Download equity method of accounting

Chapter 33
Accounting for equity
investments
.
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33-1
Objectives of this lecture
• Be aware of how to account for equity investments
• Be aware that investments in associates (defined as
investees over which the investor has significant
influence) must be accounted for by using the equity
method of accounting, and know how to apply this
method of accounting
• Understand that if the investor is a parent entity (that is, it
has at least one subsidiary) then the cost method of
accounting is to be used in its own individual financial
statements and the equity method in the consolidation
worksheet to account for the investments in associates
• Understand that if an investor is not a parent entity (it has
no subsidiaries) the equity method of accounting is to be
used in its own accounts to account for investments in
associates
.
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33-2
Objectives (cont.)
• Be aware of tests that can be applied to
determine the existence of significant influence
• Be aware of the disclosure requirements of
AASB 128 Investments in Associates
.
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33-3
Introduction to accounting for equity
investments
• The lecture considers how to account for equity
investments where the investor does not have
control over the investee
• To determine the correct accounting treatment
for equity investments a number of factors
should be considered:
– What is the nature of the investor’s operations?
– Is the investment held for trading purposes?
.
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33-4
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 and
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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33-5
Why do firms make equity investments?
• Instead of leaving cash in low interest bank
deposits
• To have ready access to funds for dividend
payments, taxes and periodic capital works
• When sources of cash are needed in the short
term, firms invest in marketable securities
readily convertible to cash
– Disclosed as current assets
• Marketable securities:
– are debentures, shares, options or bonds readily sold
at reasonably short notice
.
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33-6
Why do firms make equity investments?
(cont.)
• Long-term investments
– Shares in listed companies to yield income from
dividends and increases in market value
– Diversified portfolio of shares to reduce overall risk
exposure
– Larger stake in a specific company in anticipation of a
takeover bid or to gain representation on the board
.
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33-7
Types of investments
• Equity investments
– Usually shares in an organisation
– Give investor an ownership interest and therefore
share in profits
• Bonds
– Instrument that binds one party to repay funds to
another party at a specified time and rate
– For example, debentures and unsecured notes
– Can be issued at face value, discount or premium
– Some can have both debt and 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 and buildings
Held to earn rentals and/or capital appreciation
Can be purchased directly or through a property trust
• Also derivative instruments (Chapter 15)
– Derive their value from other underlying assets
– For example, futures and options
.
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Accounting standards for equity investments
• There are a number of accounting standards that apply to
equity instruments (and equity instruments are a subset of
financial instruments), including:
– AASB 7 Financial Instruments: Disclosure
– AASB 132 Financial Instruments: Presentation
– AASB 139 Financial Instruments: Recognition and
Measurement
• Financial instrument (AASB 132) is:
– any contract that gives rise to a financial asset of one entity
and a financial liability or equity instrument of another entity
• Categories of financial instruments in which equity investments
can be included (AASB 139):
– Financial asset or financial liability at fair value through profit
and loss
– Available-for-sale financial assets
.
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33-10
Accounting standards for equity investments
(cont.)
• Financial asset at fair value through profit or
loss
– Equity investments (current or non-current assets)
can be recorded at fair value
– Any periodic adjustments for movements in fair value
are included in the profit or loss for the period
– Classified as held for trading or, upon initial
recognition, designated at fair value through profit or
loss
.
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33-11
Accounting standards for equity investments
(cont.)
• Available-for-sale financial assets
– Includes all financial assets that do not fall within
other categories in AASB 139
– Are to be measured at fair value with changes in fair
value to be recognised directly in equity
– When financial asset is derecognised, e.g. through
sale, changes in fair value are to be transferred out
of equity and recognised in profit or loss
.
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33-12
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 and operating policy decisions
(but not control or joint control)
.
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33-13
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
.
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33-14
Equity method of accounting (cont.)
• AASB 128 requires:
– use of equity accounting within the financial
statements, and
– application of equity accounting to include corporate
investments and 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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33-15
Equity method of accounting (cont.)
• Significant influence (cont.):
– 20% is not intended as an absolute cut-off point and
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 and 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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33-16
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 postacquisition 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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33-17
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 and
equipment and foreign exchange translation
differences
• Investor’s share of changes recognised directly
in investor’s equity
.
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33-18
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, and
– 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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33-19
Is the investor a parent entity?
.
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33-20
Application of the equity method of
accounting (cont.)
• At acquisition, the difference between investor’s share of
adjusted values of investee’s net assets and 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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33-21
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 and 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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33-22
Application of the equity method of
accounting (cont.)
• Refer to Worked Example 33.1 (p. 1077)—Comparison of
cost method and equity method of accounting
• Cost method
To recognise initial acquisition of shares
Dr
Investment in X Ltd
Cr
Cash at bank
To recognise receipt of pre-acquisition dividend
Dr
Cash at bank
Cr
Investment in X Ltd
.
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33-23
Application of the equity method of
accounting (cont.)
• Cost method (cont.)
To recognise dividends provided by associate
from post-acquisition profits
Dr
Dividend receivable
Cr
Dividend revenue
To recognise receipt of previous dividend
provided
Dr
Cash at bank
Cr
Dividend receivable
.
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33-24
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
Dr
Investment in X Ltd
Cr
Share of associate’s profit
To recognise investor’s share of dividends
Dr
Dividend revenue
Cr
Investment in X Ltd
.
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33-25
Application of the equity method of
accounting (cont.)
In consolidation worksheet (Year 2)
Prior period share of profits
Dr
Investment in X Ltd
Cr
Retained earnings (opening)
To recognise share of associate’s losses
Dr
Share of associate’s profit/loss
Cr
Investment in X Ltd
.
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33-26
Application of the equity method of
accounting (cont.)
To recognise investor’s share of dividends
Dr
Dividend revenue
Cr
Investment in X Ltd
Investor’s share of associate’s increase in
revaluation reserve
Dr
Investment in X Ltd
Cr
Revaluation surplus
.
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33-27
Application of the equity method of
accounting (cont.)
Equity method (where investor is not a parent)
In investor’s accounts (Year 1)
Initial acquisition
Dr Investment in X Ltd
Cr Cash at bank
Dividends from associate’s pre-acquisition earnings
Dr Cash at bank
Cr Investment in X Ltd
Share of associate’s profit
Dr Investment in X Ltd
Cr Share of associate’s profit
Investor’s share of associate’s declared dividends
Dr Dividend receivable
Cr Investment in X Ltd
.
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33-28
Application of the equity method of
accounting (cont.)
In investor’s accounts (Year 2)
Receipt of dividend declared in previous period
Dr Cash at bank
Cr Dividend receivable
Investor’s share of current loss of associate
Dr Share of associate’s profit/loss
Cr
Investment in X Ltd
Investor’s share of dividend declared by associate
Dr Dividend receivable
Cr Investment in X Ltd
Investor’s share of increase in associate’s revaluation surplus
Dr Investment in X Ltd
Cr Revaluation surplus
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
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33-29
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
• Carrying amount of investment to be adjusted by
(AASB 128):
– post-acquisition increments or decrements in
associate’s total reserves except to the extent that
movements have already been reflected in associate’s
or in carrying amount of investment
.
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33-30
Worked Example 33.1—Comparison of the cost and equity
methods of accounting
• On 1 July 2011 Cassie Ltd acquires a 30% 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
$480 000
Total shareholders’ funds
$1 800 000
Additional information
• For the year ending 30 June 2012, 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
2012, with the dividend coming from profits earned in the 2011–12 financial
year
• In October 2012 Joy Ltd pays the $40 000 dividend provided for on 30 June
2012
• For the year ending 30 June 2013, Joy Ltd records an after-tax loss of
$50 000. On 30 June 2013 Joy Ltd declares dividends of $20 000, to be paid
out of the profits earned in the 2012 financial year
• On 30 June 2013 Joy Ltd revalues its land upwards by an amount of $400 000
• Cassie Ltd recognises dividends as revenue when the investee declares the
dividends (that is, Cassie Ltd also recognises a dividend receivable)
• The corporate tax rate is 30%
.
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33-31
Worked Example 33.1—Solution
(a) Journal entries using the cost method in the accounts of Cassie Ltd
Year ending 30 June 2012
July 2011
Dr Investment in Joy Ltd
540 000
Cr Cash at bank
540 000
June 2012
Dr Dividend receivable
Cr Dividend revenue
Year ending 30 June 2013
October 2012
Dr Cash at bank
Cr Dividend receivable
June 2013
Dr Dividend receivable
Cr Dividend revenue
.
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12 000
12 000
12 000
12 000
6 000
6 000
33-32
Worked Example 33.1—Solution (cont.)
(b) Journal entries using the equity method in the consolidated financial
statements of Cassie Ltd (a parent entity)
30 June 2012 (in consolidation worksheet)
Dr Investment in Joy Ltd
30 000
Cr Share of associate’s profit
Dr Dividend revenue
12 000
Cr Investment in Joy Ltd
30 June 2013 (in consolidation worksheet)
Dr Investment in Joy Ltd
18 000
Cr Retained earnings—30 June 2012
Dr Share of associate’s profit/loss
15 000
Cr Investment in Joy Ltd
Dr Dividend revenue
6 000
Cr Investment in Joy Ltd
Dr Investment in Joy Ltd
84 000
Cr Revaluation surplus
.
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30 000
12 000
18 000
15 000
6 000
84 000
33-33
Worked Example 33.1—Solution (cont.)
Journal entries using the equity method in the accounts of Cassie
Ltd (not a parent entity)
Year ending 30 June 2012
July 2011
Dr Investment in Joy Ltd
540 000
Cr Cash at bank
540 000
30 June 2012
Dr Investment in Joy Ltd
Cr Share of associate’s profit
Dr Dividend receivable
Cr Investment in Joy Ltd
.
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30 000
30 000
12 000
12 000
33-34
Worked Example 33.1—Solution (cont.)
Year ending 30 June 2013
October 2012
Dr Cash at bank
Cr Dividend receivable
30 June 2013
Dr Share of associate’s profit/loss
Cr Investment in Joy Ltd
.
12 000
12 000
15 000
15 000
Dr Dividend receivable
Cr Investment in Joy Ltd
6 000
Dr Investment in Joy Ltd
Cr Revaluation surplus
84 000
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6 000
84 000
33-35
Worked Example 33.2—Adoption of equity accounting in the
presence of a difference between the fair values and book values of
depreciable assets; and a post-acquisition asset revaluation
On 1 July 2010 Rankin Ltd, a parent entity acquires a 25% 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
$165 000
Retained earnings
$60 000
Total shareholders’ equity
$225 000
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 2010 of 20 years.
• For the year ending 30 June 2011 Coombes Ltd reported an after-tax profit of
$50 000 from which it declared a dividend of $20 000
• For the year ended 30 June 2012, 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 2012
• 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%
.
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33-36
Worked Example 33.2—Solution
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 2011
Rankin Ltd’s equity interest in Coombes Ltd
less Building depreciation adjustment (see above)
Rankin Ltd’s share of Coombes Ltd’s adjusted profit
$50 000
× 25%
$12 500
(437.50)
$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 2011 financial year,
but unpaid at year end, will not be recognised in calculating Rankin’s
share of the associate’s profits
June 2011 (in consolidation worksheet)
Dr Investment in Coombes Ltd
12 062.50
Cr Retained earnings as at 30 June 2011
.
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12 062.50
33-37
Worked Example 33.2—Solution (cont.)
June 2012 (in consolidation worksheet)
Dr Investment in Coombes Ltd
Cr Share of associate’s profit
Dr
Cr
Dividend revenue
Investment in Coombes Ltd
24 562.50
24 562.50
5 000
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
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4 375
33-38
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 and investor (or any controlled entities), and
– associate and any other associate of the investor
.
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Inter-entity transactions (cont.)
• Transactions between associate and 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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33-40
Inter-entity transactions (cont.)
• Refer to Figure 33.2—Investor Company and its
subsidiaries and 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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33-41
.
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Inter-entity transactions (cont.)
Figure 33.2 (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 $5000 = $2000
.
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33-43
Inter-entity transactions (cont.)
Figure 33.2 (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 = $1800
.
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33-44
Inter-entity transactions (cont.)
• Investor might not be able to access necessary
information owing to lack of control over
associate
• Refer to Worked Example 33.3 (p. 1066)—Sale
of inventory and a depreciable asset from an
associate to an investor
– Journal entries as per previous examples
.
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33-45
Losses incurred by an associate
• Equity method to be discontinued when:
– effect of equity-accounting losses or revaluation
decrements causes investment carrying amount to fall
below zero
• When it is possible that associate will generate
accounting profits or recognise revaluation
increments in a subsequent period:
– investment in associate to be increased only by
investor’s share of profits or revaluation increments
when such increases offset losses and revaluation
decrements not recognised following suspension of
the equity method
.
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33-46
Carrying amount of the investment in an
associate
• If investment carrying amount exceeds recoverable
amount:
– carrying amount to be written down to recoverable amount,
and
– write-down to be recognised in the income statement as an
impairment loss
• If recoverable amount then increases above carrying
amount:
– reversal required up to maximum of previous write-down(s)
– reversal amount to be recognised in income statement
• Maximum amount to be shown for investment in
associate is carrying amount from equity method
.
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Disclosure requirements
• As per AASB 128
– Fair value of investments in associates with published price
quotations
– Summarised financial information of associates, including
the aggregated amounts of assets, liabilities, revenues and
profit or loss
– Reasons why investor concludes it has significant influence
when it has less than 20% voting power
– Reasons why investor concludes it does not have
significant influence when it has more than 20% voting
power
– Reporting date of associate’s financial reports if different
from that of investor
.
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33-48
Disclosure requirements (cont.)
As per AASB 128 (cont.)
– Nature and extent of significant restrictions on associates’
ability to transfer funds to the investor
– Unrecognised share of associate’s losses
– The fact that an associate is not accounted for under the
equity method
– Summarised financial information of associates not
accounted for using the equity method
– Various details of significant associates
– Amount of investor’s share of associates’ profit or loss
before income tax and income tax expense
– Amount of impairment losses and reversals
– Amount of investor’s share of associates’ capital and other
expenditure commitments
.
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33-49
Disclosure requirements (cont.)
As per AASB 128 (cont.)
– Investments in associates accounted for using the
equity method to be classified as non-current assets
– Investor’s share of associates’ profit or loss to be
separately disclosed
– Investor’s share of changes recognised directly in
associates’ equity to be recognised directly in equity
by the investor
.
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33-50
Disclosure requirements (cont.)
• In accordance with AASB 137 an investor shall
disclose
 its share of associate’s contingent liabilities incurred
jointly with other investors
 those contingent liabilities arising because investor is
severally liable for associate’s liabilities
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
33-51
Summary
• The lecture considers issues relating to the
valuation and disclosure of equity investments
• If an active market, equity investments to be
valued at fair value (AASB 139)
• If investor has significant influence over investee
(i.e. an associate), equity accounting must be
used to account for investor’s interest in
associate
• If an entity is deemed to be an associate, various
disclosures are required in notes to investor’s
financial statements (regardless of whether
equity accounting is applied)
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
33-52