Question

The accountant of Chocolate Ltd, Ms Fraser, has been advised by her auditors that the entity’s investment in Corio Milk Ltd should be accounted for using the equity method of accounting. Chocolate Ltd holds only 20.2% of the voting shares currently issued by Corio Milk Ltd. Since the investment was undertaken purely for cash flow reasons based on the potential dividend stream from the investment, Ms Fraser does not believe that Chocolate Ltd exerts significant influence over the investee.

Required

Discuss the factors that Ms Fraser should investigate in determining whether an investor–associate relationship exists, and what avenues are available so that the equity method of accounting does not have to be applied.

Answer 1

ANSWER:

According to IAS 28, significant influence is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies.

If an investor holds, directly or indirectly (i.e., through subsidiaries), 20% 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. Conversely, if the investor holds, directly or indirectly (i.e., through subsidiaries), less than 20% 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.

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

· Representation on the board of directors or equivalent governing body of the investee;

· Participation in policy-making processes, including participation in decisions about dividends or other distributions;

· Material transactions between the investor and the investee;

· Interchange of managerial personnel; or

· Provision of essential technical information.

Points of discussion:

1. Why the investment was undertaken by Chocolates Ltd. is irrelevant. The definition of significant influence is based on the capacity to participate, not the actual participation or intention to participate. Therefore, their intention to only invest for cash flow reasons is not relevant in determining if Chocolates Inc. has significant influence over Corio Milk Ltd.

2. Whether Chocolates Ltd. Actually exerts influence is irrelevant, but rather do they have the ability to exercise influence is how the presence of significant influence is determined.

3. The 20% threshold is a guideline only and professional judgment must be exercised in determining if Chocolates Ltd. has significant influence over Corio Milk Ltd. or not.

4. Factors will include those listed above. Further, an analysis of the 79.8% holding by other parties is very important. If it is closely held, then the ability for Chocolates Ltd. to participate is limited and likely cannot significantly influence the financial and operating policies.