Advanced Financial Accounting: Chapter 6 Group Reporting V: Equity Accounting under IAS 28 Tan, Lim & Lee Chapter 61© 2015

Advanced Financial Accounting: Chapter 6

Group Reporting V: Equity Accounting under IAS 28

Tan, Lim & Lee Chapter 6 1© 2015

Learning Objectives

1. Reinforce your understanding of the concept of “significant influence”

2. Appreciate the different accounting policies for investment in associate

3. Understand the differences between cost and equity method and

consolidation

4. Know how to apply equity method for investment in associate

5. Perform an analytical check on the investment in associate balance

6. Appreciate the accounting of joint arrangements

Tan, Lim & Lee Chapter 6 2© 2015

Content

Tan, Lim & Lee Chapter 6 © 2015 3

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



Concept of “Significant Influence”

• The power to participate in, but not control or joint control of those policies

Power Ability Returns Control

Contractual sharing of

power

Unanimous consent

Joint control

Power to participate in the financial

and operating policies

Not control or joint control

Significant influence


Concept of “Significant Influence”

• Default assumption:– Percentage ownership of ≥ 20% and ≤ 50% of investee’s voting rights

deemed as giving rise to “ significant influence”

– Investor may depart from threshold if the investor is able to demonstrate that the quantitative threshold is not indicative of 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

– Provision of essential technical information


Accounting Policy for Investments In Associates

Levels of financial reporting Accounting policy1. 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 statements in place of consolidated financial statements (with associates): economic entity

Equity method


Equity Method

• Equity accounting:– Investment is initially recognized at cost and adjusted thereafter for

investor’s share of change in post-acquisition retained earnings– Profit or loss of investor includes investor’s share of profit or loss of the

investee– Dividends are not treated as income but as repayment of equity-

accounted profit– Investment account is not eliminated

Investment in associate

Share of bookvalue of net assets

Unamortized FV adjustments

Implicit goodwill

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Cost Method Versus Equity Method Versus Fair Value Through Profit or Loss (FVTPL)Dimensions Cost Method Equity Method FVTPL

Income recognition

• Dividend income • Emphasizing reliability and realized income

• Share of profits• Emphasizing the predictive value of information of unrealized gains

• Dividend income and change in fair value

Asset measurement

• Historical acquisition cost less impairment loss

• Cost; and• Share of post acquisition change in equity

• Fair value

Profit on sale • Large terminal profit • Smaller terminal profit• Profits are recognized systematically over holding period

• Zero terminal profit

Nature of the economic relationship between investor and investee

• No economic relationship• Investor is deemed as a passive holder of investment

• Economic interdependence • Investor has “significant influence” over the investee

• No economic relationship• Investment may be held for trading or quantifies for fair value measurement

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Rationale for Differences in Presentation

• Equity accounting captures the substance of consolidation but not the form– Individual line items of financial statements of investor and associate are

not consolidated– Results and net assets of associate are recognized in single line items:

• Share of profit of associate in the income statement• Investment in associate account in the statement of financial position

– Consolidation and equity method will achieve the same group retained earnings and net assets (with minor exceptions for upstream and downstream sales adjustments)

• Decision rights implicit in “significant influence” are not as strong as in “control” – Might be misleading to aggregate associate’s individual assets and

liabilities


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Consolidation Vs Equity Method

Dimensions Consolidation Equity MethodIncome recognition

• Income statement items of subsidiary are added in full with the parent’s

• Share of profit is reported as a single line item in the consolidated income statement

Non-controlling interests (NCI)

• NCI’s share of profit after tax is shown separately as an allocation of consolidated profit after tax

• Only investor’s share of profit 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:– Book value of net assets of associate– Fair value adjustments– Goodwill


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Dimensions Consolidation Equity MethodGoodwill on consolidation

Shown separately as an asset on the consolidated statement of financial position

Implicit in the investment account

Unamortized balance of FV adjustments

Adjustments are made on the specific assets or liabilities on the consolidated statement of financial position

Unamortized balance is implicit in the investment account

Profit on sale of investment

Profit on sale = Sales proceeds – (Share of net assets + goodwill + unamortized balance of FV adjustments)

Profit on sale = Sales proceeds – (Share of net assets + implicit goodwill+ unamortized balance of FV adjustments)


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Dimensions Consolidation Equity MethodEconomic relationship between investor and investee

Economic integration based on “control” by investor

Lesser economic integration based on “significant influence” by investor

Impact on financial ratios

• Because of the line by line summation, certain reported items are larger (e.g. assets and liabilities)• Ratios such as net profit margin and debt-equity are likely to be different under consolidation and equity method

As the equity method does not entail the aggregation of line items of an associate, certain ratios (e.g. debt-equity ratio) may appear more favorable under the equity method


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Methodology of Equity Accounting

1. Investment is initially recorded at cost

2. Investment at cost comprises of:• Share of the book value of the net assets of the associate;• Share of the fair value adjustments of net identifiable asset of the

associate; and• Goodwill

3. Goodwill that is implicit in the cost of investment is written off when 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


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5. Investor’s share of past and current amortization of fair value adjustments is adjusted against the investment account

6. Initial investment is adjusted for the post-acquisition change in investor’s share of net assets of the investee

7. 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 date from initial recognition to disposal date

8. Share of current profit of the associate will be adjusted for:• Unrealized profit arising from current year transfer (downward adjustment)• Realized profit in current year arising from previous year transfer (upward

adjustment)


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9. Dividends reduce the carrying value of investments• 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

10. Other changes in equity (e.g. increase in revaluation reserve) are recognized in accordance with the investor’s interest


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balance


4. Performing an analytical check on the investment in associate balance


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Analytical Check

Investment in associate

Share of book value of net assets

Unamortized FV adjustments

Implicit goodwill

Investor’s share X (Book value of net

assets -/+ unrealized profit/loss at period

end)

Investor’s share X(Unamortized

balance of excess FV over book value of net identifiable asset on

Initial recognition)

Initial cost –Investor’s share of FV of

identifiable net assets at acquisition date – impairment loss*

*Assume that impairment loss, if any, is made against goodwill firstTan, Lim & Lee Chapter 6 © 2015

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balance

5. Specific procedures relating to the equity method 5. Specific procedures relating to the equity method


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Conversion to the Equity Method

Accounting for Investment in Associate Investor’s separate financial Consolidated financial statements

Cost method Equity methodAs a financial instrument under IAS 39 Equity method

Begin with the investor’s separate financial statements and prepare equity accounting adjustments in associate under the equity method


Consolidation Procedures Not Applicable to Equity Method

1. Elimination of intragroup balances and perfectly offsetting income statement items are not required

• Equity method does not entail line by line aggregation

2. Investment in associate is not eliminated• Investment account captures:

– Implicit goodwill

– Share of change in post-acquisition retained earnings

– Realization of earnings through dividends

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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 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%

Prepare the equity accounting entries for the year ended 31 Dec 20X5


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Illustration 1: Amortization of FV Adjustments of Identifiable Net Assets

EA1: Share of post-acquisition retained earningsDr Investment in associate 1,000,000Cr Opening retained earnings 1,000,000RE 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

Note: This entry capitalizes the share of past profits in the investment account


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EA2: Share of past cumulative depreciation on undervalued fixed assets (after-tax)Dr

Opening retained earnings80,000 (20% x 80% x $5,000,000 / 10)

Cr Investment in associate 80,000Any adjustment relating to an asset or liability of the associate is made against the investment in associate account

− investment account acts as a proxy for the “net assets” of the associate


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EA3: Share of current profit after tax of associateDr Investment in associate 1,500,000 [20% x ($9,500,000-$2,000,000)]Cr Share of profit of associate 1,500,000Net profit before tax $10,000,000

Less current excess depreciation (500,000)

Adjusted net profit before tax $9,500,000

Tax expense $2,100,000

Less tax on current excess depreciation (100,000)

Adjusted tax expense $2,000,000


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Goodwill Impairment

• Goodwill is not recognized as a stand-alone asset but is implicit in the investment account, hence, not tested for impairment on its own

• Impairment test is performed for investment as a whole– Carrying amount of the investment is compared with recoverable

amount– Recoverable amount is the higher of:

• Value in use, and• FV less cost to sell

• Impairment losses: – Will reduce the investment account– May be attributed to book value of net assets, fair value adjustments or

goodwill


Illustration 2

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• 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 losses2) The impairment loss relates to the share owned by the investor; hence there

is no need to apply ownership percentage

EA1: Share of past impairment lossDr

Opening RE 250,000

Cr Investment in Associate 250,000


Illustration 2

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EA 2: Share of current profit after tax of associate

DrInvestment in associate

1,480,000Cr Share of profit of associate 1,480,000

Share of profit before tax of associate (20%) 2,000,000Less: current impairment loss (100,000)Adjusted net profit before tax 1,900,000

Share of tax of associate (20%) 420,000

*Impairment loss relating to goodwill is assumed to be non-tax deductibleShare of profit after tax 1,480,000


Transfer of Assets between Investor and Associate• Gains and losses from transactions between an investor and its associate

are recognized in the investor’s economic entity financial statements only to the extent of unrelated investors’ interests in the associate (IAS 28 paragraph 28)

• This principle applies to both upstream and downstream transfers• For example, in a “downstream” transfer, Investor makes a profit of

$100,000 from sale to Associate who then sells the goods to third parties. The profit of $100,000 will be reduced by the share of the higher cost of sales of the associate. Let’s say Investor has a 30% ownership interest in Associate and ignoring taxes, the net impact on the profit of Investor is shown below. Effectively, the net impact on profit is that Investor recognizes only 70% (or the unrelated investor’s interest) on the profit from the transfer.


Profit from sale to associate $100,000Share of profit of the associate reduced by (30,000)

Net impact on profit $70,000

Transfer of Assets between Investor and AssociateIf we assume an “upstream” transfer• For example, Associate makes a profit of $100,000 from sale to Investor

who then sells the goods to third parties. The share of profit will be reduced by the higher cost of sales of the Investor. Let’s say Investor has a 30% ownership interest in the associate and ignoring taxes, the net impact on the profit of Investor is shown below. Effectively, the net impact on profit is that Investor recognizes only 70% (or the unrelated investor’s interest) of the higher cost of sales.


Higher cost of sales of investor ($100,000)Share of profit of the associate 30,000

Net impact on profit ($70,000)

Transfer of Assets between Investor and Associate• In the two short examples of the downstream and upstream sales, we see

that the net impact is that the Investor recognizes the net impact of 70% of the profit on sale or cost of sale from the transfer

• No adjustments are required because the goods are fully resold to third parties in the same period

• In the situation that the transferred goods are not fully-resold to third parties, the share of profit should not include the profit from the unsold inventory

• For example, in the upstream sale illustration, let’s assume that 10% of the inventory was unsold at the end of the reporting period


Higher cost of sales of investor ($90,000)Share of profit of the associate 27,000

Net impact on profit ($63,000)

30% x 90% x $100,000

Impact excludes

the unsold portion

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Transfer of Assets between Investor and Associate

“Upstream sale”

X %

Sales were made from associate to investor

Investor Investor

Associate

X %

Sales were made from investor to associate

“Downstream sale”

In both upstream & downstream sales:• Investor recognizes profit only to the extent of unrelated investor’s interest in associate (1-X%)• Investor’s share of profit arising from transfers is eliminated (X%)• Quantitative impact of adjustment for upstream and downstream sales is the same

Associate


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Transfer of Assets between Investor and Associate• Two approaches to adjust the unrealized profit on a downstream

or upstream transfer between an investor and its associate: Method 1: Adjust the specific accounts affected (e.g. upstream, adjust

equity accounted profit and the inventory of the investor; downstream, adjust the line item sales, cost of sales and investment in associate

Method 2: Use the one-line adjustment approach – adjust through the investment account and the share of profit (with footnote disclosures to explain)

• Method 2 better differentiates accounting for associates from accounting for subsidiaries

• Effectively, the associate is akin to a “quasi-third party” and the line items of the investor is not adjusted but only the quantum of the unrealized profit is adjusted through share of profit of associate − principle is that transactions and balances with associates are not

eliminated but the quantum of the reported profit should include only profit with unrelated investors


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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%

Prepare the equity accounting entries for I.


Illustration 3

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EA 1: Share of current profit of associate

DrInvestment in associate 156,800

Cr Share of profit of A 156,800

A’s net profit after tax $800,000

Less unrealized profit in the current year (80% x 1/3 x $60,000) (16,000)

A’s adjusted net profit after tax $784,000

I’s share of net profit at 20% $156,000


Illustration 3

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I’s profit (at group level)Adjusted

I’s profit (at group level)Unadjusted

Gross profit from downstream sale 60,000 60,000Share of A’s profit 156,800 160,000Profit effect 216,800 220,000

I is not able to recognize its share of unrealized profit of $3,200 ($60,000 x 20% x 1/3 x 80%). However, I is able to recognize 80% of the unrelated investor’s share as if it had sold the inventory to unrelated investors of A


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Illustration 3 (extension)

• Consider the impact of the adjustment on unrealized profit on an upstream transfer (same situation as in the previous example)

• Associate A sells inventory to the investor U

• Note: both upstream and downstream adjustments are effected through the share of profit and investment in associate accounts

I’s profit (at group level)Adjusted

I’s profit (at group level)Unadjusted

Gross profit from downstream sale (40,000) (40,000)Share of A’s profit 156,800 160,000Profit effect 116,800 120,000

Difference between the adjusted and unadjusted amount is $3,200 which is I’s share of the unrealized profit on the upstream transfer


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Treatment 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 separate investor’s financial statements dividend is recognized as an income– To convert from cost to equity method, dividends have to be

reclassified from income statement to the statement of financial position

Dr Dividend income (I/S)

Cr Investment in associate (B/S)


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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• Unamortized fair value adjustments• Implicit goodwill

– Dividends income are reclassified to investment account

• Transfer of assets between investor and associate– In both upstream and downstream sales:

• Investor’s share of profit arising from transfers is eliminated


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Appendix: Accounting for Joint Arrangements• Joint arrangement exists when two or more parties to the

arrangement has joint control – Existence of a contractual arrangement– Parties to the contract has joint control over arrangement

• Joint ventures vs. joint operations– Determination of the type of joint arrangement often involves judgment– Joint arrangement that is not structured through a separate vehicle is a

joint operations


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Appendix: Joint Ventures

• Parties that have joint control of the arrangement have rights to the net assets of the arrangements– Does not give rise to rights to specific assets and obligations for specific

liabilities

• Account for joint venture:− Using the equity method in the consolidated financial statements− At cost or as a financial instrument in the separate financial statements− Same as accounting for associates


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Appendix: Joint Operations

• Parties that have joint control of the arrangement have rights to the assets, and obligations for the liabilities, relating to the arrangements– E.g. first operator who contributes knowledge and expertise have rights to

the intellectual property while second operator who contributes physical equipment have rights to property, plant and equipment

• Account for joint operations in the same manner in both the separate and consolidated financial statements

• Each operator will “recognize in relation to its interest in a joint operation:− Its assets, including its share of any assets held jointly;− Its liabilities, including its share of any liabilities incurred jointly;− Its revenue from the sale of its output arising from the joint operation;− Its share of the revenue from the sale of the output by the joint operation;

and− Its expenses, including its share of any expenses, incurred jointly.”(IFRS 11, paragraph 20)Tan, Lim & Lee Chapter 6 © 2015

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Advanced Financial Accounting: Chapter 6 Group Reporting V: Equity Accounting under IAS 28 Tan, Lim & Lee Chapter 61© 2015