Equity Method of Accounting Investments in Associates

IAS 28 Investments in Associates and Joint Ventures outlines using the equity method of accounting when investing in associates. The first point we should consider is what is 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, a party might exercise significant influence with a lower than 20% holding or even higher than 50%. The latter can be the exception to the rule. In any case, you should apply the equity method of accounting when a party can exert significant influence.

Equity Accounting Definition

As mentioned above, the equity method of accounting refers to the treatment 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 control the associate. And therefore, you should not consolidate the associate’s accounts.

Investment in Associate and Accounting Treatment

IAS 28 sets a clear framework for how a reporting party accounts for an investment in an associate. You can find an example below, but briefly, the following points apply:

• The investment is initially recognized at fair value, i.e. the price paid to acquire the holding in the associate company;
• You do not account for goodwill separately as it already included in the fair value;
• The statement of financial position includes 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 statement of financial performance of the investing company should include the post acquisition share of profits that the associate company generated as a single line (“profits from associate”), and;
• The reporting entity must pro-rate profits when an investment is made part-way through a year.

Dividends Received From an Associate Company

If the associate company distributes its profits through dividends (let’s assume that $500,000 is the share of the dividends for the investing company), then the parent company recognizes the receipt with the following double entry:

You might be wondering why the investing company does not record the dividends on its statement of financial performance. Let’s consider the scenario that the associate company reports dividends on its statement of financial performance. The investing company would then recognise its share of the associate company’s profits and the dividends distributed. The result would be that you would count the associate’s income twice.

Equity Accounting Example

We will use an example to explain how the investment should be recorded on the financial statements. Let’s assume that company A bought 40% of company B at the beginning of the year for $500,000. Company B generated profits of $500,000 during the year. The draft statements of financial position and performance before taking into account the investment in the associate are as follows:

Statement of Financial Position

Statement of Financial Performance

To account for the investment in the associate, company A would record the following:

1. On the statement of financial position and under the non current assets, the investment in Company B should be recorded at $500,000 plus 40% of the $500,000 which are the post acquisition profits that the associate generated. Therefore, the total carrying value should be $700,000.
2. On the statement of financial performance, the $200,000 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”.

Therefore, the revised accounting statements should be as follows:

Statement of Financial Position

Statement of Financial Performance

Disposal of an Investment in an Associate

Equity accounting requires a reporting entity to recognise the gain or loss on the disposal of an associate. The profit or loss is the difference between the sale price and the carrying value of the investment.

An illustration might help to understand how you would calculate the gain or the loss. 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 and disposed of it for $16m.

Company A would calculate the gain as:

Elimination of Unrealised Profits

One should eliminate associate unrealised profits in the same way that they are for a subsidiary. The main difference is that we should not eliminate the whole unrealised profits but our share of the unrealised profits. To be more specific, if the investing company sells goods to the associate company (let’s assume a 40% holding) and all of these goods remain unsold at the year-end, the investing company should eliminate 40% of the profit from this transaction in the investing company’s books.