Equity Method

Equity method is used to account for investments in associates and joint-ventures. Simply put, the equity 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. To achieve this outcome, the investment in another entity is initially recognised at cost (e.g. price paid) and subsequently adjusted for the post-acquisition change in the investor’s share of the net assets. For example, the investor’s share of the profit or loss of the associate/ joint-venture is included in its P/L (as one line).

Equity method is governed by IAS 28. As stated in paragraph IAS 28.26, many of the procedures that are appropriate for the application of the equity method are similar to the consolidation procedures described in IFRS 10. When more than one subsidiary holds interest in a associate/joint-venture, consolidated financial statements should take into account total interest held by the group. Specific aspects of application of equity method are discussed in subsequent sections.

Let’s start with a simplified introductory example for applying equity method:

Example: simple illustration of application of equity 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 $150. 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.

You can download an excel file for this example. Note that you can scroll the tables horizontally if they don’t fit your screen.

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:

50Investment in Entity B at cost
$m
37.525% share in B's net assets as per its financial statements
3.7525% share in fair value adjustment relating to real estate
8.75goodwill (not presented separately and not amortised)

Goodwill in the table above was calculated as shown below:

8.7525% interest in implicit goodwill attributable to Entity A ($35m x 25%)
$m
200implicit consideration for 100% interest, taking into account $50m paid for 25% ($50m/25%)
150Entity B's net assets as per its financial statements
15fair value adjustment on real estate
35total implicit goodwill of Entity B ($200m-$150m-$15m)

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:

DRCR
Investments in associates0.5
Share of profit of associates2.25*
Cash1.75**

* 25% share of net income of 10$ less 25% share in depreciation of fair value adjustment
** dividends received


An investment accounted for using the equity method is initially recognised at cost. The term ‘at cost’ is not defined in IAS 28 and a discussion similar to that in IAS 27 applies here as well.

When an investment becomes an associate/joint-venture after being a consolidated subsidiary, the cost for the initial recognition purposes is the fair value of retained interest at the date when the control is lost (IFRS 10.25b).

Initial recognition gets more complicated when there is a development in opposite direction, i.e. a ‘regular’ equity investment (e.g. a 5% interest) becomes an associate/joint-venture. The same discussion on how to determine the cost of a subsidiary when control is achieved is stages applies.

When an investment in an associate becomes an investment in a joint venture (or vice versa), the entity continues to apply the equity method and does not remeasure the retained interest (IAS 28.24).

If additional interest is acquired in an entity that already was and still is an associate/joint-venture accounted under the equity method, the additional consideration is simply added to the carrying amount of the investment without recognition of any additional gains or losses (this is not covered in IFRS).

On acquisition of an investment in associate/joint-venture accounted under the equity method, entities need to recognise their interest in fair value of net assets and goodwill of the associate/joint-venture. This is similar to IFRS 10 requirements, except that all items are subsumed into one line (IAS 28.32). Similarities include additional depreciation of fair value adjustments or assets recognised only on consolidation (such as internally generated brand). As goodwill is not recognised separately from the investment under the equity method, IAS 36 requirements for mandatory annual impairment test do not apply (IAS 28.42).

Fair valuation will usually be much harder to do for an associate, as significant influence will often be insufficient to obtain all the necessary valuation inputs. Therefore, approximations and estimates will often be made to an extent greater than usual.

An example of an investment in associate/joint-venture accounted for under the equity method and broken down into investor’s share in net assets, fair value adjustments and goodwill is included in the simple example.

Associates and joint-ventures are not part of the group as the group consists of a parent and its subsidiaries. Therefore, intercompany transactions with associates and joint-ventures are not eliminated in consolidated financial statements. However, IAS 28 prescribes specific treatment of transactions involving assets.

Example – revenue earned from an associate

Company P has 20% interest in Company A, its associate. During the year, P provides consulting services to A for $100.

As services are provided, P recognises revenue in its books:

$mDRCR
Receivable100
Revenue100

Associate A recognises corresponding expense:

$mDRCR
Payable100
Expenses100

When applying the equity method in its consolidated financial statements, Company P does not eliminate recognised revenue and receivable, but it needs to recognise 20% of its share in A’s profit or loss:

$mDRCR
Investments in associates20
Share of profit/loss of associates20

All in all, this transaction has the following impact on P’s consolidated financial statements:

$mDRCR
Receivable100
Revenue100
Investments in associates20
Share of profit/loss of associates20

IAS 28.28 requires gains and losses resulting from ‘upstream’ (sales by associate/joint-venture to investor)  and ‘downstream’ (sales by investor to associate/joint-venture) transactions involving assets to be recognised only to the extent of unrelated investors’ interests. The investor’s share in the investee’s gains or losses resulting from these transactions is eliminated when applying the equity method. This is illustrated in the examples that follow.

Example: accounting for a downstream transaction

Entity A holds 20% interest in Entity B, exercises significant influence over it and accounts for it using the equity method.  During year 20X0, Entity A sold an item of inventory to Entity B for $1m. This inventory was carried at cost in A’s books at $0.7m. During year 20X1, Entity B sold this inventory to its client for $1.5 million. Deferred tax is ignored in this example.

You can download an excel file for this example. Note that you can scroll the tables horizontally if they don’t fit your screen.

year 20X0

Entity A recognises the sale to Entity B in its books:

$mDRCR
Revenue1
Cost of sales0.7
Cash1
Inventory0.7

At the same time, Entity B recognises the purchase in its books:

$mDRCR
Cash1
Inventory1

In consolidated financial statements, Entity A recognises the following adjustment in order to eliminate the gain on sale of inventory with respect to its 20% interest in Entity B:

$mDRCR
Revenue0.2
Cost of sales0.14
Investment in Entity B0.06*

* Entity A adjusts the value of its investment in B, as the asset subject to elimination is held by B.

year 20X1

Entity B recognises the sale to a client:

$mDRCR
Revenue1.5
Cost of sales1
Cash1.5
Inventory1

In consolidated financial statements, Entity A reverses the previous entry and recognises the 20% portion of revenue and cost of sales:

$mDRCR
Revenue0.2
Cost of sales0.14
Investment in Entity B0.06

Additionally, Entity A recognises its share in gain made by Entity B:

$mDRCR
Investment in Entity B0.1
Share of profit of associates0.1

Example: accounting for an upstream transaction

Entity A holds 20% interest in Entity B, exercises significant influence over it and accounts for it using the equity method. During year 20X0, Entity B sold an item of inventory to Entity A for $1m. This inventory was carried at cost in B’s books at $0.7m. During year 20X1, Entity A sold this inventory to its client for $1.5 million. Deferred tax is ignored in this example. Note that you can scroll the tables horizontally if they don’t fit your screen.

year 20X0

Entity B recognises the sale to Entity A in its books:

$mDRCR
Revenue1
Cost of sales0.7
Cash1
Inventory0.7

At the same time, Entity A recognises the purchase in its books:

$mDRCR
Cash1
Inventory1

In consolidated financial statements, Entity A recognises its share in gain made by Entity B:

$mDRCR
Investment in Entity B0.06
Share of profit of associates0.06

At the same time, Entity A eliminates the effect of upstream transaction with respect to its 20% interest in consolidated financial statements. There are two approaches to this step and both are acceptable and used in practice.

Approach 1:
$mDRCR
Inventory0.06
Share of profit of associates0.06
Approach 2:
$mDRCR
Investment in Entity B0.06
Share of profit of associates0.06

year 20X1

Entity A recognises the sale to a client:

$mDRCR
Revenue1.5
Cost of sales1
Cash1.5
Inventory1

Additionally, Entity A reverses the consolidation entry made in year 20X0 (see above) and includes the profit that B made on sale to A.


Similar approach should be followed on a contribution of non-monetary assets to associate/joint-venture (IAS 28.30).

IAS 28 is silent on how to account for transactions, when there are no assets recognised as a result of them. Therefore, no adjustments/eliminations are necessary, but are allowed. Consider the following example:

Entity A has 20% interest in Entity B. During year 20X0, Entity A charges a consultancy fee of $1m on Entity B. There are two approaches to accounting under the equity method as follows (taxation ignored):

Approach 1:

Full amount of $1m is included in A’s P/L. At the same time, 20% of this income ($0.2m) is ‘automatically’ shown as a reduction of profit of associates accounted for using the equity method. Therefore, without any consolidation adjustments, the net impact on A’s P/L (before tax) is $0.8m.

Approach 2:

Entity A eliminates 20% of the consultancy income from its P/L and, at the same time, eliminates this expense from the line presenting profit of associates accounted for using the equity method. The net impact on P/L is the same as in Approach 1, but shown in different lines.

Share of investee’s P/L and OCI is determined based on its consolidated basis, i.e. includes investee’s consolidated subsidiaries and other investments accounted for using the equity method (IAS 28.10). IAS 28 is silent on how to treat non-controlling interest in the investee’s group, but it is most reasonable for the investor to account only for the controlling interest’s share of P/L and OCI, as the investor is the owner of the parent only and net income attributable to non-controlling interest will never make its way to the ‘ultimate’ investor.

Under the equity method, dividends and other capital distributions received from an investee reduce the carrying amount of the investment (IAS 28.10).

IAS 28 is silent on how to account for equity transactions (i.e. transactions without impact on P/L/OCI) carried out by an associate/joint-venture accounted for using the equity method. On one hand, the definition of equity method (IAS 28.3) requires adjustments for the post-acquisition change in the investor’s share of the investee’s net assets. On the other hand, IAS 28.10 refers only to investor’s share of P/L and OCI. Various approaches are adopted in practice, as illustrated below.

Example: equity transactions of associate accounted for as deemed disposal

On 1 January 20X0, Entity A acquires 25% interest in Entity B for $150m and accounts for it using the equity method. Entity B’s net assets as per its financial statements amount to $350m and this approximates their fair value. Additionally, Entity B has an internally generated brand (indefinite useful life) with a fair value of $100m. Deferred tax is ignored in this example. You can download an excel file for this example. Note that you can scroll the tables horizontally if they don’t fit your screen.

On 1 January 20X0, Entity A recognises its investment in Entity B at cost ($100m), which can be broken down as follows:

150Investment in Entity B at cost
$m
87.525% share in B's net assets as per its financial statements
2525% share in fair value of brand (unrecognised by B)
37.5goodwill (not presented separately and not amortised)

Goodwill in the table above was calculated as shown below:

37.525% interest in implicit goodwill held by Entity A ($150m x 25%)
$m
600implicit consideration for 100% interest, given $150m paid for 25% ($150m/25%)
350Entity B's net assets as per its financial statements
100fair value of brand (unrecognised by B)
150total implicit goodwill of Entity B ($600m-$350m-$100m)

On 2 January 20X0, Entity B issues additional shares which are not subscribed by Entity A for a total proceeds of $170m. As a result of the new issue, Entity’s A interest in B decreases to 20%, but it is still able to exercise significant influence. Such circumstances are not covered in IFRS Standards, in practice they are often referred to as ‘deemed disposals’. Because an investor loses part of its interest in associate/joint-venture, it is widely accepted that an investor needs to account for such a deemed disposal with a resulting gain or loss recognised in P&L, as under the equity method the investment in associate/joint-venture is ‘adjusted for the post-acquisition change in the investor’s share of the investee’s net assets.’

Entity A calculates gain on disposal on part of interest in B in the following way:

4Gain on deemed disposal
30Cost of investment disposed of ($150mx5%/25%)
34A's share in proceeds from share issue (based on interest after the share issue) ($170m x 20%)

Example: equity transactions of associate that is a parent with non-controlling interest in its consolidated financial statements

Entity A holds 20% interest in Entity B with carrying amount of $100m and accounts for it using the equity method. Entity B has a subsidiary in which it holds 70% interest. In its consolidated financial statements, Entity B has $500m of equity attributable to owners of parent and $200 of non-controlling interest. During year 20X1, Entity B acquires remaining 30% interest in its subsidiary for $300m. This transaction is reflected in consolidated financial statements of B as follows. Deferred tax is ignored in this example.

$mDRCR
Cash300
Non-controlling interest200
Retained earnings100

After the transaction, Entity B reports $400m equity attributable to owners of parent and $0 non-controlling interest. Although Entity A still holds 20% interest, this interest translates only to $80m of equity/net assets (20% x $400m) instead of $100m (20% x $500m) before the transaction. Entity A need to account for this change as under the equity method the investment in associate/joint-venture is ‘adjusted for the post-acquisition change in the investor’s share of the investee’s net assets.’ There are two possible approaches to this:

Approach 1

Entity A recognises the change directly in equity as share in changes in equity of associates accounted for using the equity method. This approach stems from the fact that there is no profit or loss included in B’s financial statements to be brought to A’s P&L. IAS 28.26 states that ‘many of the procedures that are appropriate for the application of the equity method are similar to the consolidation procedures described in IFRS 10.’

Approach 2

Entity A  recognises the change in net assets attributed to its holding in its P&L. Arguments in favour of this approach are as follows: Holders of non-controlling interest in Entity B were not shareholders of the Entity A (Group A), therefore the effect of transactions with them cannot be accounted for directly in equity without impact on P&L/OCI (IAS 1.109).

An investor recognises losses in an associate/joint-venture up to the amount of its investment. In other words, when the value of investment drops to zero, investor stops recognising losses under the equity method unless there is a legal or constructive obligation that require recognition of a liability. Subsequent profits of such an investee are recognised only after the unrecognised losses have been made up for (IAS 28.38-39).

It is important to note that the investment in an associate is not confined to ordinary shares held, but also includes all long-term interests (e.g. long-term financing) that, in substance, form part of the entity’s net investment in an associate/joint-venture. If such interest exist, cumulative losses exceeding the (equity accounted) carrying amount of ordinary shares held by the investor are attributed to other components of the entity’s interest in the reverse order of their seniority (i.e. priority in liquidation). Examples of financial assets that form part of the  net investment are preference shares and long-term receivables or loans without adequate collateral (IAS 28.38).

Impairment requirements for investments accounted for using the equity method are covered in paragraphs IAS 28.40-43. Impairment testing relates to total net investment in an associate/joint-venture, i.e. includes all long-term interests (e.g. long-term financing) that, in substance, form part of the entity’s net investment (see Loss making associate/joint-venture above). Impairment losses recognised by associate/joint-venture will not always be brought to the P/L of the investor in the same amount, mainly due to fair value adjustments and goodwill recognised by the investor.

May 2016 IFRIC update clarifies interaction between IAS 28 and IFRS 9 with respect to financial assets that form part of the entity’s net investment:

  • an entity accounts for long-term interests applying IFRS 9, including the impairment requirements in IFRS 9;
  • in allocating any losses of the associate or joint venture applying the requirements in paragraph 38 of IAS 28, the entity includes the carrying amount of those long-term interests (determined applying IFRS 9) as part of the net investment to which the losses are allocated;
  • the entity then assesses for impairment the net investment in the associate or joint venture, of which the long-term interests are a part, by applying the requirements in paragraphs 40 and 41A–43 of IAS 28; and
  • if an entity allocates losses or recognises impairment applying steps (b) and (c) above, the entity ignores those losses or that impairment when it accounts for long-term interests applying IFRS 9 in subsequent periods.

Discontinuing the use of the equity method is covered in paragraphs IAS 28.22-24. When an associate/joint-venture becomes a subsidiary, it starts to be fully consolidated under IFRS 10. Previously held interest is remeasured to fair value with any gain/loss recognised in P/L. In general, IFRS 3 applies.

When the change in ownership goes in the opposite direction, i.e. the interest decreases so that the investment becomes a ‘regular’ financial asset, it is accounted at fair value under IFRS 9. The difference between fair value of retained interest, proceeds received from disposal and the carrying amount of the investment at the date the equity method was discontinued is recognised in P/L.

In both cases covered above, items previously accumulated in OCI are recycled to P/L on the same basis as if the investee had directly disposed of the related assets or liabilities.

 


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Excerpts from IFRS Standards come from the Official Journal of the European Union (© European Union, https://eur-lex.europa.eu). The information provided on this website does not constitute professional advice and should not be used as a substitute for consultation with a certified accountant.