1.  Accounting Treatment of an Investment in a Group Company

Enquiry:      

The query pertains to accounting treatment of an investment in a group company and whether to treat the investment as an associate under IAS – 28 or not.

Companies involved are as follows:

Holding Company A (a public unlisted company) owns 66.66% shares of our Company B (a listed company) and 60.36% of Company C (a private company).

Company B owns 9.09% shares of Company C.

The Management (of Company B) believes that it has no influence on the financial and operating policies of the investee company (Company C) and projecting it as an associate under IAS – 28 will give wrong impression to the shareholders of the Company B (the company is listed). The query pertains to Company B’s investment in Company C.

Holding Company A has placed three non executive directors on the board of the Company B, two of them are also the non executive directors and one is an executive director of Company C.

The management of Company B understands that Company B and Company C are related parties but pleads that these are not associated undertakings under IAS-28 as no significant influence exist over the Company C and so associate accounting should not be done in the consolidated financial statements.

The management has taken its view from IAS-28 itself as it states that:

“If an investor holds, directly or indirectly (e.g. through subsidiaries), 20 per cent or more of the voting power of the investee, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case. (Company C does not hold 20% or more shareholding.)

Conversely, if the investor holds, directly or indirectly (e.g. through subsidiaries), less than 20 per cent of the voting power of the investee, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated. A substantial or majority ownership by another investor does not necessarily preclude an investor from having significant influence. (It clearly states that in less than 20% holding, it should be presumed that it is not significant influence unless some factors demonstrate otherwise and Company has 9.09% shares)”

Further, Standard gives examples of factors which can give rise to significant influence when having less than 20% ownership as follows:

The existence of significant influence by an investor is usually evidenced in one or more of the following ways:

1. representation on the board of directors or equivalent governing body of the investee; (Management pleads that representation on board would mean any of Company B’s employee or executive director on the board of Company C. Merely common directorship through non executive directors does not include representation on the board of directors. None of the employee or executive director of Company B is a director of Company C and therefore Company B has no representation on the Board of Company C).
2. participation in policy-making processes, including participation in decisions about dividends or other distributions; (No decision making rest with Company B)
3. material transactions between the investor and the investee; (The only transaction is purchase of office space in the building being owned and constructed by Company C. The portion is approximately 5% of the total project. Other than that only shares have been purchased of Company C which is 9.09% of total share capital. Company C has not made any investment or any other transaction with Company B.)
4. interchange of managerial personnel; (There is no interchange of managerial personnel) or
5. provision of essential technical information. (None)

Further points to be considered:

1. Holding Company A has placed three non executive directors on the board of the Company B, two of them are also the non executive directors and one is an executive director of Company C.
2. Company B is a listed entity. Management believes that presenting Company C as associate in the financial statements may give a wrong information to minority shareholders.
3. Company C is a private company but has 26% ownership from outside the group and is also bound by the debt contract with the foreign lender as the project is majorly financed by the foreign lender.
4.  Some views suggests that company C is an associate undertaking under IAS 28 based on COMMON DIRECTORSHIP and they believe that investment in group company automatically qualifies for associate accounting.
5.  Shareholding of Company A in Company B and Company C includes shareholding of directors of the company A.
6. The management of Company B has determined that it has no influence on the financial and operating policies of Company C.

Assistance of the esteemed technical committee is requested so that we can follow the treatment in our separate and consolidated financial statements.

Opinion:

Paragraph 7 (a) of IAS 28 ‘Investment in Associate’ as also reproduced in your enquiry clearly says that investor has significant influence when the investing company has representation on the board of directors of the investee.

Based on above, the Committee is of the view that Company C is an associate undertaking as per IAS 28 based on the ground of Common Directorship.

(March 1, 2012)

2.  Presentation of Investments in associates in accordance with the revised IAS

You must be aware that seventeen IASs were recently revised and became applicable in Pakistan with effect from January 01, 2005 and July 01, 2005 depending on whether the year end of the company is December 31, or June 30. As these are being applied for the first time in Pakistan, some issues regarding their interpretation are arising in the application of the same. We would like to bring to your kind notice certain matters with regard to IAS 28 in respect of which we require your guidance, as it affects companies that have investments in associates only.

Paragraph 13 of the revised IAS 28 Investment in Associates requires that investment in an associate should be accounted for using the equity method. Paragraph 35 of the said IAS also states that investment in an associate shall be accounted for in the investors’ separate financial statements in accordance with the requirements of paragraph 37 to 42 of IAS 27 – Consolidated and Separate Financial Statements, which states that associates that are not classified as held for sale should be accounted for at cost or in accordance with IAS 39. However, paragraph 35 does not mandate which entities are required to produce separate financial statements.

Paragraph 3 of IAS 28 states that financial statements in which the equity method is applied are not separate financial statements. Further, paragraph 4 of the said IAS states that separate financial statements may or may not be appended to, or accompany the financial statements. Therefore, it appears that it is not mandatory for a company only with investment in associates to prepare separate financial statements.

We, however, believe that preparation of separate financial statements in which the equity method is not applied is very important from a company’s point of view. Under the equity method, the investment in an associate is initially recorded at cost and the carrying amount of the investment is increased or decreased to recognize the investor’s share of the profit or loss of the associate after acquisition. The investor’s share of the profit or loss of the associate is reflected in the investor’s profit and loss account. Distributions received from the associate reduce the carrying amount of the investment. In our opinion, a company can only pay dividends out of its own profit. The profit for this purpose is accurately reflected in separate financial statements rather than the financial statements based on equity accounting as the proportionate share of the associate’s profit is included in its financial statements, but it may not have received this profit as the same is paid through dividends by the associate. Hence, financial statements prepared only on the basis of the equity method would give the impression to the shareholders that both company’s own profit and the share of the associate’s profit are available for payment of dividend, which is clearly not the case.

Moreover, a company presenting financial statements only under the equity method may face adverse income tax application as its pre-tax profit would increase by its share of the associate’s pre-tax profit. This would unfairly prejudice the company as the accounting and payment of taxation of the associate is already considered in the associate’s individual financial statements.

Section 237 of the Companies Ordinance 1984 requires that a holding company which has subsidiaries should attach to its own financial statements, consolidated financial statements of the group presented as a single enterprise. Therefore, Pakistani law is clear about the requirements for companies with subsidiaries. However, the same is not clear with regard to companies which only have investments in associates.

In order to remove any confusion arising in the shareholder’s mind regarding distributable profits, we have shown investment in associates at cost as we have been doing for many decades, to ensure continuity, but however we seek your clarification and guidance in the matter.

Opinion:

Your attention is drawn towards the following introductory paragraph  of IAS 28:-

IN8. The Standard clarifies that investments in associates over which the investor has significant influence must be accounted for using the equity method whether or not the investor also has investments in subsidiaries and prepares consolidated financial statements. However, the investor does not apply the equity method when presenting separate financial statements prepared in accordance with IAS 27.

Further the following paragraph of the same IAS defines what separate financial statements are:-

4.      Separate financial statements are those presented in addition to consolidated financial statements, financial statements in which investments are accounted for using the equity method and financial statements in which venturers’ interests in joint ventures are proportionately consolidated. Separate financial statements may or may not be appended to, or accompany, those financial statements.

5.      Entities that are exempted in accordance with paragraph 10 of IAS 27 Consolidated and Separate Financial Statements from consolidation, paragraph 2 of IAS 31 Interests in Joint Ventures from applying proportionate consolidation or paragraph 13(c) of this Standard from applying the equity method may present separate financial statements as their only financial statements.

However, there are certain exemptions to the application of the equity method which are given in the following paragraph of IAS 28:

13.     An investment in an associate shall be accounted for using the equity method except when:

(a)      the investment is classified as held for sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations;

(b)     the exception in paragraph 10 of IAS 27, allowing a parent that also has an investment in an associate not to present consolidated financial statements, applies; or

(c)      all of the following apply:

(i)      the investor is a wholly-owned subsidiary, or is 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 investor not applying the equity method;

 (ii)    the investor’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);

(iii)    the investor 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; and

(iv)     the ultimate or any intermediate parent of the investor produces consolidated financial statements available for public use that comply with International Financial Reporting Standards.

In view of the above the Committee is of the opinion that a company having investment in associate (as per IAS 28) only would be required to account for such investment in its financial statements using the equity method except for the exemption stated in paragraph 13 above. The said company may or may not enclose separate financial statements along with these financial statements. However, if it decides to do so the requirements of paragraph 37 to 42 of IAS 27 must be followed in letter and spirit.

(February 4, 2006)