Investments in Associates

When considering, during an audit, whether investments have been correctly accounted for, in terms of the relevant accounting framework, it is important to know whether the entity is required to compile consolidated financial statements. This can make a difference when determining whether the accounting policy applied for investments in associates is appropriate based on the accounting framework.

IFRS for SMEs

International Financial Reporting Standard for Small and Medium-sized Entities (IFRS for SMEs) Section 14, Investments in associates, indicates that its requirements apply to accounting for associates in consolidated financial statements, and in the financial statements of an investor that is not a parent, but that has an investment in one or more associates.

In paragraph 14.4, investors are required to account for all of their investments in associates using one of the following methods: a)    The cost model b)    The equity method c)    The fair value model.

In paragraph 14.5, it is prescribed that investments in associates must be measured at cost less any accumulated impairment losses other than those for which there is a published price quotation. In paragraph 14.7, investors are required to measure their investment in associates for which there is a published price quotation using the fair value model.

Section 14 then proceeds to set out how each method should be applied, and the required disclosure to be made in the financial statements.

Section 9, Consolidated and separate financial statements, requires entities to adopt one of the following policies for accounting for their investments in subsidiaries, and to apply the same accounting policy to all investments in associates: a)    Cost less impairment b)    Fair value with changes in fair value recognised in profit or loss c)    The equity method following the procedures in paragraph 14.8.

There are, therefore, no differences in accounting policies between consolidated and separate financial statements.

Evaluating magnitude:

This is the easier part of the risk assessment, as evaluating the magnitude simply means considering whether the risk could result in a material misstatement, should it materialise, based on the size or extent of the potential misstatement. Potential misstatements in individual statements and disclosures may be judged to be material, due to:

• Size: individually or in aggregate exceeding materiality (quantitatively material) • Nature: fraud, error, non-compliance (qualitatively material) • Circumstances: e.g. could contribute to entity not being a going concern (qualitatively material).

Both qualitative and quantitative material misstatements would influence the decisions of the users of the financial statements.

Full IFRS

According to International Financial Reporting Standards (IFRS), however, accounting for investments in associates is more complicated. International Accounting Standard 28 (IAS 28), Investments in associates and joint ventures, indicates that this standard applies to all entities that are investors with significant influence over an investee.

In IAS 28, paragraph 16, entities with significant influence over an investee are required to account for their investments in associates using the equity method, except when that investment qualifies for exemption, in accordance with paragraphs 17–19 of IAS 28.

In IAS 28, paragraph 17, it is indicated that an entity is exempt from applying the equity method to its investments in associates, if the entity is a parent that is exempt from preparing consolidated financial statements, in terms of IFRS 10 paragraph 4(a), or if all of the following apply:

a) The entity is a wholly owned subsidiary, or a partially owned subsidiary of another entity, and its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the entity not applying the equity method. b)  The entity’s debt or equity instruments are not traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets). c)  The entity did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation, for the purpose of issuing any class of instruments in a public market. d)  The ultimate parent or any intermediate parent of the entity produces financial statements available for public use that comply with IFRS, in which subsidiaries are consolidated, or measured at fair value through profit or loss, in accordance with IFRS 10.

IAS 28, paragraphs 18–19 deal with exceptions relating to investments in associates held by, or indirectly held through, entities that are venture capital organisations, or mutual funds, unit trusts and similar entities. In these cases, the entity may elect to measure such investments at fair value through profit or loss, according to IFRS 9.

According to IFRS 10, Consolidated financial statements, an entity that is a parent must present consolidated financial statements, except if it meets all the following conditions:

a)  It is a wholly owned subsidiary or partially owned subsidiary of another entity, and all its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements. b)   Its debt or equity instruments are not traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets). c) It did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market. d)  Its ultimate parent or any intermediate parent produces financial statements that are available for public use and comply with IFRS, in which subsidiaries are consolidated, or measured at fair value through profit or loss, in accordance with this IFRS.

From the paragraphs referenced above, it is evident that, where there is an ultimate parent in the group above the parent entity that is being audited, intermediate parent entities are exempt from preparing consolidated financial statements. In turn, the exemption in IAS 28, paragraph 17, applies, in respect of applying equity accounting for its investments in associates. Such entities can, therefore, default to applying the cost method to investments in associates in their separate financial statements.

However, if the intermediate parent chooses to prepare consolidated financial statements, in accordance with IFRS 10, it should again be considered whether it is appropriate to continue applying the exemption from equity accounting under IAS 28. IAS 28, paragraph 17, refers to an ‘or’ in determining whether the equity accounting exemption applies, which leads the entity to consider whether it meets the requirements in IAS 28, paragraph 17(a) to (d). If these requirements are all met, despite the entity voluntarily electing to prepare consolidated financial statements, it will not be required to apply equity accounting to its investments in associates.

Whenever intermediate parents elect to apply the exemption set out in the preceding paragraph, it is strongly recommended that the entity clearly reflect, in the accounting policies, that it has voluntarily prepared consolidated financial statements and that it meets the exemption criteria included in IAS 28, paragraph 17, despite the voluntary election to prepare consolidated financial statements. The entity should further consider any possible additional disclosure requirements that may be prescribed according to IFRS 12, Disclosures of interests in other entities.

In summary

It is crucial to understand the relevant financial reporting framework requirements when determining whether investments in associates have been correctly accounted for and disclosed in your audit client’s financial statements. Without proper consideration of the requirements, the financial statements may be materially misstated.

LEAF can assist firms with performing thorough file reviews, providing practical advice, reviewing methodology design, designing audit working paper templates and providing staff training on the relevant requirements and procedures.

References

1.  IFRS for SMEs (2015), Section 14, Investments in associates 2.  IFRS for SMEs (2015), Section 9, Consolidated and separate financial statements 3.  IAS 28, Investments in associates and joint ventures 4.  IFRS 10, Consolidated financial statements 5.  IFRS 12, Disclosures of interests in other entities.

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