3.2.2.A Lack of significant influence

The presumption of significant influence due to the existence of 20% or more of the voting power can sometimes be rebutted, for example when (see section 4.1 of Chapter 11 of EY International GAAP 2019):

• the investor has failed to obtain representation on the investee's board of directors;
• the investee or other shareholders are opposing the investor's attempts to exercise significant influence;
• the investor is unable to obtain timely financial information or cannot obtain more information – required to apply the equity method – than shareholders that do not have significant influence; or
• a group of shareholders that holds the majority ownership of the investee operates without regard to the views of the investor.

Determining whether the presumption of significant influence has been rebutted requires considerable judgement and sufficient evidence to justify rebutting the presumption.

3.2.2.B Holdings of less than 20% of the voting power

Although there is a presumption that an investor that holds less than 20% of the voting power in an investee cannot exercise significant influence, [FRS 102.14.3(b)], where investments give rise to only slightly less than 20% of the voting power careful judgement is needed to assess whether significant influence may exist.

For example, an investor may be able to exercise significant influence in the following circumstances:

• the investor's voting power is much larger than that of any other shareholder of the investee;
• the corporate governance arrangements may be such that the investor is able to appoint members to the board, supervisory board or significant committees of the investee. The investor will need to apply judgement to determine whether representation in the respective boards or committees is enough to provide significant influence; or
• the investor has the power to veto significant financial and operating decisions.

3.2.2.C Voting rights in UK company law

The provisions of paragraphs 5 to 11 of Schedule 7 to the 2006 Act (parent and subsidiary undertakings: rights to be taken into account and attribution of rights) apply in determining whether an undertaking holds 20% or more of the voting rights in another undertaking. [6 Sch 19(4)].

The ‘voting rights ’ in an undertaking are the rights conferred on shareholders in respect of their shares or, in the case of an undertaking not having a share capital, on members, to vote at general meetings of the undertaking on all, or substantially all, matters. [6 Sch 19(3)].

Voting rights on shares held as security remain the rights of the provider of the security, and are not taken into account if the rights are only exercisable in accordance with instructions from the provider of the security or in his interest. [7 Sch 8 (CA)]. Similarly, voting rights that are held in a fiduciary capacity by the entity are treated as not held by the entity. [7 Sch 6 (CA)]. Voting rights held by a nominee on behalf of the entity should be treated as held by the entity. Rights are regarded as held as nominee for another if the rights are only exercisable on the other's instruction or with the other's consent. [7 Sch 7 (CA)].

The voting rights referred to above should be reduced by any rights held by the undertaking itself. [7 Sch 10 (CA)].

3.2.2.D Potential voting rights

An entity may own share warrants, share call options, debt or equity instruments that are convertible into ordinary shares, or other similar instruments that have the potential, if exercised or converted, to give the entity voting power or reduce another party's voting power over the financial and operating policies of another entity (potential voting rights).

Section 14 requires that an entity should consider the existence and effect of potential voting rights in deciding whether significant influence exists. [FRS 102.14.8(b)]. Whilst not explicitly stated in Section 14, by using the GAAP hierarchy in Section 10, and applying the guidance in Section 9 Paragraph 6, such potential voting rights should only be considered if they are currently exercisable or convertible.

Potential voting rights are not currently exercisable or convertible when they cannot be exercised or converted until a future date or until the occurrence of a future event. The meaning of currently exercisable or convertible is discussed further in Chapter 8 at 3.2.1.

Consistent with that discussion, IAS 28 (on which the requirements of Section 14 are based) states that in assessing whether potential voting rights contribute to significant influence, an entity must examine all facts and circumstances (including the terms of exercise of the potential voting rights (both of the reporting entity and of other parties) and any other contractual arrangements whether considered individually or in combination) that affect potential voting rights, except the intention of management and the financial ability to exercise or convert those potential voting rights. [IAS 28.8].

3.2.2.E Voting rights held in a fiduciary capacity

Voting rights on shares held as security by an entity remain the rights of the provider of the security, and are generally not taken into account if the rights are only exercisable in accordance with instructions from the provider of the security or in his interest. Similarly, voting rights that are held in a fiduciary capacity may not be those of the entity itself. However, if voting rights are held by a nominee on behalf of the entity, they should be taken into account. [7 Sch 6-7 (CA)].

3.3.1.A Investor not a parent

An entity that is not a parent shall account for its investments in associates in its individual financial statements using either:

• the cost model (see 3.3.3 below);
• fair value with changes in other comprehensive income (unless reversing a revaluation decrease of the same investment previously recognised in profit or loss, in which case the revaluation increase is recognised in profit or loss, or where a revaluation decrease exceeds increases previously recognised in respect of the same investment, in which case the excess is recognised in profit or loss) (see 3.3.4 or below); or
• fair value with changes in fair value recognised in profit or loss (see 3.3.4 below and Chapter 4). [FRS 102.14.4].

The measurement options are an accounting policy choice. Section 14 does not contain the additional guidance in Section 9 that requires a parent to apply the same accounting policy for all investments in a single class. [FRS 102.9.26]. A class is a grouping of assets of a similar nature and use in an entity's operations. However, applying the FRS 102 GAAP hierarchy discussed in Chapter 9 at 3.2, it would seem logical for the same accounting policy to be applied to the same class of associates. A discussion of the meaning of class of investment in this context is in Chapter 8 at 4.2 and, in our view, associates held as part of an investment portfolio, which are required to be measured at fair value through profit or loss, are a separate class of investment.

There is no option in Section 14 to use the equity method of accounting in individual financial statements even though permitted by Regulations. However, the individual financial statements of an investor that is not a parent must disclose summarised financial information about its investments in associates, along with the effect of including those investments as if they had been accounted for using the equity method. Investing entities that are exempt from preparing consolidated financial statements, or would be exempt if they had subsidiaries, are exempt from this requirement. [FRS 102.14.15A].

Schedule 1 to the Regulations permits the equity method of accounting to be applied in respect of participating interests in the individual entity accounts of an investor. [1 Sch 29A]. However, this option cannot be applied by an investor in preparing their individual entity accounts in accordance with FRS 102 as it is not available in paragraph 14.4 of Section 14. [FRS 102.BC.A.28].

3.3.1.B Investor that is a parent

An investor that is a parent should, in its consolidated financial statements, account for all of its investments in associates using the equity method of accounting (see 3.3.2 below). [FRS 102.14.4A].

The exception to this is when the investment in an associate is held as part of an investment portfolio. These investments shall be measured at fair value with changes in fair value recognised in profit or loss in the consolidated financial statements. [FRS 102.14.4B].

An investment is held as part of an investment portfolio if its value to the investor is through fair value as part of a directly or indirectly held basket of investments rather than as a media through which the investor carries out business. A basket of investments is indirectly held if an investment fund holds a single investment in a second investment fund which, in turn, holds a basket of investments. In some circumstances, it may be appropriate for a single investment to be considered an investment portfolio, for example when an investment fund is first being established and is expected to acquire additional investments. (see Chapter 8 at 3.4.2.A). [FRS 102 Appendix I].

An entity that is a parent should account for its investments in associates in its separate financial statements in accordance with paragraphs 9.26 and 9.26A of Section 9 (see Chapter 8 at 4.2). [FRS 102.14.1].

3.3.2.A Date of commencement of equity accounting

An investor begins equity accounting for an associate from the date on which it gains significant influence over the associate (and is not otherwise exempt from equity accounting for it). In most situations, this will be when the investor purchases the investment in the associate. However, it may be that the investor only obtains significant influence over the investee at some date after having purchased its ownership interest. FRS 102 does not explicitly deal with this situation, but the investor should account for the associate by applying its selected accounting policy for such piecemeal acquisitions as discussed at 4.1.2 below.

3.3.2.B Distributions and other adjustments to carrying amount

Distributions received from an associate will reduce the carrying amount of the investment. Adjustments to the carrying amount may also be necessary due to changes in the associate's equity from items of its other comprehensive income. [FRS 102.14.8(a)].

Such changes could include those arising from the revaluation of property, plant and equipment and from foreign exchange translation differences. The investor's share of the investee's other comprehensive income is recognised in the investor's statement of comprehensive income. [FRS 102.5.5A]. Distributions received in excess of the carrying amount of the associate are dealt with at 4.2 below.

3.3.2.C Potential voting rights and share of the investee

In applying the equity method, the proportionate share of the associate to be accounted for, in many cases, will be based on the investor's ownership interest in the ordinary shares of the investee.

Although potential voting rights need to be considered in determining whether significant influence exists (see 3.2.2.D above) an investor should measure its share of profit or loss and other comprehensive income of the associate as well as its share of changes in the associate's equity based on present ownership interests. Those measurements should not reflect the possible exercise or conversion of potential voting rights. [FRS 102.14.8(b)].

If an associate has outstanding cumulative preference shares that are held by parties other than the investor and that are classified as equity, the investor should compute its share of profits or losses after adjusting for the dividends on such shares, whether or not the dividends have been declared.

If the investor also owned all of the cumulative preference shares then its share in the net assets of the associate would be £42,300 + £50,000 + £9,000 = £101,300. Its share in the net profit would be £6,000 + £4,500 = £10,500.

When an associate has a complicated equity structure with several classes of equity shares that have varying entitlements to net profits and equity, the investor needs to assess carefully the rights attaching to each class of equity share in determining the appropriate percentage of ownership interest.

Section 14 does not address the situation where in a group, shares in the associate are held by the parent and its subsidiaries. However, based on the requirements of IAS 28, it is clear that a group's share in an associate is the aggregate of the holdings in that associate by the parent and its subsidiaries. Holdings in the associate by the group's other associates or joint ventures are ignored for this purpose. [IAS 28.27].

Section 14 does not address the situation where an associate itself has subsidiaries, associates or jointly controlled entities. However, based on the Companies Act 2006 (CA 2006) and the requirements of IAS 28, it is clear that profits or losses, other comprehensive income and net assets taken into account when the investor applies the equity method should be those recognised in the associate's consolidated financial statements, but after any adjustments necessary to give effect to uniform accounting policies (see 3.3.2.H below).

It may be that the associate does not own all the shares in some of its subsidiaries, in which case its consolidated financial statements will include non-controlling interests. Under the CA 2006, any non-controlling interests are presented in the consolidated statement of financial position within equity, separately from the equity of the owners of the parent. Profit or loss and each component of other comprehensive income are attributed to the owners of the parent and to the non-controlling interests. [FRS 102.6.3(a)].

The profit or loss and other comprehensive income reported in the associate's consolidated financial statements will include 100% of the amounts relating to the subsidiaries, but the overall profit or loss and total comprehensive income will be split between the amounts attributable to the owners of the parent (i.e. the associate) and those attributable to the non-controlling interests. The net assets in the associate's consolidated statement of financial position will also include 100% of the amounts relating to the subsidiaries, with any non-controlling interests in the net assets presented in the consolidated statement of financial position within equity, separately from the equity of the owners of the parent.

Section 14 does not address whether the investor's share, for equity accounting purposes, of the associate's profits, other comprehensive income and net assets should be based on the amounts before or after any non-controlling interests in the associate's consolidated financial statements. However, as the investor's interest in the associate is as an owner of that associate (which is itself a parent), it is appropriate that the share should be based on the profit or loss, comprehensive income and equity (net assets) that are reported as being attributable to the owners of the parent in the associate's consolidated financial statements, i.e. after any amounts attributable to the non-controlling interests.

3.3.2.D Implicit goodwill and fair value adjustments

Section 14 states that on acquisition of an investment in an associate, any difference between the cost of acquisition and the investor's share of the net fair values of the investee's identifiable assets and liabilities should be accounted for in accordance with Section 19 as implicit goodwill (see Chapter 17 at 3.9), as follows: [FRS 102.14.8(c)]

• any goodwill relating to an associate is included in the carrying amount of the investment. After initial recognition, the acquirer shall measure goodwill included in the carrying amount of the investment at cost less accumulated amortisation (but not impairment, see 3.3.2.E below). Goodwill shall be considered to have a finite useful life and shall be amortised on a systematic basis over its life. If, in exceptional cases, an entity is unable to make a reliable estimate of the useful life of goodwill, the life shall not exceed 10 years. Any amortisation shall be recognised against the investor's share of the associate's profit or loss; [FRS 102.19.23]
• if the acquirer's interest in the net amount of the associate's identifiable assets, liabilities and provisions for contingent liabilities exceeds the cost of the investment (also referred to as negative goodwill), the acquirer must (after reassessing the identification and measurement of the acquiree's assets and liabilities and the measurement of the cost of the combination) recognise the excess up to the fair value of the non-monetary assets acquired in the associate's profit or loss in the periods in which the non-monetary assets are recovered. Any excess exceeding the fair value of the non-monetary assets acquired shall be recognised in profit or loss in the periods expected to be benefited (see Chapter 17 at 3.9.3). [FRS 102.19.24].

Section 14 also states that an investor should adjust its share of the associate's profits or losses after acquisition in order to account, for example, for additional depreciation or amortisation of the depreciable assets or amortisable assets (including goodwill) on the basis of the excess of their fair values over their carrying amounts at the time the investment was acquired. [FRS 102.14.8(c)].

3.3.2.E Impairment

An entity will have to test the carrying value of its investment in an associate for impairment only if an event has occurred that indicates that it will not recover the carrying value. [FRS 102.27.7].

The most common of these events, trading losses in the associate, will automatically have been taken into account in determining the carrying value of the investment, leaving only the remaining net carrying amount (i.e. after deducting the share of trading losses) to be assessed for impairment.

Determining whether an investment in an associate is impaired may be more complicated than is apparent at first sight, as it involves carrying out several separate impairment assessments:

• Underlying assets of the associate

  It is generally not appropriate for the investor simply to multiply the amount of the impairment charge recognised in the investee's own books by the investor's percentage of ownership, because the investor should measure its interest in an associate's identifiable net assets at fair value at the date of acquisition of an associate (see 3.3.2.D above). Therefore, if the value that the investor attributes to the associate's net assets differs from the carrying amount of those net assets in the associate's own books, the investor should restate any impairment losses recognised by the associate and also needs to consider whether it needs to recognise any impairments that the associate itself did not recognise in its own books.

  Any goodwill recognised by an associate needs to be separated into two elements. Goodwill that existed at the date the investor acquired its interest in the associate is not an identifiable asset of the associate from the perspective of the investor. That goodwill should be combined with the investor's goodwill on the acquisition of its interest in the associate and any impairment losses of that goodwill recognised in the financial statements of the associate should be reversed when the investor applies the equity method. However, goodwill that arises on subsequent acquisitions by the associate should be accounted for as such in the books of the associate and tested for impairment in accordance with Section 27 – Impairment of Assets – by the associate. The investor should not make any adjustments to the associate's accounting for that goodwill.

• Investment in the associate

  As well as reflecting any impairment in the underlying assets of the associate using the equity method as discussed above, Section 14 requires an investor to test the overall investment in the associate for impairment as a single asset in accordance with Section 27. Any goodwill included as part of the carrying amount of the investment in the associate is not tested separately for impairment but is tested as part of the overall investment as a whole. [FRS 102.14.8(d)].

• Other interests that are not part of the equity interest in the associate

  The investor must also apply Section 11 – Basic Financial Instruments – in order to determine whether it is necessary to recognise any additional impairment loss with respect to that part of the investor's interest in the associate that does not comprise its net investment in the associate. This could include, for example, trade receivables and payables, and collateralised long-term receivables, but might also include preference shares or loans (see 3.3.2.I below). In this case, however, the impairment is calculated in accordance with Section 11, and not Section 27.

Where the carrying amount of an investment in an associate is tested for impairment in accordance with Section 27, an impairment loss is recognised against the entire investment and is not allocated to any individual asset, including goodwill, which forms part of the carrying amount of the associate. In addition, any reversal of that impairment loss is recognised to the extent that the recoverable amount of the investment exceeds the carrying amount, subject to the reversal not exceeding the carrying amount that would have been determined had no impairment loss been recognised in previous years. [FRS 102.27.30].

In accounting for its associate, Entity B, in its consolidated financial statements for the year ended 31 December 2019, should Entity A reflect its 40% share of this impairment loss of £140,000?

As indicated above, it is generally not appropriate for the investor simply to multiply the amount of the impairment recognised in the investee's own books by the investor's percentage of ownership, because the investor should initially measure its interest in an associate's identifiable net assets at fair value at the date of acquisition of an associate. Accordingly, appropriate adjustments based on those fair values are made for impairment losses recognised by the associate (see 3.3.2.D above).

Prior to the recognition of the impairment loss by Entity B, the carrying amount of Entity A's 40% interest in the net assets of Entity B, after reflecting fair value adjustments made by Entity A at the date of acquisition, together with the goodwill arising on the acquisition is as follows:

In applying the equity method, Entity A should compare its 40% share of the cash flows attributable to each of Entity B's CGUs to determine the impairment loss it should recognise in respect of Entity B. Accordingly, in equity accounting for its share of Entity B's profit or loss, Entity A should recognise an impairment loss of £180,000 calculated as follows:

In addition, after applying the equity method, Entity A should calculate whether any further impairment loss is necessary in respect of its investment in its associate.

The carrying amount of Entity A's investment in Entity B under the equity method after reflecting the impairment loss of £180,000 would be as follows:

Based on Entity A's 40% interest in the total recoverable amount of Entity B of £460,000, Entity A would not recognise any further impairment loss in respect of its investment in the associate.

It should be noted that the impairment loss recognised by Entity A of £180,000 is not the same as if it had calculated an impairment loss on its associate as a whole i.e. by comparing its 40% share of the total recoverable amount of Entity B of £460,000 to its investment in the associate of £600,000 (prior to reflecting any impairment loss on its share of Entity B's net assets). Such an approach would only be appropriate if Entity B did not have more than one CGU.

3.3.2.F Investor's transactions with associates

Section 14 requires unrealised profits and losses resulting from what it refers to as ‘upstream’ (associate to investor) and ‘downstream’ (investor to associate) transactions between an investor (including its consolidated subsidiaries) and an associate to be eliminated from the investor's financial statements to the extent of investor's interest in the associate. Unrealised losses on such transactions may provide evidence of an impairment of the asset transferred. [FRS 102.14.8(e)].

‘Upstream’ transactions are, for example, sales of assets from an associate to the investor. ‘Downstream’ transactions are, for example, sales or contributions of assets from the investor to its associate.

Section 14 provides no further guidance as to how this broadly expressed requirement translates into accounting entries, but we suggest that the following would be appropriate:

• in the income statement, the adjustment should be taken against either the investor's profit or the share of the associate's profit, according to whether the investor or the associate recorded the profit on the transaction, respectively; and
• in the statement of financial position:
  • if the asset subject to the transaction is held by the associate, the adjustment should be made against the carrying amount for the associate (illustrated at Example 12.6 below); or
  • if the asset subject to the transaction is held by the investor, entities have an accounting policy choice as to where the adjustment is made. It would be acceptable to make the adjustment either against the carrying amount for the associate or against the asset which was the subject of the transaction. This latter approach is illustrated in Example 12.7 below.

Examples 12.6 and 12.7 below illustrate the adjustment against the asset which is the subject of the transaction. Both examples deal with the reporting entity H and its 40% associate A. The journal entries are based on the premise that H's financial statements are initially prepared as a simple aggregation of H and the relevant share of its associate. The entries below would then be applied to the numbers at that stage of the process.

This effectively defers recognition of 40% of the sale and offsets the deferred profit against the carrying amount of H's investment in A.

During 2019, when the inventory is sold on by A, this deferred profit can be released to group profit or loss, reflected by the following accounting entry.

Opening reserves are adjusted because the financial statement working papers (if prepared as assumed above) will not include the consolidation adjustments and will already include this profit in opening reserves, since it forms part of H's opening reserves.

An alternative approach would be to eliminate the profit on 40% of the sale against the cost of sales, as follows:

An argument in favour of this approach is that the revenue figures should not be adjusted because the sales to associates need to be disclosed as related party transactions. However, this may be outweighed by the drawback of the approach, namely that it causes volatility in H's reported gross margin as revenue and the related net margin are not necessarily recognised in the same accounting period.

In the following period when the inventory is sold H's separate financial statements will record a profit of £200,000 and A's individual financial statements will record no profit. On consolidation, the total profit must be increased by the £100,000 deferred from the previous period. The entry is:

Again, opening reserves are adjusted because the financial statement working papers (if prepared as assumed above) will already include this profit in opening reserves, this time, however, as part of H's share of the opening reserves of A.

A slightly counter-intuitive consequence of this treatment is that at the end of 2019 the investment in A in H's consolidated statement of financial position will have increased by £100,000 more than the share of profit of associates as reported in group profit or loss and in 2020 by £100,000 less (this would be avoided if the adjustment were to be made against the carrying amount of the associate). This is because the statement of financial position adjustment at the end of 2019 is made against inventory rather than the carrying value of the investment in A, which could be seen as reflecting the fact that A has, indeed, made a profit. It might therefore be necessary to indicate in the notes to the financial statements that part of the profit made by A is regarded as unrealised by the group in 2019 and has therefore been deferred until 2020 by offsetting it against inventory.

Note that unrealised losses on upstream and downstream transactions may provide evidence of an impairment in the asset transferred. [FRS 102.14.8(e)].

The effect of these requirements is illustrated in Examples 12.8 and 12.9 below.

1. £8 million received from B.
2. Loss on sale of property £2 million (£8 million received from B less £10 million carrying value = £2 million) not adjusted since the transaction indicated an impairment of the property. In effect, it is the result that would have been obtained if A had recognised an impairment charge immediately prior to the sale and then recognised no gain or loss on the sale.
3. Derecognition of A's original property.

1. £7 million paid to B not adjusted since the transaction indicated an impairment of B's asset.
2. Loss in B's books is £1 million (£8 million cost of property less £7 million proceeds of sale). A recognises its 40% share because the transaction indicates an impairment of the asset. In effect, it is the result that would have been obtained if B had recognised an impairment charge immediately prior to the sale and then recognised no gain or loss on the sale.
3. £7 million consideration for the property.

Elimination of ‘downstream’ unrealised profits in excess of the investment

Occasionally an investor's share of the unrealised profit on the sale of an asset to an associate exceeds the carrying value of the investment held. In that case, to what extent is any profit in excess of the carrying value of the investment eliminated?

Section 14 provides no guidance on the elimination of ‘downstream’ unrealised gains in excess of the investment. Consequently, an investor needs to determine an appropriate policy for dealing with such a situation. We believe that the investor could either recognise the excess as ‘deferred income’ or restrict the elimination to the amount required to reduce the investment to zero.

Loans and borrowings between the reporting entity and its associates

The requirement in section 14 to eliminate partially unrealised profits or losses on transactions with associates is expressed in terms of transactions. In our view, the requirement for partial elimination of profits does not apply to items such as interest paid on loans and borrowings between the reporting entity and its associates, since such loans and borrowings do not involve the transfer of assets giving rise to gains or losses. Moreover, they are not normally regarded as part of the investor's share of the net assets of the associate, but as separate transactions, except in the case of loss-making associates, where interests in long-term loans and borrowings may be required to be accounted for as if they were part of the reporting entity's equity investment in determining the carrying value of the associate against which losses may be offset (see 3.3.2.I below). Likewise, loans and borrowings, and indeed other payables and receivables, between the reporting entity and its associates should not be eliminated in the reporting entity's consolidated accounts because associates are not part of the group.

However, if the associate has capitalised the borrowing costs then the investor would need to eliminate a relevant share of the profit, in the same way it would eliminate a share of the capitalised management or advisory fees charged to an associate.

Cash flow statement

FRS 102 is silent on how cash flows relating to transactions with an associate should be presented in the consolidated cash flow statement. It is generally accepted that no adjustment should be made in respect of these cash flows, as the associate is not a member of the group and hence is not subject to the requirements on elimination of intragroup transactions as set out in paragraph 15 of Section 9. This contrasts with the requirement, in any consolidated statement of cash flows, to eliminate the cash flows between members of the group in the same way that intragroup transactions are eliminated in the profit and loss account and statement of financial position.

3.3.2.G Date of associate's financial statements

In applying the equity method, the investor should use the financial statements of the associate as of the same date as the financial statements of the investor unless it is impracticable to do so. [FRS 102.14.8(f)].

Applying a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so. [FRS 102 Appendix I].

Otherwise an investor should use the most recent available financial statements of the associate. Adjustments must then be made for the effects of significant transactions or events, for example a sale of a significant asset or a major loss on a contract, that occurred between that date and the date of the investor's financial statements. [FRS 102.14.8(f)]. There are no exemptions from this requirement despite the fact that it may be quite onerous in practice, for example, because the associate might need to produce non statutory or interim financial statements so that the investor can comply with this requirement.

3.3.2.H Associate's accounting policies

If an associate uses accounting policies different from those of the investor for like transactions and events in similar circumstances, adjustments must be made to conform the associate's accounting policies to those of the investor when the associate's financial statements are used by the investor in applying the equity method unless it is impracticable to do so. [FRS 102.14.8(g)].

In practice, this may be difficult, since an investor's influence over an associate, although significant, may still not be sufficient to ensure access to the relevant underlying information in sufficient detail to make such adjustments with certainty. Restating the financial statements of an overseas associate to FRS 102 may require extensive detailed information that may simply not be required under the associate's local GAAP (for example, in respect of business combinations, share-based payments, financial instruments and revenue recognition).

3.3.2.I Losses in excess of investment

An investor in an associate should recognise its share of the losses of the associate until its share of losses equals or exceeds the carrying amount of its investment in the associate, at which point the investor discontinues recognising its share of further losses. [FRS 102.14.8(h)].

Once the investor's interest is reduced to zero, additional losses are provided for, and a liability is recognised in accordance with Section 21 – Provisions and Contingencies (see Chapter 19), but only to the extent that the investor has incurred legal or constructive obligations or made payments on behalf of the associate. If the associate subsequently reports profits, the investor resumes recognising its share of those profits only after its share of the profits equals the share of losses not recognised. The practical effect of this is that an entity needs to track the off balance sheet losses of its associates in order to calculate subsequent income to be recognised from that associate. [FRS 102.14.8(h)].

In addition to the recognition of losses arising from application of the equity method, an investor in an associate must consider the requirements of Section 27 in respect of impairment losses. An investor also needs to consider Section 11 in order to determine whether it is necessary to recognise any additional impairment loss with respect to that part of the investor's interest in the associate that does not comprise its net investment in the associate (see 3.3.2.E above).

Section 14 does not address any long-term interests that, in substance, form part of the investor's net investment in the associate. For example, an item for which settlement is neither planned nor likely to occur in the foreseeable future might be regarded as being, in substance, an extension of the entity's investment in that associate. An investor would need to consider whether these interests are recoverable in accordance with Section 27. IAS 28, on which Section 14 is based, considers that such items include: [IAS 28.38]

• preference shares; or
• long-term receivables or loans (unless supported by adequate collateral), but do not include:
  • trade receivables;
  • trade payables; or
  • any long-term receivables for which adequate collateral exists, such as secured loans.

3.3.2.J Discontinuing the equity method

An investor discontinues the use of the equity method from the date that significant influence ceases. The subsequent accounting depends upon the nature of the retained investment.

If the associate becomes a subsidiary (because control is obtained), it will be accounted for in accordance with Section 19 (i.e. a step-acquisition, see Chapter 17 at 2.10).

If an investment in an associate becomes an investment in a joint venture it will account for its investment in accordance with Section 15 – Investments in Joint Ventures (i.e. it will continue to be accounted for under the equity method, see Chapter 13).

Otherwise the retained investment should be accounted for as a financial asset in accordance with Section 11 or Section 12 – Other Financial Instruments Issues – as discussed below. [FRS 102.14.8(i)].

If an investor disposes of some or all of its investment, such that it no longer has significant influence over the investee, it will discontinue the use of the equity method. In such situations, the entity derecognises the associate and recognises in profit or loss any difference between the:

1. the proceeds from the disposal; and
2. the carrying amount of the investment in the associate relating to the proportion disposed of or lost at the date significant influence is lost. [FRS 102.14.8(i)(i)].

The investor accounts for any retained interest as a financial asset in accordance with Section 11 or Section 12 as appropriate. The carrying amount of the proportion retained in the investment at the date that it ceases to be an associate shall be regarded as its cost on initial measurement as a financial asset.

Where an investor ceases to have significant influence due to a change in circumstances other than by partial disposal, for example, as a result of changes to the board of directors or equivalent governing body of the associate that results in a loss of significant influence, the investor will discontinue the use of the equity method. In that case, the investor does not recognise a profit or loss, but regards the carrying amount of the investment at that date as the new cost basis in accordance with Sections 11 or 12. [FRS 102.14.8(i)(ii)].

If an investor loses significant influence as a result of a disposal the gain or loss arising on that disposal shall also include amounts recognised in other comprehensive income in relation to that associate where those amounts are required to be reclassified to profit or loss on disposal. [FRS 102.14.8(i)]. Under FRS 102 this includes cash flow hedges which have not yet been reclassified to profit or loss. Amounts that are not required to be reclassified to profit or loss upon disposal shall be transferred directly to retained earnings. [FRS 102.14.8(i)].

A deemed disposal, for example, where the associate has issued shares to a new investor, would be accounted for as a regular disposal and hence a profit or loss would be recognised as set out above. The original investor would need to consider whether any profit resulting from the transaction is realised or unrealised. If unrealised, it would be taken to other comprehensive income and not to profit or loss.

3.3.2.K Transactions to create an associate

An investor may exchange a business, or other non-monetary asset, for an interest in another entity, and that other entity becomes an associate of the investor. The accounting issues that arise from these transactions are whether they should be accounted for at fair value or at previous book values and how the gain on the transaction should be reported.

The requirements in respect of such transactions are set out in Section 9 (see Chapter 8 at 3.8). The principles are that the only exception to the use of fair values should be in rare circumstances where the transaction is artificial and has no substance and that any unrealised gains should not be reported in profit or loss.

Accordingly, the following accounting treatment should be applied in the consolidated financial statements of the reporting entity:

• to the extent that the reporting entity retains an ownership interest in the business, or other non-monetary assets, exchanged, even if that interest is then held through the associate, that retained interest, including any related goodwill, is treated as having been owned by the reporting entity throughout the transaction and should be included at its pre-transaction carrying amount;
• goodwill is recognised as the difference between:
  • the fair value of the consideration given; and
  • the fair value of the reporting entity's share of the pre-transaction identifiable net assets of the other entity.

  The consideration given for the interest acquired in the associate will include that part of the business, or other non-monetary assets, exchanged and no longer owned by the reporting entity. The consideration may also include cash or monetary assets to achieve equalisation of values. Where it is difficult to value the consideration given, the best estimate of its value may be given by valuing what is acquired;

• to the extent that the fair value of the consideration received by the reporting entity exceeds the carrying value of the part of the business, or other non-monetary assets exchanged and no longer owned by the reporting entity, and any related goodwill together with any cash given up, the reporting entity should recognise a gain. Any unrealised gain arising on the exchange is recognised in other comprehensive income; and
• to the extent that the fair value of the consideration received by the reporting entity is less than the carrying value of the part of the business, or other non-monetary assets no longer owned by the reporting entity, and any related goodwill, together with any cash given up, the reporting entity should recognise a loss. The loss should be recognised as an impairment in accordance with Section 27 or, for any loss remaining after an impairment review of the relevant assets, in profit or loss. [FRS 102.9.31].

The most common situation for these transactions in practice is the contribution of a business for equity in an associate (or joint venture).

Examples 13.7 and 13.8 in Chapter 13 illustrate the required accounting for such transactions.

Section 9 does not explain how a realised gain can be distinguished from an unrealised gain. In Example 13.8 in Chapter 13, we have used a ‘top slicing’ approach whereby as much of the total gain as is backed by cash is treated as realised (i.e. £10m). ‘Top slicing’ is the recommended approach in determining realised profits for exchanges of assets in paragraph 3.18 of the ICAEW/ICAS TECH 02/17BL – Guidance on Realised and Distributable Profits under the Companies Act 2006. Paragraph 3.18A of the guidance states that when the consideration received comprise a combination of assets and liabilities, the profit will be realised only to the extent of any net balance (i.e. cash less liabilities) of qualifying consideration received.

No gain or loss is recognised in those rare cases where the artificiality or lack of substance of the transaction is such that a gain or loss on the exchange could not be justified. When a gain or loss on the exchange is not taken into account because the transaction is artificial or has no substance, the circumstances should be explained. [FRS 102.9.32]. There is no elaboration in the standard as to the circumstances where this might be applicable.

3.4.2.A General requirements

In both consolidated and individual financial statements where an entity holds an investment in an associate the following should be disclosed:

• the accounting policy for investments in associates;
• the carrying amount of investments in associates; and
• the fair value of investments in associates accounted for using the equity method for which there are published price quotations. [FRS 102.14.12].

3.4.2.B Consolidated financial statements

An investor shall disclose separately:

• its share of the profit or loss of associates accounted for in accordance with the equity method; and
• its share of any discontinued operations of such associates. [FRS 102.14.14].

3.4.2.C Individual financial statements of investors that are not parents

An investor should disclose:

• summarised financial information about the investments in associates ; and
• the effect of including those investments as if they had been accounted for using the equity method. [FRS 102.14.15A].

Summarised financial information is not defined in FRS 102, but using the GAAP hierarchy to refer to IFRS 12 – Disclosure of Interests in Other Entities, it would seem appropriate to include: current assets, non-current assets, current liabilities, non-current liabilities, revenue, profit or loss from continuing operations, post-tax profit or loss from discontinued operations, other comprehensive income, total comprehensive income. This list is not exhaustive and other items may need to be considered if deemed material. [IFRS 12 Appendix B.12].

For investments accounted for in accordance with the cost model, an investor is required to disclose the amount of dividends and any other distributions recognised as income. [FRS 102.14.13].

For investments in associates accounted for in accordance with fair value through other comprehensive income, an investor shall make the disclosures required by Section 11 paragraphs 11.43 and 11.44 (this is notwithstanding the fact that paragraph 11.43 refers to fair value through profit or loss, but the intention is clearly to make these disclosures for fair value through other comprehensive income): [FRS 102.14.15]

• the basis for determining fair value (e.g. quoted market price in an active market or a valuation technique. If the latter is used, the assumptions applied in determining fair value for each class of financial assets or liabilities must be disclosed); and
• if a reliable measure of fair value is no longer available for financial instruments that would otherwise be required to be measured at fair value through profit or loss this fact shall be disclosed and the carrying amount of those financial instruments.

For investments in associates accounted for at fair value through profit or loss, the above disclosures will also apply (see Chapter 6 at 10.3.1.D.

Investors in associates that are exempt from preparing consolidated financial statements, or would be exempt if they had any subsidiaries, are exempt from these requirements. [FRS 102.14.15A]. This would apply to an entity which failed the small company criteria and which had no subsidiaries, but only associates and joint ventures.

3.4.2.D Additional company law disclosures – consolidated financial statements

The Regulations also require that the following information must be given where an undertaking included in the consolidation has an interest in an associated undertaking:

• the name of the associate;
• the country in which the associate is incorporated for those incorporated outside the United Kingdom;
• the address of the registered office of the associate;
• The identity and proportion of the nominal value of each class of share held disclosing separately those held by the:
  • parent company; and
  • group. [4 Sch 19].

3.4.2.E Additional company law disclosures – individual financial statements

In individual financial statements the Regulations require additional disclosures in respect of significant holdings in undertakings, other than subsidiary entities. A holding is deemed significant if:

• it amounts to 20% or more of the nominal value of any class of shares in the undertaking; or
• the amount of the holding as stated in the company's individual accounts exceeds 20% of the stated net assets of the company. [4 Sch 4].

In practice, this definition will capture most investments in associates. The resulting disclosures in individual financial statements are:

• the name of each associate;
• the address of the registered office of each associate;
• the address of each associate's principal place of business if unincorporated;
• the identity and proportion of the nominal value of each class of share held. [4 Sch 5].

For each associate detailed above there must also be disclosed the aggregate amount of the capital and reserves as at the end of its relevant financial year of each entity and its profit or loss for that year (unless the associate is not required to publish its balance sheet anywhere in the world and the holding is less than 50% of the nominal value of the shares, or the information is not material). [4 Sch 6].

A parent that is exempt under sections 400 or 401 of the Act from the requirement to prepare group accounts is not required to give the additional disclosures listed above in its separate financial statements if it discloses, in the notes to its accounts, the aggregate investment in all significant holdings in undertakings (including its associates) determined by way of the equity method of valuation. [4 Sch 13].

A parent that prepares consolidated financial statements and discloses the information described at 3.4.2.D above in respect of its associates is not required to give the disclosures otherwise required by paragraphs 5 and 6 of Schedule 4 of the Regulations in its individual financial statements. [4 Sch 4].

4.1.2.A Existing investment becoming an associate

An entity may gain significant influence over an existing investment upon acquisition of a further interest or due to a change in circumstances. Section 14 gives no guidance on how an investor should account for an existing investment that subsequently becomes an associate.

It is clear under Section 19 that in a business combination where control over an acquiree is achieved in stages following a series of transactions, the cost of the business combination is the aggregate of the fair values of the assets given, liabilities assumed and equity instruments issued by the acquirer at the date of each transaction in the series. [FRS 102.19.11A]. It might be argued that a similar approach should be adopted when an associate is acquired in stages.