Classification, Measurement, and Disclosure under International Financial Reporting Standards (IFRS) for Intercorporate Investments

Intercorporate investments are investments in the debt and equity securities of other companies.

Companies invest in other companies to:

• Diversify their asset base.
• Increase profitability.
• Enter new markets.
• Gain competitive advantage.
• Deploy excess cash.

An example of an intercorporate investment is Coca-Cola’s acquisition of a bottling company to gain a cost advantage.

Categories of Intercorporate Investments

Intercorporate investments are classified based on the degree of influence or control that the investor can exercise over the investee.

Marketable debt and equity securities can be categorized as:

1. Investments in financial assets: In this case, the investor has no significant influence or control over the operations of the investee.
2. Investments in associates: In this scenario, the investor can exert significant influence (but not control) over the investee.
3. Joint ventures: In this arrangement, two or more entities share control.

Generally, the percentage of ownership is used to determine the suitable category for financial reporting purposes. However, note that the percentage of ownership is just a guideline. The appropriate category eventually depends on the investor’s ability to control or influence the investee.

The following is a summary of the investment categories. Each of the categories will be discussed in more detail in later sections.

$$\small{\begin{array}{l|l|l|l} \textbf{Investment Category} & \textbf{Ownership Percentage} & \textbf{Degree of Influence} & \textbf{Accounting Treatment} \\ \hline\text{Investments in financial assets} & <20\% & \text{No significant influence} & {\text{Amortized cost}\\ \text{FVPL}\\ \text{FVOCI}} \\ \hline\text{Investment in associates} & 20\% – 50\% & {\text{Significant influence/}\\ \text{No control}} & \text{Equity method} \\ \hline\text{Business Combinations} & \text{More than 50%}& \text{Control} & \text{Acquisition method} \\ \hline\text{Joint venture} & {\text{Control shared at least}\\ \text{two investors}} & {}& {\text{IFRS: Proportionate}\\ \text{consolidation}\\ \text{U.S. GAAP: Equity}\\ \text{method}}\\  \end{array}}$$

Investments in Financial Assets

• Here, the investor has no significant control/influence over the operations of the investee. Generally, if the investor owns less than 20% of the equity interest in the investee, he or she usually has little control. Investments in financial assets have a similar treatment under both IFRS and U.S. GAAP.

Before IFRS 9 took effect, i.e., under IAS 39, investments in financial assets were classified as:

• Held to maturity.
• Available for sale.
• Fair value through P&L (Held for trading or designated as fair value).
• Loans and receivables.

Post IFRS 9 taking effect, investments in financial assets are classified as:

• Fair value through profit and loss (FVPL).
• Fair value through other comprehensive income (FVOCI).
• Amortized cost.

In this section, we will only discuss the new standard (IFRS 9). IFRS 9 is based on an approach that considers the contractual characteristics of cash flows and the management of financial assets. It became effective on January 1st, 2018.

Additionally, IFRS 9 differs from IAS 39 in that companies are required to migrate from an actual loss model to an expected credit loss model. This implies that companies evaluate both historical and current information about loan performance and forward-looking information.

Classification and Measurement of Financial Assets under IFRS 9

Financial assets, in this case, are divided into those measured at amortized cost and those measured at fair value. All financial assets are measured at fair value when initially acquired and, subsequently, either at fair value or amortized cost.

To be measured at amortized cost, financial assets must meet the following criteria:

1. A business model test: Financial assets are being held to collect contractual cash flows.
2. A cash flow characteristic test: The contractual cash flows are exclusively payments of principal and interest on the principal.

The fair value through other comprehensive income (FVOCI) is used to measure financial assets that meet the above criteria but may be sold. However, the management may opt to use the fair value through profit and loss (FVPL) option to avoid an accounting mismatch.

Summary: Measurement of Financial Assets

$$\small{\begin{array}{l|l} \textbf{Instrument} & \textbf{Measurement Method} \\ \hline\text{Debt instruments} & \text{Amortized cost} \\ \hline
& \text{FVOCI} \\ \hline& \text{FVPL} \\ \hline\text{Equity instruments} & \text{FVPL} \\ \hline& \text{FVOCI} \\ \hline\text{Equity investments held for trading} & \text{FVPL}\\  \end{array}}$$

Example: Accounting for Investment in Financial Assets

ABC Ltd purchased a 10% annual coupon bond at the beginning of the year with a nominal value of $100,000 at a price of $94,205 to yield 12%. The fair value of the bond at the end of the year is $97,430.

Determine the impact on the company’s balance sheet and income statement if the bond is classified as:

1. Amortized cost.
2. Fair value through profit and loss.
3. Fair value through other comprehensive income.

Solution

i. Amortized Cost

$$\begin{align*}\text{Interest income recognized at the end of the year}&=\text{Beginning bond investment}\times\text{Yield}\\&=$94,205\times12\%\\&=$11,305\end{align*}$$

$$\begin{align*}\text{Amortized discount}&=\text{Interest income}-\text{Coupon payment}\\&=$11,305-($100,000\times10\%)\\&=$1,305\end{align*}$$

At the year-end, the bond is reported on the balance sheet at:

$$\begin{align*}\text{Bond’s value at the end of year}&= \text{Beginning bond investment} + \text{Amortized discount}\\&= $94,205 + $1,305\\&= $95,510\end{align*}$$

ii. Fair Value through Profit and Loss

The balance sheet is based on fair value of $97,430. Interest revenue of $11,305 and an unrealized gain of \(($97,430-$94,205-$1,305)=$1,920\).

iii. Fair Value through OCI

The balance sheet is based on the fair value of $97,430. Interest revenue of $11,305 is recognized in the income statement. The unrealized gain of $1,920 is reported in shareholders’ equity as a component of OCI.

Reclassification of Investments

1. Once equity securities are measured at FVPL or FVOCI, the decision is irrevocable.
2. Reclassifying debt instruments from FVPL to amortized cost or vice versa is only allowed when the business model changes.
3. A financial asset reclassified from amortized cost to FVPL is measured at fair value with gain or loss recognized in profit or loss.
4. For a financial asset reclassified from FVPL to amortized cost, the fair value at the reclassification date becomes the carrying amount.

Investments in Associates

Here, the investor can exercise significant influence but has no control over the investee. Typically, there is significant influence (but not control) if the investor holds between a 20% and 50% equity interest in the investee.

Other measures of significant influence include:

• Board of directors’ representation.
• Participation in the policymaking process.
• Technological dependency.
• Ability to interchange managerial personnel between investor and investee.
• Ability to make significant transactions between the two companies. 

Equity Method of Accounting

The equity method under both the IFRS and U.S. GAAP is used to account for investment in associates are accounted for using . The equity method investments are categorized as non-current assets on the balance sheet. The investor reports the initial investment in the investee at the cost of acquired shares.

The investor recognizes a proportionate amount of the investee’s earnings as a single line item on the income statement in the subsequent periods. On the other hand, the investor’s proportionate ownership interest in the assets and liabilities of the investee is disclosed as a single line item (net assets) on its balance sheet.

Finally, dividends received from the investee are treated as a return on capital and are not reported on the investor’s income statement.

$$\text{Recorded investment value}=\text{Initial cost}+(\text{Earnings}-\text{Dividends received})$$

The investor pauses the use of the equity method when the value of the investment becomes zero. No further losses are reported. The method is only resumed if the investee reports profits and the investor’s profit share exceeds the losses not reported by the pausing of the equity method. 

Example: Equity Method

Company A purchased a 25% interest in Company B for $500,000 on January 01, 2019. Company B reports incomes and dividends as follows:

$$\small{\begin{array}{l|r|r} & \textbf{Income} & \textbf{Dividends} \\ \hline2019 & \$550,000 & \$175,000 \\ \hline2020 & \$600,000 & \$225,000 \\ \hline\text{Total} & \$1,150,000 & \$400,000 \\  \end{array}}$$

Company A employs the equity method to account for its investment in Company B.

The amount related to its investment in company B that appears on Company A’s balance sheet at the end of 2020 is closest to:

Solution

At the end of 2019, Company A:

• Recognizes $137,500 i.e., \(($550,000\times25\%)\) in the income statement from its proportionate share of the net income of Company B.
• Increases its investment account on the balance sheet by $137,500, showing the proportionate share of Company B’s net assets.
• Receives $43,750, i.e., \(($175,000\times25\%)\) in cash dividends from Company B and reduces its investment in Company B by the same amount to reflect the decline in the net assets of Company B due to dividend payment.

The carrying amount of Company B on Company A’s balance sheet at the end of 2019 will be \((\$593,750=(\$500,000+\$137,500-\$43,750)\).

i.e \(\text{Carrying amount}=\text{Original investment}+\text{Proportionate share of investee’s net income}-\text{Dividend received}\)

For 2020, Company A will:

• Recognize income of $150,000, i.e., \(($600,000\times25\%)\).
• Increase the investment account by $150,000.
• Receive dividends of $56,250 i.e., \(($225,000\times25\%)\) and lower the investment account by $56,250.

At the end of 2020, the carrying value of Company B on Company A’s balance sheet will be $687,500, i.e., \(($593,750 + $150,000 – $56,250)\).

When Investment Costs > Book Value of the Investee

In most cases, an investment’s purchase price is not equal to the proportionate book value of the investee’s net assets. It is because many assets and liabilities have a book value dependent on the historical cost.

The difference between the investment’s purchase price and the investor’s proportionate share of the investee’s net identifiable assets is allocated to:

1. Any specific asset whose fair value is greater than the book value.
2. The difference between the acquisition cost and the fair value of net identifiable assets that cannot be allocated to specific assets is recognized as goodwill. Goodwill is not amortized. However, it is reviewed periodically for impairment.

Note that excess amounts allocated to identifiable assets/liabilities of the investee must be amortized on the investor’s income statement.

Calculation of Goodwill

$$\small{\begin{array}{l|c} \text{Purchase price}&\text{xxx}\\ \hline\textbf{Deduct: } (\%\ \text{of Ownership Interest}\times \text{Book Value of Investee’s Net Assets})&(\text{xxx})\\ \hline=\textbf{Excess purchase price}&\text{xxxx}\\ \hline\textbf{Deduct: }\ \text{Attribute to Net Assets:}&{}\\ \hline\text{Plant and Equipment } (\%\ \text{of Ownership Interest}\times \text{difference between book value and fair value})&(\text{xxx})\\ \hline\text{Land } (\%\ \text{of Ownership Interest}\times\text{difference between book value and fair value})&(\text{xxx})\\ \hline=\text{Goodwill}&\text{xxxx}\\ \end{array}}$$ 

Example: Calculation of Goodwill

Assume that Company A acquires 20% of the outstanding shares of Company B. Below is a representation of Company B’s recorded assets and liabilities as at the acquisition date:

$$\small{\begin{array}{l|r|r} & \textbf{Book Value} & \textbf{Fair Value} \\ \hline\text{Current assets} & \$20,000 & \$20,000 \\ \hline\text{Plant and equipment} & \$200,000 & \$230,000 \\ \hline\text{Land} & \$140,000 & \$160,000 \\ \hline{}& \textbf{\$360,000} & \textbf{\$410,000} \\ \hline\text{Liabilities} & \$200,000 & \$200,000 \\ \hline\textbf{Net assets} & \textbf{\$160,000} & \textbf{\$210,000}\\  \end{array}}$$

Company A believes the value of Company B is higher than the fair value of its identifiable net assets. It pays $200,000 for a 20% interest in Company B.

The goodwill is closest to:

Solution

$$\small{\begin{array}{l|c} \text{Purchase price}&$200,000\\ \hline\textbf{Deduct: } (\%\ \text{of Ownership Interest}\times \text{Book Value of Investee’s Net Assets}) (20\%\times$160,000)&($32,000)\\ \hline=\textbf{Excess purchase price}&$168,000\\ \hline\textbf{Deduct: }\ \text{Attribute to Net Assets:}&{}\\ \hline\text{Plant and Equipment} (\%\ \text{of Ownership Interest}\times \text{difference between book value and fair value}) (20\%\times$30,000)&($6,000)\\ \hline\text{Land} (\%\ \text{of Ownership Interest}\times\text{difference between book value and fair value}) (20\%\times$20,000)&($4,000)\\ =\text{Goodwill}&$158,000\\ \hline\end{array}}$$ 

Note that land and goodwill are not amortized since they have an indefinite useful life.

Fair Value Option

The fair value option is the option at the time of initial recognition to record an equity method investment at fair value. It is only venture capital firms that can opt for fair value under IFRS. However, the fair value option is available to all entities under US GAAP.

Impairment

Equity method investments require periodic reviews for impairment. IFRS recognizes an impairment loss if there is objective evidence of one or more loss events. Further, the recoverable amount of the investment should be less than the carrying amount. The recoverable amount is the higher of “value in use” and “net selling price.”

Under U.S. GAAP, an impairment loss is recognized in the income statement if the fair value of the investment is less than the carrying amount and the decline is considered permanent.

Reversal of an impairment loss is prohibited under IFRS (except for non-goodwill impairment losses) or U.S. GAAP.

Transactions With Associates

An investor can influence the terms and timing of transactions with associates. Therefore, the investor company’s share of any profits resulting from transactions with associates cannot be realized until a third party validates transactions. The investor company’s share of any unrealized profit is deferred by reducing the amount recorded under the equity method. The deferred profit is then added back to the equity income when confirmed.

The investee sells goods to the investor in an upstream sale. The profit is reported in the investee’s income statement. On the other hand, the investor sells goods to the investee in a downstream sale. In this case, the profit is reported in the investor’s income statement. Both the IFRS and U.S. GAAP require the elimination of profits to the extent of the investor’s ownership of the investee.

Business Combinations

Business combinations are typically motivated by expectations of:

1. Value addition through synergies.
2. Potential for increased revenues.
3. Elimination of duplicate costs.
4. Tax advantages.
5. Production process coordination.
6. Efficient assets management.

The investor controls the investee with an equity interest greater than 50%.

There is no difference among business combinations based on the resulting structure of the larger economic entity under IFRS. One party is identified as the acquirer. On the other hand, business combinations are classified as mergers, acquisitions, or consolidations based on the structure after the combination under U.S. GAAP.

• Merger: Company X + Company Y = Company X
• Acquisition: Company X + Company Y = (Company X + Company Y)
• Consolidation: Company X + Company Y = Company Z

Both IFRS and U.S. GAAP require all business combinations to be accounted for using the acquisition method. This method replaced the purchase method.

Acquisition Method

1. Assets and liabilities are reported at their fair values.
2. An acquirer is not required to acquire 100% of the target.
3. A parent-subsidiary relationship ties the acquirer and the acquired together.
4. Both parent and subsidiary prepare their financial statements.
5. The acquirer (parent) is required to provide consolidated financial statements in each reporting period under both IFRS and US GAAP.

• All of the assets, liabilities, revenues, and expenses of the subsidiary are combined with the parent.
• Intercompany transactions are excluded to prevent double counting and premature recognition of income.

Joint Ventures

Under joint ventures, control is shared between two or more investors. Joint ventures can be divided into jointly controlled operations, jointly controlled assets, and jointly controlled entities under IFRS. They are usually accounted for under IFRS using proportionate consolidation. This method requires the venturer’s share of assets, liabilities, income, and the expenses of a joint venture to be combined on a line-by-line basis.

However, a joint venture refers to jointly controlled separate entities under U.S. GAAP. A joint venture employs the equity method of accounting.

Accounting for Joint Venture

The equity method of accounting for joint ventures is required under both IFRS and U.S. GAAP. This method results in a single line item on the income statement and a single line item on the balance sheet.

Joint ventures may be allowed to use proportionate consolidation under IFRS and US GAAP in rare cases. As clarified earlier, proportionate consolidation requires the venturer’s share of assets, liabilities, income, and expenses to be combined on a line-by-line basis. IFRS prefers proportional consolidation because it displays the economic scope of an entity’s operations more effectively when those operations include interests in one or more jointly controlled entities. 

Both methods result in the same total recognized income and net assets. However, ratio analysis between the two methods is significantly different because of different effects on values for total assets, liabilities, sales, and expenses.

Special Purpose and Variable Interest Entities

Suppose a company wants to divide its assets and liabilities for defined finance purposes. It may choose to create a special purpose entity or a variable interest entity as separate legal entities.

Accounting for Special Purpose Vehicles (SPEs)

SPEs are non-operating entities created to meet the specific needs of the sponsoring entity. Formerly, sponsors could avoid consolidating SPEs because they did not have “control” over them. This way, they did not have to report the assets and liabilities of the SPE.

Financial performance as measured by unconsolidated financial statements was possibly misleading. The sponsoring company would show improved asset turnover, lower operating and financial leverage, and higher profitability. For example, Enron used SPEs to obtain off-balance-sheet financing and artificially improve its financial performance. Its subsequent collapse was partly attributable to its guarantee of the debt of the SPEs it had created.

Under IFRS, an SPE must be consolidated if the substance of the relationship indicates control. On the other hand, US GAAP requires the primary beneficiary to consolidate it as its subsidiary regardless of how much of an equity investment it has in the variable interest entity (VIE). A VIE is an entity that is financially controlled by one or more parties that do not hold a majority voting interest.

The primary beneficiary is identified as the entity expected to take up most of the VIE’s expected losses. It receives most of the VIE’s profits or both.

In a case where one entity absorbs the majority of the VIE’s expected losses while the other entity receives a majority of the VIE’s expected profits, the entity absorbing a majority of the losses must consolidate the VIE.

Finally, the non-controlling interests in the VIE are recorded in the consolidated balance sheet and income statement of the primary beneficiary.

Question

United PLC has 40% shareholding in X Ltd, 100% shareholding in Y Ltd, and 25% shareholding in Z Ltd.

United PLC has a contractual right to appoint three-quarters of the board of X Ltd and has used its voting rights to appoint all of the shareholders of Y Ltd.

Which of the following is most likely correct?

1. X Ltd and Y Ltd are associates.
2. Z is an associated company.
3. X Ltd is an associated company. 

Solution

The correct answer is B.

Z is an associated company because United PLC owns more than 20% of voting rights but does not have control.

A is incorrect. This is because United PLC controls the majority of the board of X Ltd and controls a majority of voting rights in Y Ltd.

C is incorrect. This is because United PLC controls the majority of the board of X Ltd.

Reading 11: Intercorporate Investment 

LOS 11 (a) Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for 1) investments in financial assets, 2) investments in associates, 3) joint ventures, 4) business combinations, and 5) special purpose and variable interest entities.