Inter-Entity Relationships Explained

• Different entities can engage in sales, purchases, borrowing, lending, joint operations or purchase of equity/shares.
• Two or more entities can combine through equity ownership.

Inter-Entity Relationships

• No special relationship exists with a passive shareholding.
• Control means a company holds the entire shareholding of another company, directing the investee's operations.
  • The controlling company is the parent company.
  • The investee is the subsidiary, forming a corporate group.
• Significant influence means owning enough shares to participate in directing the policies of the investee, known as an associate.
  • The equity method recognizes a proportional share of the associate's Profit & Loss (P&L).
• Joint control occurs when two investors join forces making important decisions together.
  • Joint arrangements include Joint Operators and Joint Ventures.
  • Joint Operators have proportional consolidation.

Legal vs. Accounting Entity

• A legal entity transacts with people or other companies.
• A legal entity can be identified as "Entity"
• An accounting entity treats the parent-subsidiary group as a single accounting entity when a company controls other subsidiaries.
• A reporting entity exists if there is control, making only one entity for financial reporting purposes.

Accounting for Investments under AASB 9

• AASB 9 governs accounting treatment when there is no significant influence or control.
• AASB 9 is operative from January 1, 2015.
• AASB 132 defines a financial instrument as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
• An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
• A financial asset includes an equity instrument of another entity.

Accounting for Investments (Definition)

• An ordinary share is an equity instrument for the issuing entity and a financial asset for the entity that holds/buys it.
• Focus on the holder/buyer of the shares from the investor’s perspective.

Accounting for Investments (Recognition: AASB 9)

• Recognize a financial asset when the entity becomes a party to the contract.

Accounting for Investments (Measurement: AASB 9)

• Initial measurement occurs at cost (fair value of acquisition) + direct acquisition costs capitalized unless measured at Fair Value through Profit & Loss (P&L).

Measurement Questions (AASB 9)

• Amortized Cost is the purchase price of an asset, adjusted for factors like interest rates and payments over the lifetime of the asset.
• OCI = Other Comprehensive Income
• Step 1: Amortised Cost or Fair Value?
• Step 2: Fair Value through P&L or OCI?
• Step 3: Initial Measurement: include acquisition costs?

Step 1: Amortised Cost or Fair Value?

• Financial assets are classified and measured at:

  • Amortized cost
  • Fair value through other comprehensive income (FVOCI)
  • Fair value through Profit & Loss (FVPL)

• Classification depends on the entity’s business model for financial instruments and the contractual cash flow characteristics of the financial asset.

• Financial assets measured at amortized cost require:

  • A business model to hold the asset for cash flows
  • Contractual cash flows arise at specified dates and are payments solely for principal and interest

• Financial assets measured at FVOCI require:

  • A business model to hold the asset for cash flows and selling the asset
  • Contractual cash flows arise at specified dates and are payments solely for principal and interest

• If neither of the above, then measure at fair value through profit & loss.

• Shares do not meet the criteria of amortized cost or FVOCI measurement.

Step 2: FV changes through P&L or OCI?

• Fair Value (FV) goes through Profit & Loss, unless Other Comprehensive Income is used.
• Other Comprehensive Income (OCI) is used when the entity makes an irrevocable choice to take the movements through OCI.
  • Can only do so if the equity instruments are not “held for trading”
  • Held for trading includes short-term or speculative selling & purchasing

Important

• The default way is to measure fair value through P&L.
• Companies can decide if they want to go through OCI instead with conditions.
• Managers prefer to measure through OCI as it will not represent fluctuations in profit if measured through P&L.

Step 3: Initial Measurement

• At initial recognition, a financial asset is measured at fair value.
  • Only if not measured at fair value through P&L: plus transaction costs directly attributable to the acquisition / issue.
• Directly attributable costs include brokerage and stamp duty.
• Costs of staff time is not directly attributed to the capitalization of the investment as salaries are paid to those employees regardless of the investment.

Important

• Transaction costs cannot be capitalized if shares measured at fair value through P&L.
• Transaction costs directly attributed to the transactions can be capitalized if shares measured at amortized cost or fair value through OCI.

Example 1 - Fair Value through P&L

• A Ltd purchased 5% of B Ltd ordinary shares on June 1, 2017 for $125,000 with brokerage costs of $2,500 paid on June 2.
• At June 30, 2018, the fair value of the investment was $131,200.
• The investment is not held for trading purposes and A Ltd has not elected to take fair value changes through OCI.
• A Ltd will measure at fair value through P&L, therefore cannot capitalize the transaction costs (brokerage).
• Journal Entries:
• June 1, 2017:
• Dr Shares in B Ltd $125,000
• Cr Bank $125,000
• June 2, 2017:
• Dr Brokerage Expenses $2,500
• Cr Bank $2,500
• June 30, 2018:
• Dr Shares in B Ltd $6,200
• Cr Gain on investments (P&L) $6,200 ($131,200 – 125,000)

Example 2 - Fair Value Through OCI:

• The investment is not held for the purpose of trading, therefore changes in fair value must go through OCI.
• Initial measurement: Fair Value + transaction costs directly attributable.
• Journal Entries:
• June 1, 2017:
• Dr Shares in B Ltd $125,000
• Cr Bank $125,000
• June 2, 2017:
• Dr Shares in B Ltd $2,500
• Cr Bank $2,500
• June 30, 2018:
• Dr Shares in B Ltd $3,700
• Cr Gain on investments (OCI) $3,700 ($131,200 – 127,500)
• The brokerage fee is not expensed and is capitalized to the value of the investment.