Lecture 10 : Accounting for investments in associates
HI5020 Corporate Accounting
Topics covered in this lecture
• How to account for equity investments
where the investor does not have
control over the investee
• Cost method of accounting for
investment in associate
• Equity method of accounting for
investment in associate
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Introduction to Accounting for Equity
Investments (cont.)
If the investor has significant influence over the investee,
the equity method of accounting must be applied
• Investment in an associate is increased by any postacquisition movements in the associate’s earnings &
reserves An equity investment is deemed to exist where (AASB
132):
• the investor has acquired an equity instrument, which
can be defined as:
➢any contract that evidences a residual interest in an
entity’s assets after deducting all its liabilities
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Types of Investments Equity investments
✓Usually shares in an organisation
✓Give investor an ownership interest & therefore
share in profits Bonds
✓Instrument that binds one party to repay funds to
another party at a specified time & rate
✓For example, debentures & unsecured notes
✓Can be issued at face value, discount or premium
✓Some can have both debt & equity characteristics,
e.g. convertible bonds
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Types of Investments (cont.)
✓Cash investments
✓Can be converted to cash at short notice
✓For example, interest-bearing deposits
✓Property investments
✓Various investments in physical property
✓For example, land & buildings
✓Held to earn rentals &/or capital appreciation
✓Can be purchased directly or through a property
trust
✓Also derivative instruments
✓Derive their value from other underlying assets
✓For example, futures & options
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Investments in Associates
Key terms:
Associate: investee over which the investor has
significant influence
Investee: entity in which another entity has an
ownership interest
Investor: entity/person that has an ownership
interest in another entity
Significant influence: power to participate in
investee’s financial & operating policy decisions (but
not control or joint control)
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Equity Method of Accounting
AASB 128 requires that:
where an investor does significantly influence an
investee, the investor must adopt the equity
method of accounting
Therefore, while there is a general principle that
equity investments shall be measured at fair
value, where an investor has significant
influence then we will use equity accounting to
measure the equity investment
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Equity Method of Accounting (cont.)
• AASB 128 requires:
• use of equity accounting within the financial
statements, &
• application of equity accounting to include corporate
investments & non-corporate investments
• Significant influence
• Used in determining whether the equity method is to
be applied
• Falls short of control
• Normally stems from investor’s voting power in the
investee
• Assumed to exist where investor holds 20% or more of
investee’s voting power
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Equity Method of Accounting (cont.)
• Significant influence (cont.):
• 20% is not intended as an absolute cut-off point &
significant influence may exist with an equity holding
below this rather arbitrary amount of voting power
• Other indicators
• representation on board of directors
• participation in policy-making processes
• material transactions between investor & investee
• interchange of managerial personnel
• provision of essential technical information
• If the investor subsequently ceases to have significant
influence, they must cease using equity accounting
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Application of the Equity Method of Accounting
✓As with the materiality application in other accounting
standards, if investments are not material, investor
not required to comply with AASB 128
✓Investment in associate is initially recognised at cost
✓Carrying amount of investment is increased or
decreased to recognise investor’s share of investee’s
post-acquisition profits
✓Investor’s share of investee’s profit or loss to be
included in investor’s profit or loss
✓Distributions (e.g. dividends) from investee reduce
the investment’s carrying amount
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Application of the Equity Method of Accounting (cont.)
• Adjustments to carrying amount also for:
• changes in investor’s proportionate interest in
investee from changes in investee’s equity not
included in investee’s profit or loss
• For example, revaluations of property, plant &
equipment & foreign exchange translation
differences
• Investor’s share of changes recognised directly in
investor’s equity
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Application of the Equity Method of Accounting (cont.)
• If investor is required to prepare consolidated financial
statements they should:
• recognise investment in associate by applying equity
method in consolidated financial statements, &
• apply cost or fair value methods in own individual
financial statements
• If investor does not prepare consolidated financial
reports they should:
• apply the equity method to their own ‘separate’
financial report
• (the above is summarised on the following slide)
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Is the Investor a Parent Entity?
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Application of the Equity Method of Accounting (cont.)
• At acquisition, the difference between investor’s share of
adjusted values of investee’s net assets & cost of
investment is regarded as:
• goodwill, or
• discount on acquisition
• Goodwill is not separately disclosed; however, any
impairment of goodwill is taken into account in
calculating the investor’s share of the associate’s profit
or loss
• When recognising investor’s share of associate’s postacquisition profits:
• adjustments are to be made to profit share to take into
account depreciation based on fair values of
associate’s asset
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Application of the Equity Method of Accounting (cont.)
• Rationale for adopting the equity method
• Stream of dividend receipts (revenue under the cost
method) might provide inaccurate guide to investee’s
performance & value
• Provides a better indication of investment’s
underlying worth
• Criticisms by opponents of equity method
• Breaches realisation principle tied to notion of
conservatism
• Investor reports its share of investee’s profits, even
without any dividends
• Account balance of investment is neither cost nor fair
value
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Application of the Equity Method of Accounting (cont.)
Comparison of cost method & equity method of
accounting
Cost method
To recognise initial acquisition of shares
| Investment in X Ltd Cash at bank |
XX | XX |
AssignmentTutorOnline
To recognise receipt of pre-acquisition dividend
| Cash at bank | XX |
| Investment in X Ltd | XX |
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Application of the Equity Method of Accounting (cont.)
Cost method (cont.)
To recognise dividends provided by associate from
post-acquisition profits
Dividend receivable XX
Dividend revenue XX
To recognise receipt of previous dividend provided
| Cash at bank | XX |
| Dividend receivable | XX |
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Application of the Equity Method of Accounting (cont.)
Equity method (where investor is a parent)
In consolidation worksheet (Year 1)
To record investor’s share of associate’s profit
| Investment in X Ltd | XX |
| Share of associate’s profit | XX |
To recognise investor’s share of dividends
| Dividend revenue | XX |
| Investment in X Ltd | XX |
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Application of the Equity Method of Accounting (cont.)
In consolidation worksheet (Year 2)
Prior period share of profits
| Investment in X Ltd | XX |
| Retained earnings (opening) | XX |
To recognise share of associate’s losses
Share of associate’s profit/loss XX
Investment in X Ltd XX
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Application of the Equity Method of Accounting (cont.)
To recognise investor’s share of dividends
| Dividend revenue Investment in X Ltd |
XX | XX |
Investor’s share of associate’s increase in
revaluation reserve
| Investment in X Ltd Revaluation surplus |
XX | XX |
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Application of the Equity Method of Accounting (cont.)
✓Investor’s share of associate’s profit/loss to
be adjusted for (AASB 128):
✓any depreciation differences caused by
reassessing values of associate’s assets to fair
value at date of acquisition
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Worked Example—Comparison of the cost and equity
methods of accounting
• On 1 July 2018, Cassie Ltd acquires a 30 per cent interest
in Joy Ltd for a cash consideration of $540 000.
• On the date of the acquisition, the assets of Joy Ltd are
reported at their fair value. The total share capital and
reserves of Joy Ltd as at the date of the acquisition are:
Share capital $1 320 000
| Retained earnings Total shareholders’ funds |
$480 000 $1 800 000 |
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Worked Example— Comparison of the cost and equity
methods of accounting-continued
Additional information
• For the year ending 30 June 2019, Joy Ltd records an after-tax profit
of $100 000. A dividend of $40 000 is declared and ratified by Joy Ltd
on 30 June 2019, with the dividend coming from profits earned in the
2018–19 financial year.
• In October 2019, Joy Ltd pays the $40 000 dividend provided for on
30 June 2019.
• For the year ending 30 June 2020, Joy Ltd records an after-tax loss
of $50 000. On 30 June 2020, Joy Ltd declares dividends of $20 000,
to be paid out of the profits earned in the 2019 financial year.
• On 30 June 2020, Joy Ltd revalues its land upwards by an amount of
$400 000.
• Cassie Ltd recognises dividends as revenue when the investee
declares the dividends (i.e. Cassie Ltd also recognises a dividend
receivable).
• The corporate tax rate is 30 per cent.
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Worked Example— Comparison of the cost and equity
methods of accounting-continued
(a) Journal entries using the cost method in the accounts of Cassie Ltd
Year ending 30 June 2019
July 2018
| Dr Investment in Joy Ltd Cr Cash at bank |
540 000 | 540 000 |
June 2019
| Dr Dividend receivable Cr Dividend revenue |
12 000 | 12 000 |
Year ending 30 June 2020
October 2019
| Dr Cash at bank Cr Dividend receivable |
12 000 | 12 000 |
June 2020
| Dr Dividend receivable Cr Dividend revenue |
6 000 | 6 000 |
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Worked Example— Comparison of the cost and equity
methods of accounting-continued
(b) Journal entries using the equity method in the consolidated financial statements of Cassie Ltd
(a parent entity)
30 June 2019 (in consolidation worksheet)
| Dr | Investment in Joy Ltd | 30 000 |
| Cr | Share of associate’s profit | 30 000 |
| Dr | Dividend revenue | 12 000 |
| Cr | Investment in Joy Ltd | 12 000 |
30 June 2020 (in consolidation worksheet)
| Dr | Investment in Joy Ltd | 18 000 |
| Cr | Retained earnings—30 June 2019 | 18 000 |
| Dr | Share of associate’s profit/loss | 15 000 |
| Cr | Investment in Joy Ltd | 15 000 |
| Dr | Dividend revenue | 6 000 |
| Cr | Investment in Joy Ltd | 6 000 |
| Dr | Investment in Joy Ltd | 84 000 |
| Cr | Revaluation surplus | 84 000 |
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Worked Example— Comparison of the cost and equity
methods of accounting-continued
Journal entries using the equity method in the accounts of Cassie Ltd (not a parent
entity)
Year ending 30 June 2019
July 2018
| Dr | Investment in Joy Ltd | 540 000 |
| Cr | Cash at bank | 540 000 |
30 June 2019
| Dr | Investment in Joy Ltd |
| Cr | Share of associate’s profit |
| Dr | Dividend receivable |
| Cr | Investment in Joy Ltd |
30 000
30 000
12 000
12 000
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Worked Example— Comparison of the cost and equity
methods of accounting-continued
Year ending 30 June 2020
October 2019
Dr Cash at bank 12 000
Cr Dividend receivable 12 000
30 June 2020
Dr Share of associate’s profit/loss 15 000
Cr Investment in Joy Ltd 15 000
Dr Dividend receivable 6 000
Cr Investment in Joy Ltd 6 000
Dr Investment in Joy Ltd 84 000
Cr Revaluation surplus 84 000
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Worked Example —Adoption of equity accounting in the presence of a difference
between the fair values and carrying amounts
On 1 July 2017, Rankin Ltd, a parent entity, acquires a 25
per cent interest in the issued capital of Coombes Ltd for a
cash consideration of $80 000.
At the date of acquisition, the shareholders’ equity of
Coombes Ltd is $225 000, represented by:
| Share capital Retained earnings Total shareholders’ equity |
$165 000 $60 000 $225 000 |
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Worked Example —Adoption of equity accounting in the presence of a
difference between the fair values and carrying amounts
Additional information
• On the date of acquisition, land and buildings have carrying
amounts in the books of Coombes Ltd of $200 000 and $400 000
respectively. The market value of the land at the time is $225 000,
and the buildings’ market value is $450 000. The buildings have a
remaining expected useful life from 1 July 2017 of 20 years.
• For the year ending 30 June 2018, Coombes Ltd reported an aftertax profit of $50 000 from which it declared a dividend of $20 000.
• For the year ended 30 June 2019, Coombes Ltd reports an after-tax
profit of $100 000, from which it declared a dividend of $50 000.
• Coombes Ltd revalues its land to $250 000 in June 2019.
• Rankin Ltd recognises dividends as revenue on receipt of the
dividends.
• It is assumed that any goodwill acquired has not subsequently been
impaired.
• The tax rate is 30 per cent.
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Worked Example —Adoption of equity accounting in the presence of a
difference between the fair values and carrying amounts
Extra depreciation expense pertaining to buildings: ($50 000 ÷ life of the buildings) ×
Rankin Ltd’s ownership interest = ($50 000 ÷ 20) × 25% = $625. The after-tax effect of
this is $625 × (1 – 0.30) = $437.50
Associate’s profit for the year ending 30 June 2018 $50 000
| Rankin Ltd’s equity interest in Coombes Ltd | × 25% $12 500 (437.50) |
| less Building depreciation adjustment (see above) |
Rankin Ltd’s share of Coombes Ltd’s adjusted profit $12 062.50
As Rankin’s policy is to recognise dividends as revenue only as they are received, the
dividend provided by Coombes in the 2018 financial year, but unpaid at year end, will
not be recognised in calculating Rankin’s share of the associate’s profits.
June 2018 (in consolidation worksheet)
| Dr | Investment in Coombes Ltd | 12 062.50 |
| Cr | Retained earnings as at 30 June 2018 | 12 062.50 |
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Worked Example —Adoption of equity accounting in the presence of a
difference between the fair values and carrying amounts
June 2019 (in consolidation worksheet)
| Dr | Investment in Coombes Ltd | 24 562.50 |
| Cr | Share of associate’s profit | 24 562.50 |
| Dr | Dividend revenue | 5 000 |
| Cr | Investment in Coombes Ltd | 5 000 |
We increase the investment account for the share in the postacquisition movement in the revaluation surplus, after tax, which is
calculated as:
($250 000 – $225 000) × (1 – tax rate) × 25% = $4375.
| Dr | Investment in Coombes Ltd | 4 375 |
| Cr | Revaluation surplus | 4 375 |
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Inter-entity Transactions
✓Carrying amount of investment in associate must be
increased or decreased by:
✓amount of investor’s share of associate’s postacquisition profit or loss after adjustments for
certain inter-entity transactions
✓Investor required to adjust share of associate’s profit
or loss for its share of any unrealised profits or losses
from transactions between:
✓associate & investor (or any controlled entities), &
✓associate & any other associate of the investor
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Inter-entity Transactions (cont.)
✓Transactions between associate & member
of economic entity
✓The proportion of unrealised profits or losses to
be eliminated is investor’s ownership interest in
associate
✓Transactions between two associates of the
investor
✓The proportion of unrealised profits or losses to
be eliminated is product of investor’s ownership
interest in each associate
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Inter-entity Transactions (cont.)
✓Refer to Figure 32.2—Investor Company &
its subsidiaries & associates—on the next
slide
✓Investor Company
✓Subsidiary A: 100% owned
✓Subsidiary B: 80% owned
✓Associate A: 40% owned
✓Associate B: 30% owned
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Inter-entity Transactions (cont.)
Figure 32.2 (cont.)
✓Transaction 1
✓Associate A sells goods to Subsidiary A for a
profit of $10,000
✓At reporting date, Subsidiary A still has 50% of
the goods on hand
✓Amount of unrealised gain = 50% of $10,000 =
$5000
✓Amount to be eliminated = 40% of $5,000 =
$2,000
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Inter-entity Transactions (cont.)
Figure 32.2 (cont.)
Transaction 2
Same circumstances as Transaction 1, except goods
sold by Associate A to Subsidiary B
Same amount to be eliminated, even though
Subsidiary B is only 80% held
Transaction 3
Associate A sells goods to Associate B for a $20,000
profit
At reporting date, 75% of goods on hand
Amount of unrealised gain = 75% of $20,000 = $15,000
Amount to be eliminated = 12% (0.40 X 0.30) of $15,000
= $1,800
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The following topics have been discussed in this lecture:
• Equity investment –investor associate relationship
• Cost method of accounting for equity investment
• Equity method of accounting for equity investment
• Dealing with inter-equity transactions
Lecture Summary
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