Equity method

Equity method is used to account for investments in associates and joint-ventures. Simply put, the equity accounting method is a simplified form of consolidation (IAS 28 27), with one major difference: items are not added line-by-line, but a single asset (investment in associate or joint-venture) is recognised in the statement of financial position and single lines are presented in P/L and OCI.

The equity method is a method of accounting whereby the investment is initially recognised at cost and adjusted thereafter for the post-acquisition change in the investor’s share of the investee’s net assets.

The investor’s profit or loss includes its share of the investee’s profit or loss and the investor’s other comprehensive income includes its share of the investee’s other comprehensive income. Equity method for associates and joint ventures

Investments in associates under IAS 28 or IFRS 9
An investing entity can hold more than one financial instrument (different types of shares and/or loans) issued by the equity-accounted associate/investee. For the different types of shares it is relatively straight forward how to allocate the share of the investee’s profit or loss to the investment in the associate.

Preference shares are shares of a company’s stock with dividends that are paid out to shareholders before common stock dividends are issued. If the company enters bankruptcy, preferred stockholders are entitled to be paid from company assets before common stockholders. Most preference shares have a fixed dividend, while common stocks generally do not. As a result in many cases preference shares are only entitled to the preference part (dividend), common shares are entitles to the remainder of profit or loss after the allocation of dividends (which may be accumulating or not if a dividend in any year was not distributed due to a loss).

For loans (and/or other additional instruments) the investing entity has to determine at initial recognition whether the loan (and/or other additional instruments):

  • forms part of the investment in an associate or joint venture which as a result of this classification is accounted for under IAS 28 and not under IFRS 9, or
  • is a separate financial instrument  that is accounted for under IFRS 9 and not IAS 28.

When a loan is part of the investment in an associate or joint venture losses may be deducted first from the equity share investment and then from the loan investment in the investee rather than recognition of a provision (credit on the balance sheet) after the equity share investment has become zero.

When a loan is a separate financial instrument the headroom for the investing entity is lower, resulting in earlier recognition of a provision (credit on the balance sheet) after the equity share investment has become zero.

Keep in mind that after the investing entity’s interest in the associate is reduced to zero, additional losses are provide for, and a liability is recognised, only to the extent the investing entity has incurred legal or constructive obligations or made payments on behalf of the associate.

Something else -   Completely understand 1 consolidated and 2 separate financial statements

The equity accounting method should generally be used when an investment results in a 20% to 50% stake in another company, unless it can be clearly Equity methodshown that the investment doesn’t result in a significant amount of influence or control. If, however, the investor has less than 20% of the investee’s shares but still has significant influence in its operations, then the investor must still use the equity method and not the cost method.

In this case, the terminology of “parent” and “subsidiary” are not used, unlike in the consolidation method where the investor exerts full control over its investee. Instead, in instances where it’s appropriate to use the equity method of accounting, the investee is often referred to as an “associate” or “affiliate”. Equity method for associates and joint ventures

The equity accounting method either increases or decreases the investment account based on income earnings and dividend payments. It is best illustrated through an example.

Example: simple illustration of application of equity accounting method

Entity A acquired 25% interest in Entity B on 1 January 20X1 for a total consideration of $50m and accounts for it using the equity method. Entity B’s net assets as per its financial statements amounted to $150m. Entity B’s assets include a real estate with a carrying amount of $20m and fair value of $35m and remaining useful life of 15 years. For other assets and liabilities, the carrying amount approximates fair value. Deferred tax is ignored in this example. Equity method for associates and joint ventures

At the date of acquisition, Entity A recognises an investment in Entity B at cost, that is at $50m. This amount can be broken down as follows:

Something else -   Executory contract

EUR millions

25% share in B’s net assets as per its financial statements

37.50

25% share in fair value adjustment relating to real estate

3.75

Goodwill (not presented separately and not amortised) – remainder

8.75

Investment in Entity B at cost

50.00

Calculations: EqEquity methoduity method for associates and joint ventures

Net assets at carrying values as per the financial statements amount to EUR 150m, 25% thereof is EUR 150m * 25% = EUR 37.50m.

Real estate fair value EUR 35m less its carrying value of EUR 20m is EUR 15m, 25% thereof is EUR 15m * 25% = EUR 3.75m.

Goodwill is calculated as the difference between the total consideration of the 25% interest and the assets acquired at fair value (as per above, the net assets at carrying values acquired as per the financial statements plus the fair value of some of the assets acquired).

The journal entry at payment of the consideration is as follows:

DT

CR

Investments in associates

50.00

Cash

50.00

During the year ended 31 December 20X1, Entity B generated net income of $10m and paid dividends of $7m. Additionally, when applying equity method, Entity A needs to account for the $0.25m of additional depreciation charge on the fair value adjustment on real estate. This is calculated as fair value adjustment on real estate / 15 years of remaining useful life *25% share of Entity A (i.e. $15m/15 years * 25% interest).

Entries made by Entity A at 31 December 20X1 are as follows:

DT

CR

Investments in associates

(net income accounting less depreciation)

0.50

Share of profit of associates – Dividend 25% of EUR 7m

1.75

Share of profit of associates – Depreciation fair value adjustment

0.25

Share of profit of associates – Net income accounting

25% of (net income EUR 10m -/- dividend EUR 7M)

0.75

Cash (receipt dividend)

1.75

Something else -   Contingent liability

See also: Interest in joint arrangements and joint ventures

Equity method

Equity method for associates and joint ventures

Equity method

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Something else -   Associate

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