Advanced Financial
Accounting: Chapter 5
Group Reporting IV:
Learning Objectives
1.
Appreciate the different accounting policies for investment in
associate
2.
Understand the differences between cost and equity method and
consolidation
3.
Know how to apply the equity method for investment in associate
Content
1.
Equity method versus cost method
2.
Equity method versus consolidation
3.
An overview of the methodology of equity accounting
4.
Performing an analytical check on the investment in associate
balance
Concept of “Significant Influence”
•
The power to participate in, but not govern, the financial and
operating decisions of the investee
•
Default assumption:
– Percentage ownership of ≥ 20% and ≤ 50% of investee’s voting rights deemed as giving rise to “ significant influence”
•
Other evidence of “significant influence”:
– Representation on the board of directors;
– Participation in policy-making processes;
– Material transactions between the investor and investee;
– Interchange of managerial personnel; or
Accounting Policy for Investments In
Associates
Levels of financial reporting Accounting policy
1. Investor’s separate financial statements: legal entity
Cost or
as a financial instrument (IAS 39) 2. Consolidated financial
statements (with subsidiaries and associates): economic entity
Equity method
3. Investor’s financial statement in place of consolidated financial statements (with associates):
economic entity
Equity Method
•
Equity accounting:
– Investment is initially recognized at cost and adjusted thereafter for investor’s share of change in post-acquisition retained earnings
– Dividends are not treated as income but as repayment of equity-accounted profit
– Investment account is not eliminated
Investment in associate
Share of book value of net assets
Share of unamortized FV adjustments
Cost Method Versus Equity Method
Dimensions Cost Method Equity Method
Income
recognition • Dividend income • Emphasizing reliability and
realized income
• Share of profits
• Emphasizing the predictive value of information of unrealized gains
Asset
measurement • Historical acquisition cost –impairment loss • Cost and• Share of post-acquisition change in
equity
Profit on sale • Large terminal profit • Smaller terminal profit
• Profits are recognized systematically over holding period
Content
1.
Equity method versus cost method
2.
Equity method versus consolidation
3.
An overview of the methodology of equity accounting
4.
Performing an analytical check on the investment in associate
balance
Rationale for Differences in Presentation
•
Equity accounting captures the substance of consolidation but not
the form
– Individual line items of investor and associate are not combined
– Results and net assets of associate are recognized in single line items:
• Share of profit of associate
• Share of tax of associate
• Investment in associate account
– Consolidation and equity method will achieve the same group retained earnings and net assets
•
Decision rights implicit in “significant influence” are not as strong as
in “control”
Consolidation Vs Equity Method
Dimensions Consolidation Equity Method
Income
recognition • Income statement items of subsidiary are added with the parent’s
• Share of profit and share of tax are reported as a single items in the income statement
Non-controlling
interests (NCI) • NCI is shown separately as an allocation of profit after tax • Only investor’s share of profit and tax of associates are recognized
• NCI allocation is not necessary
Asset
measurement • Investment account is eliminated, and
• Substituted with line items of net assets, FV adjustments and goodwill
• Investment is carried at cost + share of post-acquisition change in equity
• Investment account includes:
– Share of book value of net assets of associate
Consolidation Vs Equity Method
Dimensions Consolidation Equity Method
Goodwill on
consolidation Shown separately as an asset on the consolidated balance sheet
Implicit in the investment account
Unamortized balance of FV adjustments
Adjustments are made on the specific assets or liabilities on the consolidated balance sheet
Unamortized balance is implicit in the investment account
Profit on sale of
investment Profit on sale = Sales proceeds – (Share of net identifiable assets + goodwill + Share of unamortized balance of FV adjustments)
Profit on sale = Sales proceeds – (Share of net identifiable assets + implicit goodwill+ share of
Consolidation Vs Equity Method
financial ratios Because of the line by line summation, certain reported items are larger (e.g. assets and liabilities) making some ratios (e.g. return on assets and debt-equity) worse off
Content
1.
Equity method versus cost method
2.
Equity method versus consolidation
3.
An overview of the methodology of equity accounting
4.
Performing an analytical check on the investment in associate
balance
Methodology of Equity Accounting
1.
Investment is initially recorded at cost
2.
Investment at cost comprises of:
• Share of book value of the net identifiable assets of the associate
• Share of fair value adjustments of net identifiable assets
• Goodwill
3.
Goodwill is implicit in the investment account and is written off
when the investment in associate is impaired
4.
Fair value adjustment included in the cost of investment is
amortized or expensed off and adjusted against investor’s share
of profit in the period when amortization take place
Methodology of Equity Accounting
6.
Post-acquisition change in the investor’s share of net assets is
added to the investment account
• Include share of profit and tax in each reporting period from acquisition date to disposal
7.
Share of current profit of the associate will be adjusted for:
• Unrealized profit arising from current year transfer
• Realized profit in current year arising from previous year transfer
8.
Dividends
• Deemed as a repayment of profits
• Since share of profit is recognized by the investors, dividends should not be recognized as profit
• It will be credited to the investment account as a realization of equity -accounted profit
Content
1.
Equity method versus cost method
2.
Equity method versus consolidation
3.
An overview of the methodology of equity accounting
4.
Performing an analytical check on the investment in associate
balance
5.
Specific procedures relating to the equity method
Analytical Check
balance of excess of FV
over book value of net
Content
1.
Equity method versus cost method
2.
Equity method versus consolidation
3.
An overview of the methodology of equity accounting
4.
Performing an analytical check on the investment in associate
balance
Conversion from the Cost Method to the
Equity Method
Accounting for Investment in Associate
Investor’s separate financial
statements Consolidated financial statements
Cost method Equity method As a financial instrument under
IAS 39 Equity method
Begin with the investor’s
Reclassification of Dividends
•
Dividends and other distributions are deemed as repayment of
profits
– These payments will reduce the investment account
•
Under the equity method, income is recognized only on the basis of
net profit of the associate
•
However, in the investor’s separate financial statements, dividend is
recognized as income
– To convert from cost to equity method, dividends have to be reclassified from the income statement to the balance sheet
– Equity accounting entry:
Dr Dividend income (I/S)
Consolidation Procedures Not Applicable to
Equity Method
1.
Elimination of intragroup balances is not required
• Equity method does not entail line by line aggregation
• Perfectly offsetting items and balances are not required
2.
Investment in associate is not eliminated
• Investment account captures:
– Implicit goodwill
– Share of fair value of net identifiable assets at acquisition
– Share of change in post-acquisition retained earnings and other equity
Illustration 1: Amortization of FV
Adjustments of Identifiable Net Assets
•
I acquired 20% of A’s share on 1 Jan 20X4
•
Excess of fair value over book value of a depreciable asset at
acquisition date was $5,000,000
•
Depreciation was over remaining life of ten years
•
Retained earnings as at acquisition date: $15,000,000; as at 1 Jan
20X5: $20,000,000
•
Current year net profit before tax for 20x5: $10,000,000, tax
expense: $2,100,000
•
Tax rate was 20%
Illustration 1: Amortization of FV
Adjustments of Identifiable Net Assets
EA 1: Share of change in retained earnings (RE) from acquisition date to beginning of current period
Dr Investment in associate 1,000,000
Cr Opening RE 1,000,000 RE as at 1 Jan 20X5 20,000,000 RE as at acquisition date 15,000,000
Change in RE 5,000,000
Share of A’s post-acquisition RE (20%) 1,000,000
Illustration 1: Amortization of FV
Adjustments of Identifiable Net Assets
Note:
1) Any adjustments relating to associate’s asset or liabilities are made against the investment account (a proxy for net assets)
2) This entry can be combined with the previous entry (EA 1) 3) Adjustment includes the tax effects
EA 2: Share of past cumulative depreciation on undervalued fixed assets (after-tax)
Dr Opening RE 80,000
Cr Investment in associate 80,000
Illustration 1: Amortization of FV
Adjustments of Identifiable Net Assets
EA 3: Share of current profit after tax of associate Dr Investment in associate 1,500,000
Note: The spilt between profit and tax is necessary as the two items are shown
5,000,000 / 10
Impairment Test
•
Goodwill is not tested for impairment as a stand-alone asset
•
Impairment test is performed for the investment in its entirety
– Carrying amount of the investment is compared with recoverable amount
– Recoverable amount is the higher of:
• Value in use, and
• Fair value less cost to sell
•
Impairment losses:
– Will reduce the investment account
Illustration 2
•
P owned 20% of A
•
Past impairment of investment in A: $250,000
•
Current impairment: $100,000
•
Current year net profit before tax: $10,000,000
•
Tax expense: $2,100,000
Q: Prepare the equity accounting entries for the current year
Note:
1) This entry re-enacts past impairment losses
2) The impairment loss relates to the share owned by the investor; hence there EA 1: Share of past impairment loss
Dr Opening RE 250,000
Illustration 2
EA 2: Share of current profit after tax of associate Dr Investment in associate 1,480,000 Dr Share of tax of associate 420,000
Cr Share of profit before tax 1,900,000 Share of profit before tax of associate 2,000,000 Less: current impairment loss (100,000) Adjusted net profit before tax 1,900,000 Share of tax of associate 420,000 Impairment loss relating to goodwill is assumed to be non-tax deductible
20% X $10,000,000
Transfer of Assets between Investor and
In both upstream & downstream sales:
Illustration 3
•
Investor (I) owned 20% of Associate (A)
•
I sells $200,000 of inventory to A
•
The original cost of inventory is $140,000
•
1/3 remains in A’s warehouse at the end of the year
•
A’s net profit before tax is $1,000,000 and tax expense is $200,000
•
Tax rate is 20%
Illustration 3
EA 1: Share of current profit after tax of associate Dr Investment in associate 156,800 Dr Share of tax of associate 39,200
Cr Share of profit before tax 196,000 Share of profit before tax of associate 1,000,000 Less: unrealized profit (20,000) Adjusted net profit before tax 980,000 I’s share of profit (20%) 196,000 Share of tax of associate 200,000 Less: tax on unrealized profit (4,000) Adjusted tax expense 196,000 I’s share of tax (20%) 39,200
1/3 X $60,000
Illustration 3
I’s profit (at group level) Adjusted
I’s profit (at group level) Unadjusted
Gross profit from downstream sale 60,000 60,000 Share of A’s pre-tax profit 196,000 200,000 Profit effect 256,000 260,000
Conclusion
•
The equity method is applied to accounting for associates in the
consolidated financial statements
– It does not involve line by line summation of an associate’s financial statements
– Investment account is not eliminated, instead it comprises of:
• Share of book value of net assets
• Share of unamortized fair value adjustments
• Implicit goodwill
– Dividend is a repayment of profit and not income under the equity method
•
Transfer of assets between investor and associate
– In both upstream and downstream sales:
