The equity method of accounting is used to record investments in associates as outlined by IAS 28 “Investments in Associates”. The first point we should consider is what exactly can be described as an “associate”. Based on the International Accounting Standards, an associate company is a company in which the investing company can exercise significant influence.
The accounting standards say that the rule is that an associate is any holding that is higher than 20% and lower than 50%. On the other hand, significant influence might be possible to be exercised with a holding that is lower than 20% or even higher than 50%. The latter can be the exception to the rule. In any case, equity accounting should be applied when significant influence can be exerted.
Equity Accounting Definition
As mentioned above, equity accounting refers to the accounting treatment that is applied for investments in associates as defined by International Accounting Standards. Equity Accounting reflects the economic reality (the substance) that the investing company does not have control over the associate and therefore, their accounts should not be consolidated.
Investment in Associate and Accounting Treatment
IAS 28 sets a clear framework for the way that an investment in an associate should be recorded. An example can be found below but briefly, the following points apply:
- The investment is initially recognized at fair value which is the same as the price paid to acquire the holding in the associate company.
- Goodwill is not separately calculated since it is already included in the fair value.
- The statement of financial position include the initial fair value (price paid), plus the share of the post acquisition profits generated by the associate company, less the share of any impairment in the investment, less any dividends distributed by the associate company.
- The income statement of the investing company should include the post acquisition share of profits that the associate company generated as a single line (“profits from associate”).
- If the acquisition is made in the middle the year, then the profits should be pro-rated to only reflect the post acquisition part of the profits generated.
Dividends received from an associate company
If the associate company distributes it’s profits through dividends (let’s assume that $500k is the share of the dividends for the investing company) , then the parent company recognizes the receipt with the following double entry:
Dr Cash (or accounts receivable if they are declared but unpaid) $500k
Cr Investment in Associate $500k
You might be wondering why the dividends are not recorded on the income statement of the investing company since they are a form of income. Let’s consider the scenario that the dividends were actually reported on the income statement. Then, the investing company would recognize it’s share of the profits that the associate company had and the dividends distributed. The result would be that the same income would be included twice.
Equity Accounting Example
We will use an example to explain how the investment should be recorded on the statement of the financial position and the income statement. Let’s assume that company A bought 40% of company B in the beginning of the year for $500k. Company B generated profits of $500k during the year. The draft statement of financial position and the income statement before taking into accounting the investment in the associate are as follows:
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In order to account for the investment in the associate that company A has, the following two things should be recorded:
- On the statement of financial position and under the non current assets, the investment in Company B should be recorded at $500k plus 40% of the $500 which are the post acquisition profits that the associate generated. Therefore, the total carrying value should be $700k.
- On the income statement, the $200k which is the share of the profits from the associate should be recorded before the tax expense for the year under a heading like “profits from associate companies”.
Balance Sheet with Associate Company
Income Statement with Associate Company
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Disposal of an investment in Associate
When a company disposes the investment it holds in an associate company a gain or loss from this disposal should be recognized (if applicable). The gain or the loss can be calculated as the difference of the money received from the buyer less the carrying value of the investment as it appears on the statement of financial position.
An illustration might help to understand how the gain or the loss can be calculated. Let’s assume that company A purchased 40% of the shares in company B five years ago for $10m. Since then, company B has generated $2 in profits after tax and has paid $1m in dividends. Company A has impaired the investment in company B by $1m. The investment in the associate company B was disposed for $16m.
The gain can be calculated as follows:
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Elimination of Unrealized Profits
Unrealized profits should be eliminated in the same way that are eliminated for a subsidiary. The main difference is that we should not eliminate the whole unrealized profits but our share of the unrealized profits. To be more specific, if the investing company sells goods to the associate company (let’s assume that there is a 40% holding) and all of these goods remain unsold at the year end, then 40% of the profit that was generated because of this transaction should be eliminated in the investing company’s books.
- 1 Equity Accounting Definition
- 2 Investment in Associate and Accounting Treatment
- 3 Dividends received from an associate company
- 4 Equity Accounting Example
- 5 Disposal of an investment in Associate
- 6 Elimination of Unrealized Profits