Cost of Investment – amendments to IFRS 1 and IAS 27

The amendments to IFRS 1. “First-time adoption of IFRS”, and IAS 27, “Consolidated and separate financial statements”, bring three major changes :

• The cost of a subsidiary, jointly controlled entity or associate in a parent’s separate financial statements, on transition to IFRS, is determined under IAS 27 or as a deemed cost. Deemed cost is either fair value or the carrying amount under the previous accounting practice.
• Dividends from a subsidiary, jointly controlled entity or associate are recognized as income. There is no longer a distinction between pre-acquisition and post-acquisition dividends.
• The cost of the investment of a new parent in a group (in a reorganization meeting certain criteria) is measured at the carrying amount of its share of equity as shown in the separate financial statements of the previous parent.

What was the reason for the amendment ?

The main reason for the amendment is to facilitate the transition to IFRS without significantly reducing the relevance of the financial statements. IAS 27 requires an entity to account for its investments at cost or in accordance with IAS 39 in its separate financial statements. For those accounted for at cost, a parent entity could previously recognize income from the investment only to the extent that distributions were received from post-acquisition earnings. Distributions in excess of post-acquisition earnings were recognized as a reduction to the cost of the investment.

Prior to the amendment, IFRS 1 required retrospective application of this method of calculating cost, which was often cumbersome to reconstruct for investments that had been held for several years. With the amendments, a first-time adopter can use a deemed cost, which may be the previous GAAP carrying amount.

If dividends are recognized as income and not as a reduction to the cost of the investment, is there risk of impairment ?

Yes, IAS 36 has been amended to identify circumstances when a dividend payment requires impairment testing. These circumstances include :

• Dividends exceeding the total comprehensive income (under IAS 1 – revised) of the subsidiary, jointly controlled entity or associate in the period the dividend is declared; or
• The carrying amount of the investment in the separate financial statements exceeding the carrying amount in the consolidated financial statements of the investee’s net assets, including goodwill.

How will the alleviate ‘dividend trap’ issues ?

Prior to the amendment, dividends from pre-acquisition earnings were recognized as a reduction of the cost of an investment. Because they were not recognized as profits by the parent, they were not available for further distribution. Under the new standard, dividends are credited to income and available for distribution, subject to there being no impairment and subject to local legal requirements.

Source : A Practical guide to new IFRSs for 2010 - PWC publication