The previous example illustrated the basic concepts of the equity method. Besides these fundamentals, the following features are relevant for this course:
• The accounting for other changes in associate’s equity • Acquisition costs greater than carrying amount • Unrealized intercompany profits
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Jan. 1, Year 1
Investment in Safebuy 95,000
Cash 95,000
To record the acquisition of 10% of Safebuy’s shares Dec. 31, Year 1
Investment in Safebuy (10% 3 100,000) 10,000
Investment income 10,000
10% of Safebuy’s Year 1 net income
Cash (10% 3 80,000) 8,000
Investment in Safebuy 8,000
Receipt of dividend from Safebuy
The equity method picks up the investor’s share of the changes in the associate’s shareholders’ equity.
The equity method provides information on the potential for future cash flows. Income is recognized based on the income reported by the associate, and dividends are reported as a reduction of the investment account.
• Changes to and from the equity method
• Losses exceeding the balance in the investment account • Impairment losses
• Gains or losses on sale of the investment • Held for sale
• Disclosure requirements
Other Changes in Associate’s Equity In accounting for an investment by the equity method, IAS 28 requires that the investor’s proportionate share of the asso- ciate’s discontinued operations, other comprehensive income, changes in account- ing policy, corrections of errors relating to prior-period financial statements, and capital transactions should be presented and disclosed in the investor’s financial statements according to their nature.
Companies report certain items separately on their statements of comprehen- sive income so that financial statement users can distinguish between the por- tion of comprehensive income that comes from continuing operations and the portion that comes from other sources such as discontinued operations and other comprehensive income. Retrospective adjustments of prior-period results and capital transactions are shown as separate components of retained earnings or are disclosed in the footnotes.
Example A Company owns 30% of B Company. The statement of comprehensive income for B Company for the current year is as follows:
Upon receiving this statement of comprehensive income, A Company makes the following journal entry to apply the equity method:
All three income items, which total $45,000, will appear on A Company’s state- ment of comprehensive income. The investment loss from discontinued opera- tions and the other comprehensive income items require the same presentation as
The investor’s statement of comprehensive income should reflect its share of the investee’s income according to its nature and the different statement classifications.
B COMPANY
STATEMENT OF COMPREHENSIVE INCOME
Sales $500,000
Operating expenses 200,000
Operating income before income tax 300,000
Income tax 120,000
Net income from operations 180,000
Loss from discontinued operations (net of tax) 40,000
Net income 140,000
Other comprehensive income (net of tax) 10,000
Comprehensive income $150,000
Investment in B Company (30% 3 150,000) 45,000
Discontinued operations 2 investment loss (30% 3 40,000) 12,000
Other comprehensive income (30% 3 10,000) 3,000
Investment income (30% 3 180,000) 54,000
The investor’s shares of income from continuing operations, discontinued operations, and other comprehensive income are reported separately.
would be made if A Company had its own discontinued operations or other com- prehensive income items. Full footnote disclosure is required to indicate that these particular items arise from an investment in associate accounted for by the equity method. Materiality has to be considered because these items do not require spe- cial treatment in A Company’s statement of comprehensive income if they are not material from A Company’s point of view, even though they are material from B Company’s perspective.
Many of the accounting procedures for the application of the equity method are similar to the consolidation procedures for a parent and its subsidiary. Fur- thermore, the concepts underlying the procedures used in accounting for the acquisition of a subsidiary are also adopted in accounting for the acquisition of an investment in an associate. The next two sections briefly describe procedures required in applying the equity method that are equally applicable under the con- solidation process. In this chapter, we will describe the procedures very generally. We will discuss these procedures in more detail in later chapters when we illus- trate the consolidation of a parent and its subsidiary.
Acquisition Costs Greater than Carrying Amounts In the previous examples, we recorded Jenstar’s initial investment at its cost, but we did not consider the implications if this cost was different from the carrying amount of Safebuy’s net assets at the time of the acquisition. We now add a new feature to equity method reporting by considering the difference between the amount paid for the investment and the investor’s share of the carrying amount of the associ- ate’s net assets.
Companies’ shares often trade at prices that are different from their car- rying amount. There are many reasons for this. The share price presumably reflects the fair value of the company as a whole. In effect, it reflects the fair value of the assets and liabilities of the company as a whole. However, many of the company’s assets are reported at historical cost or cost less accumulated amortization. For these assets, there will be a difference between the fair value and the carrying amount. Some of the company’s value may be attributed to assets that are not even reported on the company’s books. For example, the company may have expensed its research and development costs in the past but is now close to patenting a new technology. This technology could have consid- erable value to a prospective purchaser, even though there is no asset recorded in the company’s books. Last but not least, the company’s earnings potential may be so great that an investor is willing to pay an amount in excess of the fair value of the company’s identifiable net assets. 3 This excess payment is referred to as goodwill.
The difference between the investor’s cost and the investor’s percentage of the carrying amount of the associate’s identifiable net assets is called the acquisition
differential. The investor allocates this differential to specific assets and liabilities
of the associate, and then either depreciates the allocated components over their useful lives or writes down the allocated component when there has been impair- ment in its value. This process of identifying, allocating, and amortizing the acqui- sition differential will be illustrated in later chapters.
Unrealized Profits As we will see in later chapters, consolidated financial state- ments result from combining the financial statements of a parent company with
Many accounting procedures required for consolidated purposes are also required under the equity method.
The investor’s cost is usually greater than its share of the carrying amount of the associate’s net assets.
the financial statements of its subsidiaries. The end result is the financial reporting of a single economic entity, made up of a number of separate legal entities. One of the major tasks in this process is to eliminate all intercompany transactions— especially intercompany “profits”—so that the consolidated statements reflect only transactions with outsiders. The basic premise behind the elimination is that, from the point of view of this single accounting entity, “you cannot make a profit selling to yourself.” Any such “unrealized profits” from intercompany transfers of inventory (or other assets) must be held back until the specific assets involved are sold to outside entities or used in producing goods or providing services to outsiders.
In the case of a significant influence investment, any transactions between the investor and the associate (they are related parties) must be scrutinized so that incomes are not overstated through the back-and-forth transfer of assets. From an accounting perspective, any transfer is acceptable provided that both parties record the transfer at the value at which it is being carried in the records of the selling company. However, if the transfer involves a profit, a portion of that profit must be held back on an after-tax basis in the investor’s equity method journal entries. When the asset in question is sold outside or consumed by the purchaser, the after-tax profit is realized through an equity method journal entry, again made by the investor. The entries under the equity method to account for unrealized and realized profit from intercompany transactions will be discussed and illustrated in detail in Chapters 6 and 7.
Changes to and from the Equity Method The classification of investments will change as the particular facts change. An investment may initially be FVTPL and subsequently change to one of significant influence. This could happen if addi- tional shares were acquired. Once significant influence has been achieved, a switch from the previous way of reporting is made on a prospective basis. The carrying amount of the FVTPL investment, which would be the fair value of the invest- ment, becomes its new cost. If circumstances change, significant influence may also be achieved without additional shares being acquired, in which case the equity method would commence. For example, the holdings of a large block of investee shares by another company could prevent an investor from exercising significant influence. But if that other company sells its block on the market, the investor’s previous FVTPL investment may now amount to significant influence. See Part A of Self-Study Problem 1 for an example of changing from FVTPL to the equity method on a prospective basis.
When an investment changes from significant influence to FVTPL, the equity method ceases to be appropriate and the fair value method takes its place, also on a prospective basis. On this date, the investor shall measure at fair value any investment the investor retains in the former associate. The investor shall recog- nize in net income any difference between
(a) the fair value of any retained investment and any proceeds from disposing of the part interest in the associate, and
(b) the carrying amount of the investment at the date when significant influence is lost.
If an investor loses significant influence over an associate, the investor must account for all amounts recognized in other comprehensive income in relation to
Consolidated statements should reflect only the results of transactions with outsiders.
Profits from intercompany transactions must be eliminated until the assets are sold to outsiders or used in producing goods or providing services to outsiders.
Changes in reporting methods are accounted for prospectively if they are changed because of a change in circumstance.
that associate on the same basis as would be required if the associate had directly disposed of the related assets or liabilities. When the investor sells its investment in the associate, it is, in effect, selling its proportionate share of the assets and liabilities of the associate. Therefore, if a gain or loss previously recognized in other comprehensive income by an associate would be reclassified to net income on the disposal of the related assets or liabilities, the investor reclassifies the gain or loss from accumulated other comprehensive income to net income (as a reclassification adjustment) when it loses significant influence over the associ- ate. For example, if an associate had reported other comprehensive income on a cash flow hedge and the investor loses significant influence over the associate, the investor must reclassify to net income the gain or loss previously recognized in OCI in relation to that hedge. If an investor’s ownership interest in an asso- ciate is reduced, but the investment continues to be an associate, the investor must reclassify to net income only a proportionate amount of the gain or loss previously recognized in OCI.
When an investment changes from significant influence to control, the prepa- ration of consolidated statements commences, again on a prospective basis. The concepts relating to this particular situation will be discussed at length in later chapters.
Losses Exceeding the Balance in the Investment Account A question arises as to the appropriate accounting when an investor’s share of an associate’s losses exceeds the carrying amount of the investment. There are two possible ways to treat this. The investor could reduce the investment account to zero and recom- mence the use of the equity method when its share of associate’s earnings exceeds its share of losses. Alternatively, the investor could continue to accrue losses, even though they result in a negative balance in the investment account. IAS 28 provides some guidance on this issue. After the investor’s interest in the associate is reduced to zero, additional losses are provided for, and a liability is recognized, only to the extent that the investor has incurred legal or constructive obligations or made pay- ments on behalf of the associate. The investor would have an obligation if it guar- anteed certain liabilities of the associate or if it committed to provide additional financial support to the associate. If a liability is not reported, the investor resumes recognizing its share of those profits only after its share of them equals the share of losses not recognized.
If the investor has other long-term interests in the associate over and above its equity investment, these other assets may also have to be written down. Such items may include preference shares and long-term receivables or loans but do not include trade receivables, trade payables, or any long-term receivables for which adequate collateral exists. Losses recognized under the equity method in excess of the investor’s investment in ordinary shares are applied to the other components of the investor’s interest in an associate in the reverse order of their seniority (i.e., pri- ority in liquidation). Accordingly, an investment in preferred shares should be writ- ten down before a long-term note receivable because the preferred share becomes worthless before a note receivable. In other words, the note receivable has priority over the investment in preferred shares in the event that the associate is liquidated. Impairment Losses If there is an indication that the investment may be impaired, the investment is tested for impairment in accordance with IAS 36, as a single asset, by comparing its recoverable amount (higher of value in use and fair value less
If an investor guaranteed an investee’s obligations, the investor could end up reporting its investment as a liability rather than an asset.
Other long-term interests in the associate may have to be written down when the associate is reporting losses.
costs of disposal) to its carrying amount. In determining the value in use of the investment, an entity estimates
(a) its share of the present value of the estimated future cash flows expected to be generated by the associate, including the cash flows from the operations of the associate and the proceeds on the ultimate disposal of the investment, or (b) the present value of the estimated future cash flows expected to arise from
dividends to be received from the investment and from its ultimate disposal. If the recoverable amount is less than the carrying amount, the investment is written down to the recoverable amount. The impairment loss is not allocated to goodwill or any other assets underlying the carrying amount of the investment because these underlying assets were not separately recognized. If the recoverable amount increases in subsequent periods, the impairment loss can be reversed.
Gains and Losses on Sale of Investments When all the shares that make up a long-term investment are sold, the gain (loss) is shown on the income statement and is calculated as the difference between the sale proceeds and the carrying amount of the investment. When only some of the shares are sold, the gain is calculated using the average carrying amount of the investment. Formulas such as first in, first out (FIFO), last in, first out (LIFO), or specific identification are not permitted. If a portion of a significant influence or a control investment is sold, a re-evaluation must be made to determine whether the previous classification is still valid.
Held for Sale Investments in associates that meet the criteria to be classified as held for sale should be measured at the lower of carrying amount and fair value less costs of disposal, and should be reported as current assets. An entity shall clas- sify an investment in associate as held for sale if its carrying amount will be recov- ered principally through a sale transaction rather than through continuing use. For this to be the case, the asset must be available for immediate sale in its present con- dition, subject only to terms that are usual and customary for sales of such assets, and its sale must be highly probable. For the sale to be highly probable, the appro- priate level of management must be committed to a plan to sell the asset, and an active program to locate a buyer and complete the plan must have been initiated. Further, the asset must be actively marketed for sale at a price that is reasonable in relation to its current fair value. In addition, the sale should be expected to qualify for recognition as a completed sale within one year from the date of classification, and actions required to complete the plan should indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.
Presentation and Disclosure Requirements Investments in associates shall be classified as noncurrent assets. The investor’s share of the profit or loss of such associates and the carrying amount of these investments must be separately dis- closed. In addition, the following summarizes the main disclosures required in IFRS 12 for investments in associates:
(a) Nature of the entity’s relationship with the associate and the proportion of ownership interest or participating share held by the entity
(b) Fair value of investments in associates for which there are published price quotations
Average cost should be used in determining any gain or loss when an investor sells part of its investment.
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The fair value of an investment in associate should be disclosed when it is readily available.
(c) Summarized financial information of associates, including the aggregated amounts of assets, liabilities, revenues, and profit or loss
(d) Unrecognized share of losses of an associate, both for the period and cumu- latively, if an investor has discontinued recognition of its share of losses of an associate
(e) Nature and extent of any significant restrictions on the ability of associates to transfer funds to the entity in the form of cash dividends, or to repay loans or advances made by the entity
(f) Contingent liabilities incurred relating to its interests in associates
Aecon Group Inc. is a publicly traded construction and infrastructure- development company incorporated in Canada. Aecon and its subsidiaries pro- vide services to private and public sector clients throughout Canada and on a selected basis internationally. It reported numerous construction projects under the equity method in its 2011 financial statements. Excerpts from these statements, which applied the disclosure requirement in IAS 28 rather than IFRS 12, are pre- sented in Exhibit 2.2 . Much of the disclosure provided under IAS 28 would also be required under IFRS 12.
5. Summary of Significant Accounting Policies 5.24 Associates
Entities in which the Company has significant influence and which are neither subsidiar-