CHAPTER 6

Intercompany Relations

About This Chapter

Because of well-known company names, there is a tendency to think of a company as a single, discrete institution. That is not the case. There are many types of business relationships. Companies merge, acquire other companies, work together on various projects, and invest in other companies. These corporate activities not only involve strategic and managerial decisions, but are also subject to legal, tax, and accounting requirements. In this chapter, we concentrate solely on the accounting requirements.

Several of these business relationships are complex. Sometimes, managers in one company may lack certain competences and remedy these by cooperating with a company that can assist. Such arrangements may take the form of licensing agreements, mergers and acquisitions, strategic alliances, joint ventures as well as mergers and acquisitions and can be very prevalent in some industries (Kohut 2019). A case study of Heineken’s Acquisition of Asia Pacific Breweries provides a good example of the potential complexities (Tan and Lim 2017).

One company may have several subsidiaries that it owns, or part owns, as well as agreements and relationships with other companies. Some of these arrangements may all be within one country but can frequently involve several countries. It is important that the users of financial statements are aware of this network and the possible connection with a company’s financial results. If one company acquires another or makes a large investment, it does so in the expectation of future economic benefits. One company may own, or partly own, many others. There may even be cases where ownership is difficult to identify. Standard setters must decide the accounting treatment of all of these relationships.

The international standard setters have attempted to issue regulations that cover all types of relationships. Understandably, there are several standards and some of them are linked. The changes in the nature of business relationships can lead to amendments in standards. It can also mean the withdrawal of a particular standard and the issue of new regulations to address the changes taking place.

In this chapter, we explain all of the relevant standards in their numerical order. To clarify the connections of the standards and their sphere of application, we have constructed Table 6.1.

Table 6.1 Business combination standards

IAS 24 Related Party Disclosures	Reissued in 2009, it requires disclosures about transactions and outstanding balances with a company’s related parties.
IAS 27 (2011) Separate Financial Statements	The original IAS 27 was withdrawn and replaced by this 2011 version. It covers the accounting and disclosure requirements for separate financial statements by a parent, company, or an investor in a joint venture or an associate.
IAS 28 Investment in Associates and Joint Ventures	Amended in 2011, it covers the application, with certain limited exceptions, of the equity method to investments in associates and joint ventures.
IFRS 3 Business Combinations	A revised version was issued in 2008 and covers the accounting when an acquirer obtains control of a business (e.g., an acquisition or merger).
IFRS 10 Consolidated Financial Statements	Issued in 2011, it covers the preparation and presentation of consolidated financial statements. These are often referred to as Group Accounts.
IFRS 11 Joint Arrangements	Issued in 2011, it covers accounting for a joint venture or a joint operation.
IFRS 12 Disclosure of ­interests in Other Entities	Issued in 2011, this standard covers all those relationships not covered by any other standards. It requires disclosure of an entity’s interests in subsidiaries, joint arrangements, associates, and unconsolidated “structured entities.”

IAS 24 Related Party Disclosures

Business relationships can be very complex. Without knowledge of all the various types of relationships, users may not be able to fully assess the financial position and performance of a company. Although this chapter discusses standards that address specific relationships, there may be some that are not fully captured by these regulations.

IAS 24 attempts to cover all those relationships not addressed by the other standards. Its intention is that a company’s financial statements provide information on the relationship, transactions, and outstanding balances with other organizations that may impact its financial position and profit or loss. A related party transaction is where there is a transfer of resources, services, or obligations between related parties, regardless of whether a price is charged or not.

The disclosure requirements are extensive and include the name of a parent company and, if different, the ultimate controlling company. If neither the entity’s parent nor the ultimate controlling party produces financial statements available for public use, the name of the next most senior parent that does so must also be disclosed.

If transactions have taken place with related parties excluding subsidiaries, the entity must disclose the nature of the related party relationship. It must also give information about the transactions, including the amount of the transactions and outstanding balances, including terms and conditions and guarantees.

With major international companies, there are frequently a considerable number of different relationships with companies in different countries. Although IAS 24 requires disclosures, it is argued that managers might use some of the arrangements to benefit personally. They can misappropriate assets by having their companies purchase goods at inflated prices from entities the managers control or enhance reported earnings by selling goods at inflated prices to affiliated companies (Clikeman and Liu 2017).

Evidence for such practices has been observed in an Indian study. Data was collected from 218 companies for the financial year 2014 and 2015. The findings were that there is a statistically significant relationship between related party transactions (RPTs) and earnings management (Abdul Rasheed and Mallikarjunappa 2018). Other studies suggest that this is an international issue not confined to any one country.

IAS 27 Separate Financial Statements

Separate financial statements are very different from consolidated financial statements that are those of a group of companies. Consolidated financial statements show the assets, liabilities, equity, income, expenses, and cash flows of the parent and all its subsidiaries as if it were a single economic entity. Understandably, investors require details of these various relationships. This need is met by the requirements in IAS 27.

A brief note is in order before we consider IAS 27. The requirements for investment entities differ and come under IFRS 10, which we discuss later in this chapter. IFRS 10 applies to a parent as an investment company. Such a company should measure its investment in a subsidiary at fair value through profit or loss. The investment company must also account for its investment in a subsidiary in the same way in its separate financial statements.

IAS 27 sets out the requirements when a company chooses, or is required by local regulations, to present separate financial statements and these statements comply with International Financial Reporting Standards.

Separate financial statements refer to those financial statements that are not consolidated. The standard applies to the financial statements of:

• •a parent company (i.e., an investor with control of a subsidiary),
• •an investor with joint control of, or significant influence over, an investee.

A company preparing separate financial statements can measure investments at cost or use the equity method, as we describe in the next section on IAS 28.

The standard also covers the situation where a parent reorganizes the structure of its group by establishing a new company as its parent. There are a number of variations of this situation, but, essentially, all of these reorganizations must comply with the accounting requirements of IAS 27 subject to certain criteria.

It is possible, under IFRS 10, for a parent company to choose not to prepare consolidated financial statements and to prepare separate financial statements instead. A lengthy list of disclosures is required in these separate financial statements.

IAS 28 Investments in Associates and Joint Ventures

Investors may have a significant influence in a company that is not a subsidiary and is therefore not incorporated in the consolidated financial statements. However, the users of financial statements must be informed of the nature and implications of this investment. IAS 28 applies to all companies that are investors with joint control of, or significant influence over, an investee. Investors must use the equity method to account for these investments.

The main features of the standard are:

• •the investor must show the investments in its balance sheet;
• •the investor must apply the equity method;
• •it does not have any disclosures requirements as these are covered in IFRS 12, which we discuss later in this chapter.

Associates and Joint Ventures

The term joint ventures is very specific and applies to a joint arrangement where the parties have joint control of the arrangement and the joint venturers have rights to the net assets of the arrangement. To be a “joint” venture, there must be two or more parties. The investor will not prepare consolidated financial statements, but it must show the investments in its balance sheet.

A “joint operation” is covered by IFRS 11. This requires joint control, and the parties should have agreed on a contract that shares control of the arrangement. We discuss these arrangements later in this chapter.

IAS 28 defines an associate company as an entity over which the investor has significant influence. If the investing entity has significant influence, the entity in which the investment is made is an associate company. In this case, the investor has the power to participate in the financial and operating policy decisions of the investee. The important qualification is that it does not have control or joint control of those policies.

Joint control is the contractually agreed sharing of control of an arrangement. This agreement exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control.

Under IAS 28, if the investor has 20 percent or more of the voting power, it has significant influence. However, there is some flexibility. An investor may be able to demonstrate that it does not have significant influence although its holding is above this level. Also, an investor with a <20 percent holding may be able to prove that it does have significant influence.

The standard provides the following examples of evidence that an investor has significant influence:

• •representation on the board of directors or equivalent governing body of the investee;
• •participation in the policy-making process, including participation in decisions about dividends or other distributions;
• •material transactions between the entity and the investee;
• •interchange of managerial personnel; or
• •provision of essential technical information.

An entity loses significant influence over an investee when it loses the power to participate in the financial and operating policy decisions of that investee. The loss of significant influence can occur with or without a change in absolute or relative ownership levels.

The general rule is that investors with a significant influence or joint control over an investee must use the equity method to account for its investment. However, there are some relaxations of this requirement. Where the investor is exempt from preparing consolidated financial statements, it does not need to use the equity method. There are also several other conditions that if met by an investor exempt the latter from using the equity method of accounting.

The equity method of accounting has two distinct stages. In stage 1, an investor recognizes at cost in the statement of financial position any investment in an associate or a joint venture. Any difference between the cost of the investment and the entity’s share of the net fair value of
the investee’s identifiable assets is included in the carrying amount of the investment.

In stage 2, the initial carrying amount is adjusted subsequently to recognize postacquisition changes. These can arise for various reasons, and the investor amends the carrying amount to show the investor’s share of the profit or loss of the investee.

An investor must use the equity method until the investment in the associate or joint venture ends. The reasons for the cessation can vary and require different accounting treatments. If the investee becomes a subsidiary of the investor, IFRS 3 and IFRS 10 apply, as explained later in this chapter. Another reason for cessation is the loss of influence by the investor. In these circumstances, the investor must account for the investment as a financial asset.

The application of the equity method is straightforward, and the main requirements are summarized in the following list below.

• •The investor should ensure that the financial statements of the associate or joint venture have the same financial dates as itself. If this is not possible, the reporting dates of the investor and associate should not differ by more than 3 months.
• •The accounting policies of the associate or joint venture should be the same as the investor.
• •The investor should show the investment in an associate or a joint venture in its own separate financial statements.
• •If there are transactions between the investor and the associate or joint venture, any profits or losses resulting from these transactions are eliminated to the extent of the investor’s interest in the associate or joint venture.

In practice, it has been argued that there are weaknesses in the standard, and little guidance is given in the conceptual framework (Bradbury 2018). It will be interesting to see whether the International Accounting Standards Board (IASB) can respond positively to these issues and revise the standard.

IFRS 3 Business Combinations

IFRS 3 was first issued in 2004, and a revised version was issued in 2008. It explains the appropriate accounting treatment when an acquirer obtains control of a business through an acquisition or a merger. These business combinations must be accounted for by using the “acquisition method.” The aim is to improve the relevance, reliability, and comparability of information.

The standard explains the procedures for the recognition and measurement of acquired assets and liabilities, the determination of goodwill, and the necessary disclosures. There are four main aspects of the standard that we summarize in what follows.

Identifying a Business Combination

Only acquisitions or mergers of one business with another to form a business combination come under the standard. A business combination is where an acquirer obtains control of one or more businesses. The term control is important but not defined in IFRS 3 but rather in IFRS 10, which we explain later in the chapter.

Where the acquisition is on an agreed date and is made by shares, cash, or a combination of both, the acquirer must apply the acquisition method to the transaction. The acquirer (parent) gains control of the acquiree (subsidiary). This may be either a 100 percent acquisition, where the parent holds all the equity in the subsidiary, or where the acquirer holds only a part of the equity but has gained control. In a partial ownership, there will be other owners, called noncontrolling interests. These were previously named minority interests.

The acquisition method for accounting can result in the buyer having to include goodwill on its balance sheet. We discussed goodwill in Chapter 4.

The Cost of the Acquisition

The cost of an acquisition is the total of the fair values of the consideration given by the acquirer plus any directly attributable costs of the business combination. Fair value is the price an entity would receive on selling an asset or pay to transfer a liability.

Payment may be in cash or other assets, the taking on of liabilities by the acquirer, and the issue of shares. The accounting treatment for calculating fair value is given in IFRS 13, which we discuss in Chapter 9.

The acquisition may involve contingent consideration, where it is agreed the acquirer will make further payment if some future economic events occur. This agreement is based on the acquirer’s assumption that the acquired business will continue to make profits in the future and even increase those profits.

Both the acquirer and acquiree may want a contingent consideration agreement as both may benefit if the business achieves certain agreed targets. The acquirer benefits from any future success of the business and the previous owners by further payments. The acquirer must recognize, at the date of acquisition, the fair value of the contingent consideration as part of the consideration for the acquiree.

Intangible Assets and Goodwill

An acquiree may have developed intangible assets, for example a brand name. Under IAS 38, the acquiree cannot recognize intangible assets internally that it has developed. However, the acquirer obtains these previously unidentified intangible assets and adds them to its balance sheet. The problem lies in calculating the fair value of such intangibles.

IFRS 13, discussed further in Chapter 9, provides some guidance. Identifiable intangible assets must be recognized separately from goodwill, and the standard establishes the criteria that must be met. Once the fair value of the identifiable intangible assets is determined, the acquirer may find that the fair value of all the assets less any liabilities is greater than the acquisition payment. In such cases, the acquirer recognizes goodwill at the acquisition date. Goodwill is really a balancing figure. In Chapter 4 we reviewed the debate on the treatment of goodwill.

There are takeovers where there is negative goodwill. An acquirer may purchase an entity where the cost is less than the fair value of the identifiable net assets. In these circumstances, there is a “negative” goodwill, and the acquirer has made a gain. This will be shown in the income statement, but the standards contain several requirements to ensure that it is a bargain purchase.

Although there may have been what is commonly called a takeover, another party may still hold a minor part of the equity. This is known as a noncontrolling interest. We discuss noncontrolling interests in the next section, where we examine IFRS 10.

A number of articles have questioned the application of IFRS 3 by companies and the valuation placed on goodwill and other intangible assets. One study of business combinations in Portugal concluded that companies do not individually identify and disclose intangibles acquired in business combinations and that the disclosure of information on goodwill does not meet the requirements of IFRS 3 (Carvalho, Rodrigues, and Ferreira 2016b).

IFRS 10 Consolidated and Separate Financial Statements

IFRS 10 was issued in 2011 and covers the preparation and presentation of consolidated financial statements. Consolidation is required where one entity controls one or more other entities and the financial statements of a group of entities that are presented as being a single economic entity. The standard has a single consolidation model, based on control, applicable to all entities regardless of the nature of the investee. It is important to note that IFRS 10 has no disclosure requirements. These are contained in IFRS 12,
which we discuss in the last section of this chapter.

IFRS 10 defines consolidated financial statements as those where the assets, liabilities, equity, income, expenses, and cash flows of the parent and its subsidiaries are presented as those of a single economic entity. In other words, the financial statements of all companies in the group are added together, a process that can be very difficult in practice.

It is useful if we explain the problems with consolidated accounts. A group of companies can consist of a large number of companies, frequently in excess of 100 and in different countries and using different currencies. The intent of IFRS 10 is to help companies to prepare financial statements that show the financial position and performance of the entire group.

Parent entities must consolidate all investees that they control. To achieve this, the standard provides

1. 1.The definition of control and its importance as the basis for consolidation
2. 2.The application of the principle of control to identify whether an investor controls an investee
3. 3.The accounting requirements for the preparation of consolidated financial statements
4. 4.The definition of an investment entity and the exception of consolidation for particular subsidiaries of an investment entity.

The concepts of control and power are linked. An investor (the parent) is required to prepare consolidated financial statements only where it has control and power over the investee. The investor has control where it is entitled to variable returns, such as dividends, cost reductions, scarce products, and remuneration, and has the power to influence those returns.

The power may be through voting rights granted by equity instruments or more complex measures. These can include the rights to appoint key personnel or decision-making rights. Where the investor does not hold all the equity, and there are other parties with a minor holding, these are known as noncontrolling interests. You sometimes see this category on the published financial statements.

Consolidation

The process of consolidating the financial statement of the parent company and its subsidiaries can be simplified into the following three steps:

1. 1.Identify the assets, liabilities, income, expenses, and cash flows of the parent, and combine these with like items of the subsidiaries.
2. 2.Eliminate the carrying amount of the parent’s investment in each subsidiary and the parent’s portion of equity of each subsidiary.
3. 3.The final stage of accounting for intergroup activities is the most complex. It is likely that some of the entities in the group have conducted some transactions among themselves. Although individual entities may have had a profit or loss through such activities, these internal movements do not result in profits or loss for the group. Examples are the transfer of machinery to another group entity at a price higher than the written down amount in its own accounts and inventory purchased from another group member at above original cost. Profits or losses that were recognized at the time of the transaction by the subsidiary must be eliminated in full from the group accounts.

Where the parent entity loses control of a subsidiary, it must

• •remove the subsidiary’s assets and liabilities from the consolidated statement of financial position.
• •recognize any investments retained in the former subsidiary.
• •recognize the gain or loss associated with the loss of control.

Investment Entities

A parent entity must decide whether it is an investment entity as there is special accounting treatment. IFRS 10 defines an investment entity as one that obtains funds from one or more investors and provides investment management services to them. It invests these funds solely for returns from capital appreciation, investment income, or both. Under IFRS 10, a qualifying investment entity must account for investments in controlled entities, associates, and joint ventures at fair value through profit or loss.

The above requirement does not apply where the investee is a subsidiary giving investment-related services or engages in investment-related activities with investees. Where this is the case, the investment entity has to prepare consolidated financial statements.

IFRS 11 Joint Arrangements

We have already discussed the accounting treatment under IAS 28 for investments in associates and joint ventures. Where an arrangement can be categorized as a joint arrangement, it does not come under IAS 28 but under IFRS 11. This standard provides the accounting requirements for entities that jointly control an arrangement.

For there to be a joint arrangement, there must be a contractual arrangement binding a number of parties together. The contract must give two or more of those parties joint control of the arrangement. For there to be joint control, the parties should have agreed a contract that shares control of the arrangement.

The contract normally contains such issues as the purpose, activity, and duration of the joint arrangement, as well the decision-making process, the capital, or other contributions required of the parties and how the parties share assets, liabilities, revenues, expenses, or profit, or loss relating to the joint arrangement.

The contractual arrangements are usually in the form of a document, or a series of documents. The latter could be the minutes of meetings held by the parties. Any contractual arrangements should be enforceable. Where a separate entity is formed, the articles, charter, or bylaws of that entity should be included in the contractual arrangement.

The requirement for joint control should not be interpreted as each party having equal shares. For example, an arrangement may consist of four parties, three with 30 percent share and one with the remaining
10 percent share. If the contractual agreement states that a decision requires 65 percent of the votes, any combination of three of the four parties could pass the decision. Such an arrangement does not meet the requirements of IAS 11 unless the agreement specifies which parties are required to agree unanimously.

The financial performance and position of the joint operations must be included in the financial statements of the parties involved. Their income statements will contain their share of the revenue from the sale of the output by the joint operation and the share of their expenses, including the share of any expenses incurred jointly. Their balance sheets will contain the assets, including the share of any assets held jointly, and the liabilities, including the share of any liabilities incurred jointly. The initial investment in the joint operation is also shown on the balance sheet of the parties.

IFRS 11 does not contain any disclosure requirements for joint arrangements. IFRS 12 Disclosure of Interests in Other Entities outlines the disclosures required. We discuss this standard in the next section.

IFRS 12 Disclosure of Interest in Other Entities

IFRS 12 was issued in 2011 and is a consolidated disclosure standard. It requires the disclosures of an entity’s interests in subsidiaries, joint arrangements, associates, and unconsolidated “structured entities.” The standard does not contain any specific accounting treatments for different economic transactions and events. It focuses only on the disclosure of financial information. In doing this, a number of accounting standards are affected.

The following list summarizes the main disclosure requirements in IAS 12:

Significant judgments and assumptions made in deciding

• •that it controls another entity.
• •that it has joint control of an arrangement or significant influence over another entity.
• •the type of joint arrangement (i.e., joint operation or joint venture) when the arrangement has been structured through a separate vehicle.

Interests in subsidiaries to assist users of consolidated financial statements to

• •understand the composition of the group.
• •understand the interest that noncontrolling interests have in the group’s activities and cash flows.
• •evaluate the nature and extent of significant restrictions on its ability to access or use assets, as well as settle the liabilities of the group.
• •evaluate the nature of, and changes in, the risks associated with its interests in consolidated structured entities.
• •evaluate the consequences of changes in its ownership interest in a subsidiary that do not result in a loss of control.
• •evaluate the consequences of losing control of a subsidiary during the reporting period.

Interests in unconsolidated subsidiaries by investment entities disclosing

• •the fact that the entity is an investment entity.
• •information about significant judgments and assumptions it has made in determining that it is an investment entity.
• •details of subsidiaries that have not been consolidated.
• •details of the relationship and certain transactions between the investment entity and the subsidiary.
• •information where an entity becomes, or ceases to be, an investment entity.

Interests in unconsolidated structured entities assisting users to

• •understand the nature and extent of its interests in unconsolidated structured entities.
• •evaluate the nature of, and changes in, the risks associated with its interests in unconsolidated structured entities.

Since its issue, a number of minor amendments have been made to the requirements of IFRS 12.

Conclusions

This chapter has concentrated on the financial disclosures that companies should make. In doing this, we have considered the different arrangements, strategies, and agreements companies enter into. Corporate relationships arise in different types of industries and for various reasons. The standards attempt to identify the nature of these relationships and to establish the accounting regulations.

In this chapter, we discussed business combinations. IFRS 3 Business Combinations relies on the concepts of control and power to determine the entities that are subsidiaries. IFRS 10 Consolidated financial statements establishes the principles for the presentation and preparation of consolidated financial statements when an entity controls one or more other entities.

One key issue for entities is to determine the nature of the relationship that exists. The choices are

IAS 24 Related party transactions. The standard defines related parties and the disclosures they should make.

IAS 27 Separate financial statements. This standard refers to those financial statements that are not consolidated. It applies to a parent or an investor in a joint venture or associate.

IAS 28 Investments in associates and joint ventures. The standard distinguishes between joint operations and joint ventures and describes the concept of significant influence. The standard regulates only associates and joint ventures and requires the application of the equity method of accounting.

IFRS 3 Business combinations. This standard explains the appropriate accounting treatment when an acquirer obtains control of a business through an acquisition or a merger. These business combinations must be accounted for by using the “acquisition method.”

IFRS 10 Consolidated financial statements. This standard covers the preparation and presentation of consolidated financial statements, where one entity controls one or more other entities. It has a single consolidation model, based on control, applicable to all entities regardless of the nature of the investee. IFRS 10 has no disclosure requirements, and these are covered in IAS 12.

IFRS 11 Joint arrangements establishes the accounting requirements for entities that jointly control an arrangement. Joint control involves the contractually agreed sharing of control. Such arrangements can be either a joint venture or a joint operation.

IFRS 12 Disclosures in other entities. This standard explains the disclosures of an entity’s interests in subsidiaries, joint arrangements, associates, and unconsolidated “structured entities.”

Our preceding discussions demonstrate that the task is difficult, for both the standard setters and the entities that must comply with the regulations. If you have an arrangement, regardless of what the contractual agreement states, a charismatic person may well control or significantly influence decisions.

We would argue that it is impossible to regulate every type of relationship. There are times where entities must examine their activities and determine how best to account for them. If this is the route they take, it must be explained to the users.

Minor amendments were made in 2017 to some of the above standards when the IASB conducted an annual improvements project. The most recent amendment has been to IFRS 3, which was amended in 2018 to improve the definition of a business. Undoubtedly, business relationships can be very complex, but we do not envisage the standard setters attempting any significant changes to the current regulations.