 52, FAS 95, FAS 130, FAS 141, FAS 154, APB 28, APB 30, ARB 43, SEC Regulation S-X, FIN 39.