05 Equity accounting under IAS 28
Advanced Financial
Accounting: Chapter 5
Group Reporting IV:
Equity Accounting under IAS 28
Tan & Lee Chapter 5
© 2009
1
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
4.
Perform an analytical check on the investment in associate
balance
Tan & Lee Chapter 5
© 2009
2
Content
1.
Equity
Equity method
method versus
versus cost
cost method
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
Tan & Lee Chapter 5
© 2009
3
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
– Provision of essential technical information
Tan & Lee Chapter 5
© 2009
4
Accounting Policy for Investments In
Associates
Levels of financial reporting
1. Investor’s separate financial
statements: legal entity
2. Consolidated financial
statements (with subsidiaries
and associates): economic entity
3. Investor’s financial statement in
place of consolidated financial
statements (with associates):
economic entity
Tan & Lee Chapter 5
Accounting policy
Cost or
as a financial instrument (IAS 39)
Equity method
Equity method
© 2009
5
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 equityaccounted profit
– Investment account is not eliminated
Investment
in associate
Share of book
value of net assets
Tan & Lee Chapter 5
Share of
unamortized
FV adjustments
© 2009
Implicit goodwill
6
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
Nature of the
economic
relationship
between
investor and
investee
• Economic independence
• Investor is deemed as a
passive holder of investment
• Economic interdependence
• Investor has “significant influence”
over the investee
Tan & Lee Chapter 5
© 2009
7
Content
1.
Equity method versus cost method
2.
Equity
Equity method
method versus
versus consolidation
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
Tan & Lee Chapter 5
© 2009
8
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”
– Might be misleading to aggregate associate’s individual assets and
liabilities
Tan & Lee Chapter 5
© 2009
9
Consolidation Vs Equity Method
Dimensions
Consolidation
Equity Method
• Share of profit and share of tax are
reported as a single items in the
income statement
Income
recognition
• Income statement items of
subsidiary are added with the
parent’s
Non-controlling
interests (NCI)
• NCI is shown separately as an • Only investor’s share of profit and
allocation of profit after tax
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
Tan & Lee Chapter 5
© 2009
• Investment is carried at cost +
share of post-acquisition change in
equity
• Investment account includes:
– Share of book value of net assets
of associate
– Share of fair value adjustments
– Goodwill
10
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
unamortized balance of FV
adjustments)
Tan & Lee Chapter 5
© 2009
11
Consolidation Vs Equity Method
Dimensions
Consolidation
Equity Method
Economic
relationship
between
investor and
investee
“Control”
“Significant influence”
Impact on
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 debtequity) worse off
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
Tan & Lee Chapter 5
© 2009
12
Content
1.
Equity method versus cost method
2.
Equity method versus consolidation
3.
Anoverview
overviewof
ofthe
themethodology
methodologyof
ofequity
equityaccounting
accounting
An
4.
Performing an analytical check on the investment in associate
balance
5.
Specific procedures relating to the equity method
Tan & Lee Chapter 5
© 2009
13
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
5.
Investor’s share of past and current amortization of fair value
adjustments is adjusted against the investment account
Tan & Lee Chapter 5
© 2009
14
Methodology of Equity Accounting
6.
Post-acquisition change in the investor’s share of net assets is
added to the investment account
•
7.
8.
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
Dividends
•
•
•
9.
Include share of profit and tax in each reporting period from acquisition
date to disposal
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
Other changes in equity are recognized in accordance with the
investor’s interest
Tan & Lee Chapter 5
© 2009
15
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
balance
5.
Specific procedures relating to the equity method
Tan & Lee Chapter 5
© 2009
16
Analytical Check
Investment
in associate
Share of book
value of net assets
Share of unamortized
FV adjustments
Implicit goodwill
Investor’s share X
(Book value of net
assets -/+ unrealized
profit/loss)
Investor’s share X
(Unamortized
balance of excess of FV
over book value of net
identifiable assets at
acquisition date)
(Acquisition cost –
Share of FV of net
identifiable assets
at acquisition
date) – impairment
loss
Tan & Lee Chapter 5
© 2009
17
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
Specific procedures
procedures relating
relating to
to the
the equity
equity method
method
Tan & Lee Chapter 5
© 2009
18
Conversion from the Cost Method to the
Equity Method
Begin with the investor’s
separate financial statements
and prepare equity accounting
adjustments in associate under
the equity method
Accounting for Investment in Associate
Investor’s separate financial
Consolidated financial statements
statements
Cost method
Equity method
As a financial instrument under
IAS 39
Equity method
Tan & Lee Chapter 5
© 2009
19
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)
Cr
Investment in associate (B/S)
Tan & Lee Chapter 5
© 2009
20
Consolidation Procedures Not Applicable to
Equity Method
1.
2.
Elimination of intragroup balances is not required
•
Equity method does not entail line by line aggregation
•
Perfectly offsetting items and balances are not required
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
–
Tan & Lee Chapter 5
Realization of profit through dividends
© 2009
21
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%
Prepare the equity accounting entries for the year ended 31 Dec 20X5
Tan & Lee Chapter 5
© 2009
22
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
Cr
Opening RE
1,000,000
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
Note: This entry capitalizes the share of past profits in the investment account
Tan & Lee Chapter 5
© 2009
23
Illustration 1: Amortization of FV
Adjustments of Identifiable Net Assets
EA 2: Share of past cumulative depreciation on undervalued
fixed assets (after-tax)
Dr
Opening RE
Cr
Investment in associate
20% X (5,000,000 /
10) X 80%
80,000
80,000
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
Tan & Lee Chapter 5
© 2009
24
Illustration 1: Amortization of FV
Adjustments of Identifiable Net Assets
EA 3: Share of current profit after tax of associate
Dr Investment in associate
Dr Share of tax of associate
Cr
Share of profit before tax
1,500,000
400,000
1,900,000
Net profit before tax
Less: excess depreciation
Adjusted net profit before tax
Share of profit before tax (20%)
10,000,000
(500,000)
9,500,000
1,900,000
Tax expense
Less: tax on excess depreciation
Adjusted tax expense
Share of tax of associate (20%)
2,100,000
(100,000)
2,000,000
400,000
5,000,000 / 10
500,000 x 20%
Note: The spilt between profit and tax is necessary as the two items are shown
separately in the income statement
Tan & Lee Chapter 5
© 2009
25
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
– May be attributed to book value of net assets, fair value adjustments or
goodwill
Tan & Lee Chapter 5
© 2009
26
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
EA 1: Share of past impairment loss
Dr
Opening RE
250,000
Cr
Investment in Associate
250,000
Note:
1) This entry re-enacts past impairment losses
2) The impairment loss relates to the share owned by the investor; hence there
is no need to apply ownership percentage
Tan & Lee Chapter 5
© 2009
27
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
Less: current impairment loss
Adjusted net profit before tax
2,000,000
(100,000)
1,900,000
20% X $10,000,000
Share of tax of associate
420,000
Impairment loss relating to goodwill is assumed to be non-tax
deductible
20% X $2,100,000
Tan & Lee Chapter 5
© 2009
28
Transfer of Assets between Investor and
Associate
“Upstream sale”
“Downstream sale”
Investor
Investor
X%
Sales
were
made from
associate
to investor
X%
Sales
were
made from
investor to
associate
Associate
Associate
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%)
Tan & Lee Chapter 5
© 2009
29
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
Tan & Lee Chapter 5
© 2009
30
Illustration 3
EA 1: Share of current profit after tax of associate
Dr
Dr
Cr
Investment in associate
Share of tax of associate
Share of profit before tax
156,800
39,200
196,000
Share of profit before tax of associate
Less: unrealized profit
Adjusted net profit before tax
I’s share of profit (20%)
Share of tax of associate
Less: tax on unrealized profit
Adjusted tax expense
I’s share of tax (20%)
Tan & Lee Chapter 5
1,000,000
(20,000)
980,000
196,000
200,000
(4,000)
196,000
39,200
© 2009
1/3 X $60,000
20% X $20,000
31
Illustration 3
I’s profit (at group level)
Adjusted
Gross profit from downstream sale
Share of A’s pre-tax profit
Profit effect
60,000
196,000
256,000
I’s profit (at group level)
Unadjusted
60,000
200,000
260,000
I is not able to recognize its share of unrealized profit of $4,000 ($60,000x 20%x 1/3).
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
Tan & Lee Chapter 5
© 2009
32
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:
• Investor’s share of unrealized profit arising from transfers is eliminated
Tan & Lee Chapter 5
© 2009
33
Accounting: Chapter 5
Group Reporting IV:
Equity Accounting under IAS 28
Tan & Lee Chapter 5
© 2009
1
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
4.
Perform an analytical check on the investment in associate
balance
Tan & Lee Chapter 5
© 2009
2
Content
1.
Equity
Equity method
method versus
versus cost
cost method
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
Tan & Lee Chapter 5
© 2009
3
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
– Provision of essential technical information
Tan & Lee Chapter 5
© 2009
4
Accounting Policy for Investments In
Associates
Levels of financial reporting
1. Investor’s separate financial
statements: legal entity
2. Consolidated financial
statements (with subsidiaries
and associates): economic entity
3. Investor’s financial statement in
place of consolidated financial
statements (with associates):
economic entity
Tan & Lee Chapter 5
Accounting policy
Cost or
as a financial instrument (IAS 39)
Equity method
Equity method
© 2009
5
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 equityaccounted profit
– Investment account is not eliminated
Investment
in associate
Share of book
value of net assets
Tan & Lee Chapter 5
Share of
unamortized
FV adjustments
© 2009
Implicit goodwill
6
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
Nature of the
economic
relationship
between
investor and
investee
• Economic independence
• Investor is deemed as a
passive holder of investment
• Economic interdependence
• Investor has “significant influence”
over the investee
Tan & Lee Chapter 5
© 2009
7
Content
1.
Equity method versus cost method
2.
Equity
Equity method
method versus
versus consolidation
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
Tan & Lee Chapter 5
© 2009
8
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”
– Might be misleading to aggregate associate’s individual assets and
liabilities
Tan & Lee Chapter 5
© 2009
9
Consolidation Vs Equity Method
Dimensions
Consolidation
Equity Method
• Share of profit and share of tax are
reported as a single items in the
income statement
Income
recognition
• Income statement items of
subsidiary are added with the
parent’s
Non-controlling
interests (NCI)
• NCI is shown separately as an • Only investor’s share of profit and
allocation of profit after tax
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
Tan & Lee Chapter 5
© 2009
• Investment is carried at cost +
share of post-acquisition change in
equity
• Investment account includes:
– Share of book value of net assets
of associate
– Share of fair value adjustments
– Goodwill
10
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
unamortized balance of FV
adjustments)
Tan & Lee Chapter 5
© 2009
11
Consolidation Vs Equity Method
Dimensions
Consolidation
Equity Method
Economic
relationship
between
investor and
investee
“Control”
“Significant influence”
Impact on
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 debtequity) worse off
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
Tan & Lee Chapter 5
© 2009
12
Content
1.
Equity method versus cost method
2.
Equity method versus consolidation
3.
Anoverview
overviewof
ofthe
themethodology
methodologyof
ofequity
equityaccounting
accounting
An
4.
Performing an analytical check on the investment in associate
balance
5.
Specific procedures relating to the equity method
Tan & Lee Chapter 5
© 2009
13
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
5.
Investor’s share of past and current amortization of fair value
adjustments is adjusted against the investment account
Tan & Lee Chapter 5
© 2009
14
Methodology of Equity Accounting
6.
Post-acquisition change in the investor’s share of net assets is
added to the investment account
•
7.
8.
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
Dividends
•
•
•
9.
Include share of profit and tax in each reporting period from acquisition
date to disposal
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
Other changes in equity are recognized in accordance with the
investor’s interest
Tan & Lee Chapter 5
© 2009
15
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
balance
5.
Specific procedures relating to the equity method
Tan & Lee Chapter 5
© 2009
16
Analytical Check
Investment
in associate
Share of book
value of net assets
Share of unamortized
FV adjustments
Implicit goodwill
Investor’s share X
(Book value of net
assets -/+ unrealized
profit/loss)
Investor’s share X
(Unamortized
balance of excess of FV
over book value of net
identifiable assets at
acquisition date)
(Acquisition cost –
Share of FV of net
identifiable assets
at acquisition
date) – impairment
loss
Tan & Lee Chapter 5
© 2009
17
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
Specific procedures
procedures relating
relating to
to the
the equity
equity method
method
Tan & Lee Chapter 5
© 2009
18
Conversion from the Cost Method to the
Equity Method
Begin with the investor’s
separate financial statements
and prepare equity accounting
adjustments in associate under
the equity method
Accounting for Investment in Associate
Investor’s separate financial
Consolidated financial statements
statements
Cost method
Equity method
As a financial instrument under
IAS 39
Equity method
Tan & Lee Chapter 5
© 2009
19
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)
Cr
Investment in associate (B/S)
Tan & Lee Chapter 5
© 2009
20
Consolidation Procedures Not Applicable to
Equity Method
1.
2.
Elimination of intragroup balances is not required
•
Equity method does not entail line by line aggregation
•
Perfectly offsetting items and balances are not required
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
–
Tan & Lee Chapter 5
Realization of profit through dividends
© 2009
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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 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%
Prepare the equity accounting entries for the year ended 31 Dec 20X5
Tan & Lee Chapter 5
© 2009
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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
Cr
Opening RE
1,000,000
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
Note: This entry capitalizes the share of past profits in the investment account
Tan & Lee Chapter 5
© 2009
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Illustration 1: Amortization of FV
Adjustments of Identifiable Net Assets
EA 2: Share of past cumulative depreciation on undervalued
fixed assets (after-tax)
Dr
Opening RE
Cr
Investment in associate
20% X (5,000,000 /
10) X 80%
80,000
80,000
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
Tan & Lee Chapter 5
© 2009
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Illustration 1: Amortization of FV
Adjustments of Identifiable Net Assets
EA 3: Share of current profit after tax of associate
Dr Investment in associate
Dr Share of tax of associate
Cr
Share of profit before tax
1,500,000
400,000
1,900,000
Net profit before tax
Less: excess depreciation
Adjusted net profit before tax
Share of profit before tax (20%)
10,000,000
(500,000)
9,500,000
1,900,000
Tax expense
Less: tax on excess depreciation
Adjusted tax expense
Share of tax of associate (20%)
2,100,000
(100,000)
2,000,000
400,000
5,000,000 / 10
500,000 x 20%
Note: The spilt between profit and tax is necessary as the two items are shown
separately in the income statement
Tan & Lee Chapter 5
© 2009
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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
– May be attributed to book value of net assets, fair value adjustments or
goodwill
Tan & Lee Chapter 5
© 2009
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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
EA 1: Share of past impairment loss
Dr
Opening RE
250,000
Cr
Investment in Associate
250,000
Note:
1) This entry re-enacts past impairment losses
2) The impairment loss relates to the share owned by the investor; hence there
is no need to apply ownership percentage
Tan & Lee Chapter 5
© 2009
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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
Less: current impairment loss
Adjusted net profit before tax
2,000,000
(100,000)
1,900,000
20% X $10,000,000
Share of tax of associate
420,000
Impairment loss relating to goodwill is assumed to be non-tax
deductible
20% X $2,100,000
Tan & Lee Chapter 5
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Transfer of Assets between Investor and
Associate
“Upstream sale”
“Downstream sale”
Investor
Investor
X%
Sales
were
made from
associate
to investor
X%
Sales
were
made from
investor to
associate
Associate
Associate
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%)
Tan & Lee Chapter 5
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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
Tan & Lee Chapter 5
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Illustration 3
EA 1: Share of current profit after tax of associate
Dr
Dr
Cr
Investment in associate
Share of tax of associate
Share of profit before tax
156,800
39,200
196,000
Share of profit before tax of associate
Less: unrealized profit
Adjusted net profit before tax
I’s share of profit (20%)
Share of tax of associate
Less: tax on unrealized profit
Adjusted tax expense
I’s share of tax (20%)
Tan & Lee Chapter 5
1,000,000
(20,000)
980,000
196,000
200,000
(4,000)
196,000
39,200
© 2009
1/3 X $60,000
20% X $20,000
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Illustration 3
I’s profit (at group level)
Adjusted
Gross profit from downstream sale
Share of A’s pre-tax profit
Profit effect
60,000
196,000
256,000
I’s profit (at group level)
Unadjusted
60,000
200,000
260,000
I is not able to recognize its share of unrealized profit of $4,000 ($60,000x 20%x 1/3).
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
Tan & Lee Chapter 5
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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
• 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:
• Investor’s share of unrealized profit arising from transfers is eliminated
Tan & Lee Chapter 5
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