Topic5

ACCOUNTING FOR INVESTMENTS IN ASSOCIATES

Equity Accounting

LEARNING OBJECTIVES
By the end of this topic you should be able to: Explain the difference between a subsidiary and an associate Determine the existence of significant influence Apply the equity method of accounting to account for investments in associates (defined as investees over which the investor has significant influence) Apply the disclosure requirements of AASB 128 Investments in Associates

REQUIRED READING
Leo et al, 2008, Chapter 19. Ignore section 19.5.3 AASB 128. Investments in Associates

INTRODUCTION
The previous topic considered the accounting requirements where one entity has control over another and is therefore required to prepare consolidated accounts for the group. Here, we are looking at the situation where one entity has an investment in another but where the requirements for control have not been satisfied.

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Learning objective 1: difference between a subsidiary and an associate

There are many types of equity investments where the investor does not have control over the investee but our specific focus here is on investments in shares in an organisation which give the investor an ownership interest and therefore a share in the profits of that organisation. In particular, we are considering investments which must be accounted for under the provisions of AASB128, Investments in Associates. The relationship between an investor and its associated entities (as defined in the standard) is different to the group relationship we have already considered, but is still significant enough to have a specific method of accounting applied to it. That method is called Equity Accounting. Equity accounting is a method of accounting which must be adopted for those investments over which an investor has significant influence but not control. Where significant influence, but not control, exists the investee is referred to as an associate of the investor. AASB 128 paragraph 2 specifically states that this includes both corporate and unincorporated entities over which the investor has significant influence. Since the term significant influence is so important, we will consider it further here.

Learning objective 2: Significant influence

This concept is used in determining whether the equity method is to be applied. It falls short of control and therefore the investee is not a subsidiary. Significant influence is defined in paragraph 2 of AASB 128 as The power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies Note the use of the word participate here. This is what essentially differentiates associates from subsidiaries. Significant influence normally stems from the investors voting power in the investee and is assumed to exist ( see paragraph 6) where the investor holds 20 per cent or more of the investees voting power (the equity method is only applied where shares are held in the other entity. If significant influence is obtained by any other method, AASB 128 does not apply). Be careful though just owning 20% of the shares of another entity may not give significant influence so it is a rebuttable assumption and if the investor is able to demonstrate that significant influence does not exist, then equity accounting does not apply. On the other hand, if the shareholding is not at least 20%, there may be other indicators of significant influence. These are outlined in paragraph 7 of AASB 128 as representation on the board participation in policy-making processes material transactions between the investor and the investee interchange of managerial personnel provision of essential technical information If an investor subsequently ceases to have significant influence, they must cease using equity accounting.

Learning objective 3: Application of the equity method of accounting

First and foremost, as with the materiality application in other accounting standards, if investments are not material, an investor is not required to comply with AASB 128. The basic methodology of equity accounting is as follows:

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Equity accounting is applied from acquisition date, which is the date on which significant influence over the investee was obtained by the investor. The investment in the associate is initially recognised at cost. The carrying amount of the investment is increased or decreased to recognise the investors share of the associates post-acquisition profits. The investors share of the associates profit or loss is included in the investors profit or loss. Distributions (e.g. dividends) from the associate reduce the carrying amount of the investment. The carrying amount of the investment will also be adjusted to take account of any changes in the investors proportionate interest in the associate from changes in the associates equity not included in associates profit or loss. This can arise from transactions such as revaluations of property, plant and equipment and foreign exchange translation differences which directly affect the equity of the associate. The investors share of such changes is recognised directly in the investors equity.

Before going any further, we need to consider how equity accounting is actually implemented by the investor. This will depend on whether the investor needs to prepare consolidated accounts because they are the parent entity in a group of companies (that is, they have at least one subsidiary in addition to this associate we are considering here). If the investor is required to prepare consolidated accounts they should: recognise the investment in the associate by applying the equity method in the consolidated financial statements; and apply cost or fair value methods in their own individual financial statements If the investor does not prepare consolidated financial reports they should: apply the equity method to their own separate financial report To summarise: Is the investor a parent entity? Yes No

In investors separate financial report: Record investment in associate at cost or fair value In the consolidated financial report: Account for investment using the equity method

In investors separate financial report: Record investment in associate using the equity method

Recording the investment As is the case with consolidated accounts, at acquisition the difference between the investors share of the net fair values of the associates net assets and the cost of investment is regarded as goodwill or excess on acquisition. For the purposes of illustration here however, we will assume that all the identifiable assets and liabilities of the associate are recorded at fair value.

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Note though, that if there is goodwill, it is not separately disclosed, but any impairment of goodwill is taken into account in calculating the investors share of the associates profit or loss. We will come back to this issue shortly.

In the following example we will be considering the equity method of accounting as it applies where the investor (a) is a parent entity and is therefore required to prepare consolidated financial statements and (b) is not a parent entity. Study these and the examples in the text carefully to ensure you understand how the entries differ depending on whether consolidated accounts are prepared.

Example 1 - Equity method where investor is a parent

On 1 July 2008 Bungee Ltd acquired a 30% interest in Ralph Ltd for $600,000. On the date of acquisition the assets of Ralph Ltd are reported at their fair value. The total share capital and reserves of Ralph Ltd on the date of acquisition are: Share capital Retained earnings $1,760,000 240,000 $2,000,000

In September 2008 Ralph Ltd pays a dividend of $10,000. This dividend is from profits earned in the 2007-2008 financial year. For the year ending 30 June 2009, Ralph Ltd records an after tax profit of $80,000 and declares a dividend of $30,000 from that profit. That dividend is paid in September 2009. On 30 June 2010 Ralph Ltd. revalues land upwards by $40,000 Tax rate is 30% In the books of Bungee Ltd: To recognise initial acquisition of shares July 2008 Dr Investment in Ralph Ltd Cr Cash at bank To recognise receipt of pre-acquisition dividend September 2008 Dr Cash at bank Cr Investment in Ralph Ltd

600,000 600,000

3,000 3,000

This dividend is treated as a reduction of the investment. $3,000 = $10,000 x 30%

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Example 1 cont To recognise dividends provided by associate from post-acquisition profits June 2009 Dr Dividend receivable 9,000 Cr Dividend revenue

9,000

As these dividends are paid from post-acquisition profits they are recognised as revenue when they are receivable. $9,000 = $30,000 x 30% To recognise receipt of previous dividend provided September 2009 Dr Cash at bank Cr Dividend receivable

9,000 9,000

In Bungee Ltd group consolidation worksheet: To record Bungees share of Ralphs profit 30 June 2009 Dr Investment in Ralph Ltd Cr Share of associates profit

24,000 24,000

The investor is required to recognise as part of profits its share of the profits of the associate. This amount is recorded as an increase in the investment. $24,000 = $80,000 x 30% To recognise investors share of dividends 30 June 2009 Dr Dividend revenue Cr Investment in Ralph Ltd

9,000 9,000

The dividend from post-acquisition profit of $9,000 has been recorded as revenue and a receivable by Bungee Ltd. Under equity accounting the dividends paid by the associate are not recognised it is the share of the associates profit that is recorded. Since this profit includes the dividends which are paid from it, to recognise the dividends as well as the profit as revenue would mean double counting the dividends. Therefore they must be reversed. No adjustment is required for the payment of the dividend from pre-acquisition profit as the investment has already been reduced by that amount. In consolidation worksheet (Year 2) Prior period share of profits 30 June 2010 Dr Investment in Ralph Ltd Cr Retained earnings (1/7/09)

15,000 15,000

Recall that these entries are made in the consolidation worksheet and therefore no balances are carried forward. In each year following the adoption of equity accounting, we need to record an adjusting entry in the consolidation worksheet to reflect the equity accounting adjustments made in previous years, so that the opening balances will match the closing balances on last years consolidated financial statements. $15,000 = $24,000 share of profit recognised less $9,000 share of dividends.

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Example 1 cont Investors share of associates increase in revaluation reserve 30 June 2010 Dr Investment in Ralph Ltd Cr Revaluation reserve

8,400 8,400

The revaluation by Ralph Ltd of land by $40,000 would have resulted in Ralph Ltd debiting Land with $40,000 and crediting Revaluation Reserve $28,000 and Deferred Tax Liability $12,000 ($40,000 x tax rate). We need to record Bungee Ltds share of the post-acquisition increase in the revaluation reserve. $24,000 x 30% = $8,400

Example 2 - Equity method (where investor is not a parent)

Same information as example 1, but as Bungee Ltd is not a parent entity it will not need to prepare consolidated accounts and the equity method of accounting must therefore be applied in recording the investment in the accounts of Bungee Ltd. Remember: these entries are made in the accounts of Bungee Ltd, not on a consolidation worksheet. To recognise initial acquisition of shares July 2008 Dr Investment in Ralph Ltd Cr Cash at bank To recognise receipt of pre-acquisition dividend September 2008 Dr Cash at bank Cr Investment in Ralph Ltd To record Bungees share of Ralphs profit 30 June 2009 Dr Investment in Ralph Ltd Cr Share of associates profit

600,000 600,000

3,000 3,000

24,000 24,000

The investor is required to recognise as part of profits its share of the profits of the associate. This amount is recorded as an increase in the investment. $24,000 = $80,000 x 30% To recognise investors share of dividends 30 June 2009 Dr Dividend receivable Cr Dividend revenue

9,000 9,000

As these dividends are paid from post-acquisition profits they are recognised as revenue when they are receivable. $9,000 = $30,000 x 30% Dr Dividend revenue Cr Investment in Ralph Ltd 9,000 9,000

The dividend from post-acquisition profit of $9,000 is recorded as revenue and a receivable by Bungee Ltd. Under equity accounting the dividends paid by the associate are not recognised it is the share of the associates profit that is recorded. Since this profit includes the dividends which are paid from it, to recognise the dividends as well as the profit as revenue would mean double counting the dividends. Therefore they must be reversed.

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Example 2 (cont) In Bungees accounts (Year 2) Receipt of dividend declared in previous period September 2009 Dr Cash at bank Cr Dividend receivable Investors share of increase in associates revaluation reserve 30 June 2010 Dr Investment in Ralph Ltd Cr Revaluation reserve

9,000 9,000

8, 400 8, 400

What you should note from this is that the calculations do not change the issue of whether the investor is a parent or not simply determines whether the equity accounting entries appear in the books of the investor or in the consolidated worksheet. If consolidated financial statements are being prepared, we just need to repeat the entries as opening adjustments in each year after equity accounting is implemented Goodwill or excess The requirements for treatment of goodwill or excess on acquisition are to be found in paragraph 23 of AASB 128, which in turn refers to AASB 3 Business Combinations. If there is goodwill on the acquisition (so an amount greater than the proportion of the fair value of the net assets is paid) it is included in the carrying amount of the investment it is not shown separately. On the other hand if there is an excess on the acquisition (so the consideration is less than the proportion of the fair value of the net assets) that amount is not included in the carrying amount of the investment. The carrying amount of the investment is recorded at the fair value of the net assets and the excess is recorded as income in determining the share of the associates profit or loss in the year of the acquisition. Note to students: when reading chapter 19 please ignore Illustrative example 19.2. We are not covering fair value adjustments in this course. Inter-entity transactions Just as on consolidation unrealised profits from transactions within the group are eliminated because those profits have not yet been realised from a group perspective, so to are those profits eliminated when implementing equity accounting the only difference is that a proportional rather than a full elimination is made. AASB 128 para 22 requires that the amount of profit from inter-entity transactions be recognised only to the extent of unrelated investors interests. This means that the profit on transactions between the investor and the associate are recognised only to the extent of ownership interests of unrelated third parties. The elimination of unrealised profits and losses on inter-entity transactions is part of the calculation of the investors share of the current operating profits and opening retained profits of the associate.

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Example 3: Unrealised profit in closing inventory

To return to the previous example, Ralph Ltds current period profit for 2009 2010 is $50,000. During the year Bungee Ltd sold inventory to Ralph Ltd and at the end of the year Ralph Ltd still had $40,000 of this inventory on hand. That inventory originally cost Bungee Ltd $32,000 and the tax rate is 30%. The following equity accounting adjustment would be required at year end: Current years profit Adjustments for inter-entity transactions: Unrealised after-tax profit in ending inventory (8,000(1-30%) Investors share 30% $50,000 (5,600) 54,400 16,320

Equity journal to record share of current profit with unrealised profit in closing inventory Dr. Investment in Ralph Ltd Cr. Share of associates profit 16,320 16,320

Example 4: Unrealised profit in opening inventory

In 2010 2011 Ralph Ltd earned a profit of $80,000. When recognising its share of that profit Bungee Ltd will need to reverse the effect of the closing entry from the previous year: Current years profit Adjustments for inter-entity transactions: Unrealised after-tax profit in opening inventory (8,000(1-30%) Investors share 30% $80,000 5,600 85,600 25,680

Equity journal to record share of current profit with unrealised profit in closing inventory Dr. Investment in Ralph Ltd Cr. Share of associates profit 25,680 25,680

Note: if consolidated accounts are being prepared, the following entry will also be required: Dr. Investment in Ralph Ltd Cr. Retained Earnings (1/7/10) 16,320 16,320

Example 5: Transfer of non-current assets

Unrealised profit can also arise from the transfer of non-current assets between the investor and the associate. This must also be adjusted for when equity accounting. Ralph Ltd sold an item of plant to Bungee Ltd. on 1 July 2009. The plant was carried in Ralph Ltds books at $50,000 and was sold to Bungee Ltd for $65,000. The remaining useful life of the plant was 5 years In June 2010 the calculation for this would be: Current years profit Adjustments for inter-entity transactions: Unrealised after-tax profit on sale of plant (15,000 (1-30%)) Realised profit on sale of plant depreciation (10,500 x years) Investors share 30% $50,000 (10,500) 2,100 12,480

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Example 5 (cont) Equity journal to record share of current profit with unrealised profit from transfer of plant: Dr. Investment in Ralph Ltd Cr. Share of associates profit 12,480 12,480

Note: if consolidated accounts are being prepared, this entry will need to be repeated the following year, with the credit being to Retained Earnings (1/7/10). These calculations and entries are continued each year and after 5 years the whole of the profit will have been realised.

What happens if the associate records losses? Where the associate records losses the investor recognises a proportion of those losses in exactly the same way as they recognise their share of profits. Such losses will reduce the carrying amount of the investment and you should note that the carrying amount cannot fall below zero. If the equity accounted value of the investment in the associate falls to zero and the associate continues to make losses then the use of equity accounting should cease. If the associate subsequently begins to record profits, then the investor should increase the value of their investment only after such increases offset the losses that were not recognised following the suspension of the equity method.

Learning objective 4: Disclosure requirements

The disclosures required for investments in associates are quite detailed, but you will find a summary and an example of them at section 19.8 of the text.

Why equity accounting?

The rationale generally used for adopting the equity method is that it provides a better indication of investments underlying worth. In addition, using the cost method of recording these investments would only record the stream of dividend receipts and it is argued that this might provide an inaccurate guide to the associates performance and value as an investment. There are however opponents of the equity method. Most criticisms centre on: the method breaches the realisation principle which is tied to the notion of conservatism; investors reports their share of investees profits, even if they dont receive any dividends; and the balance of the investment account is neither cost nor fair value.

TOPIC REVIEW QUESTIONS

Leo et al 2008 Chapter 19: Review questions 1, 3, 7, 8, 11, 12 Case studies 1, 3 Practice questions 19.1, 19.3, 19.4, 19.8, 19.10

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