Section 14 – 14.5 Equity method

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14.5 Equity method

14.5.1 Extract from FRS102: Section 14.8(a)-18.8(h)

14.8 Under the equity method of accounting, an equity investment is initially recognised at the transaction price (including transaction costs) and is subsequently adjusted to reflect the investor’s share of the profit or loss, other comprehensive income and equity of the associate.

(a) Distributions and other adjustments to carrying amount

Distributions received from the associate reduce the carrying amount of the investment. Adjustments to the carrying amount may also be required as a consequence of changes in the associate’s equity arising from items of other comprehensive income.

(b) Potential voting rights

Although potential voting rights are considered in deciding whether significant influence exists, an investor shall measure its share of profit or loss and other comprehensive income of the associate and its share of changes in the associate’s equity on the basis of present ownership interests. Those measurements shall not reflect the possible exercise or conversion of potential voting rights.

(c) Implicit goodwill and fair value adjustments

On acquisition of the investment in an associate, an investor shall account for any difference (whether positive or negative) between the cost of acquisition and the investor’s share of the fair values of the net identifiable assets of the associate in accordance with paragraphs 19.22 to 19.24. An investor shall adjust its share of the associate’s profits or losses after acquisition to account for additional depreciation or amortisation of the associate’s depreciable or amortisable assets (including goodwill) on the basis of the excess of their fair values over their carrying amounts at the time the investment was acquired.

(d) Impairment

If there is an indication that an investment in an associate may be impaired, an investor shall test the entire carrying amount of the investment for impairment in accordance with Section 27 as a single asset. Any goodwill included as part of the carrying amount of the investment in the associate is not tested separately for impairment but, rather, as part of the test for impairment of the investment as a whole.

(e) Investor’s transactions with associates

The investor shall eliminate unrealised profits and losses resulting from upstream (associate to investor) and downstream (investor to associate) transactions to the extent of the investor’s interest in the associate. Unrealised losses on such transactions may provide evidence of an impairment of the asset transferred.

(f) Date of associate’s financial statements

In applying the equity method, the investor shall use the financial statements of the associate as of the same date as the financial statements of the investor unless it is impracticable to do so. If it is impracticable, the investor shall use the most recent available financial statements of the associate, with adjustments made for the effects of any significant transactions or events occurring between the accounting period ends.

(g) Associate’s accounting policies

If the associate uses accounting policies that differ from those of the investor, the investor shall adjust the associate’s financial statements to reflect the investor’s accounting policies for the purpose of applying the equity method unless it is impracticable to do so.

(h) Losses in excess of investment

If an investor’s share of losses of an associate equals or exceeds the carrying amount of its investment in the associate, the investor shall discontinue recognising its share of further losses. After the investor’s interest is reduced to zero, the investor shall recognise additional losses by a provision (see Section 21 Provisions and Contingencies) only to the extent that the investor has incurred legal or constructive obligations or has made payments on behalf of the associate. If the associate subsequently reports profits, the investor shall resume recognising its share of those profits only after its share of the profits equals the share of losses not recognised.

14.5.2 OmniPro comment

14.5.2.1 Overview

As stated at 14.3.2, the equity method can only be used in a consolidated set of financial statements where the parent does not hold the associate as part of an investment portfolio. See Section 14.8 of FRS 102 provides the rules for equity accounting.

14.5.2.2 Application of equity accounting

Section 14.8 of FRS 102 provides the rules for equity accounting

The starting point in determining the amount of income/revenue to recognise in the consolidated accounts is to determine the percentage right of the investor to the associate’s profits/losses. In determining the percentage, no account should be taken of options to acquire shares (only consolidated when accessing if a significant influence is held), the percentage is based on the number of shares held at each reporting period. Section 14.8 (b) of FRS 102 refers.

The equity method of accounting ensures the carrying value of the investment in the consolidated financial statements is stated as follows:

Cost of the investment XX

Less share of loss after tax of the associate for the financial year (XX)

Plus share of profit after tax of the associate for the financial year XX

Plus/(minus) share of items posted to OCI in associates’ books (i.e.

revaluations, FX on retranslation) XX

Less amortisation of goodwill on the investment (XX)

Add amortisation of negative goodwill if applicable XX

Less impairments (XX)

Plus/(minus) adjustment required to show consistent accounting policies

of the group XX

Less share of dividend received or declared but not paid (XX)

Less share of unrealised profit from sale of goods by associate to

Parent/Group company still in stock (XX)

Plus share of unrealised loss from sale of goods by associate to

Parent/Group company still in stock XX

Total carrying amount in the consolidated financial statements XXX

14.5.2.2.1 Goodwill

Goodwill is consumed within the cost of the investment it is not shown as a separate asset as is the case in a business combination. Section 14.18 ensures that this goodwill is amortised over its useful life and credited against the investment year on year. Where negative goodwill is identified and once it is double checked this is written off over the life of the non-monetary assets. Section 14.8 (c)of FRS 102?

14.5.2.2.2 Worked example illustrating equity accounting requirements

The below example illustrates most of the above points.

Example 5: Equity method accounting

Company A acquired a 35% interest in Company B at the start of the financial year of CU50,000. The net assets of Company B at that time was CU50,000 but the fair value of the net assets was CU70,000, the additional uplift being on the property in the company. The property has a remaining useful life of 10 years. Goodwill is assumed to have a useful life of 20 years.

The profit after tax of Company B for the year was CU50,000 and a dividend of CU10,000 was declared. Company B posted CU5,000 to other comprehensive income.

Prior to year-end Company B sold goods worth CU1,000 to Company A and a profit of CU500 was made by company B on this sale. These goods are still in stock in Company A at the year end.

Company A prepares consolidated financial statements. Assume there is no deferred tax on any unremitted dividends.

The carrying value of the investment in Company A’s consolidated financial statements is as follows:

	CU
Total price paid for 35% share	50,000
Less fair value of net assets received (CU70,000*35%)	(24,500)
Goodwill on acquisition	25,500
Amortisation of goodwill over useful life of 20 years (CU25,500/20yrs)	1,275

	CU
Difference between fair value of net assets and carrying amount of net assets in the books of Company B (CU70,000-CU50,000)	20,000
Company A’s share of the uplift (35%*CU20,000)	7,000
Additional depreciation on uplift in fair value per annum (CU7,000/10yrs)	700

	CU
Share of Company A’s allocation of the posting to Company B’s OCI (CU5,000*35%)	1,750

	CU
Total share of unrealised profit on sale of goods to Company A which is still in Company A stock = CU500 * 35%=	175

	CU
Carrying value of investment is:
Company A’s share of net profit after tax (CU50,000*35%)	17,500
Company A’s share of OCI debit	(1750)
Less goodwill amortization	(1,275)
Less additional depreciation on fair value adjustment	(700)
Less Company A’s share of dividend (CU10,000*35%)	(3,500)
Less elimination of unrealised profit	(175)*
Total movement in the year	10,100
Initial cost of investment	50,000
Total carrying amount at end of year	60,100

*note it would also be acceptable if this was set against inventory in the consolidated financial statements

	CU	CU
The journal required to be posted to account for the movement is:
Dr Investment in Associate	10,100
Dr Share of Associates less in OCI	1,750
Cr Share of Associates Profit for year in P&L		11,850

14.5.2.3 Impairments

The investment is required to be reviewed for impairment indicators annually (see details of the indicators at 27.5.2) and once one is identified an impairment review should be performed in line with Section 27-Impairment of Assets as detailed at 27.6.2. Possible indicators of impairment would include:

Losses incurred by the associate ;
Liquidity issues affecting the payment of dividends; and
Payment of a large dividend shortly after acquisition.

Section 14.8(d) of FRS 102 refers

In assessing the recoverable amount, it should be based on the higher of the present value of the dividends that the investor expects to receive in the future and the proceeds from the ultimate sale as detailed at 27.6.2.

14.5.2.3.1 Impairment review required even where associate has booked an impairment in its own financial statement

Even where the associate has booked an impairment on its assets, this is not enough for the investor. The investor has to review the carrying amount of the investment for impairment itself. This will include reviewing:

Any additional impairment required to be booked on any fair value uplifts recognised on acquisition. In the example above at 14.5.2.2.2 the fair value of the fixed assets were CU20,000 above the net book amounts in the associate. So if we assume the associate booked an impairment in its financial statements on the carrying amount of the fixed assets this will mean that the investor would have to recognise an impairment on the CU20,000 uplift as this would not be included in the associates impairment review; and
Reviewing the carrying amount of the investment. The goodwill included in the carrying amount at that time is not tested separately for impairment but is tested as part of the overall investment as required by Section 14.8 (d) of FRS 102.

If there are any loans owed by the associate these would also be required to be accounted for under Section 11 – Basic Financial Instruments.

14.5.2.4 Transactions with associates

In the example above at 14.5.2.2.2 it can be seen how sales between the group and the associates should be accounted for i.e. the profit element relating to the investors share should be deferred until the following year as required by Section 14.8 (e) of FRS 102.

In the example above at 14.5.2.2.2 in relation to the carrying value of the investment in the consolidated financial statements, the associate sold goods to the investor, in that instance the profit was deferred and the journal posted to debit share of profit of associates and credit the investment in the associate. This is known as upward selling. In the following year the journal would be reversed to group profit and loss reserves as the profit would have already been included in the associates financial statements in the prior year.

Where downward selling occurs i.e. where members of the group or the investor sell to the associate company. In this case the journals required are to:

Dr Revenue (Value of sale X percentage of associate held)

Cr Investment in Associate (balance)

Cr Cost of Sales (Value of cost of sale X percentage of associate held)

Obviously if a loss was incurred then the journals would reverse

Example 6: Elimination of profit where investor sells goods to investee

Company A the investor sells goods to its 35% associate Company B for CU100,000. The cost of this sale is CU40,000. At the year end the associate company still has these items in stock. Therefore a journal is required to eliminate 35% of the profit on this transaction as follows:

	CU	CU
Dr Revenue (CU100,000*35%)	35,000
Cr Cost of Sales (CU40,000*35%)		14,000
Cr Investment in Associate (CU60,000*35%)		21,000

14.5.2.5 Date of associates financial statements (Section 14.8(f) of FRS 102)

An entity should make every effort to have financial statements up to the same period end as the parent. However where this is not possible the most recent available financial statements should be used. Adjustment should be made to extract the effects of significant transactions that occurred between the date of the parent entity financial statements are prepared to and the date the associates are prepared to. Note unlike a subsidiary where there is a 3 months max distance between the dates. Longer periods can exist between the two dates for an associate.

14.5.2.6 Uniform Accounting policies (Section 14.8 (g) of FRS 102)

Where different accounting policies are used by the associate to that of the parent, then adjustments should be made unless it is impracticable. It would be usually impracticable if the parent does not have the information to adjust for the differences. They cannot force information from the associate as they only have a significant influence.

14.5.2.7 Losses in excess of investment (Section 14.8(h) of FRS 102)

As stated in Section 14.8(h) of FRS 102 no provision should be made for any losses in excess of the investment amount unless a legal or constructive obligation exists in accordance with Section 21 of FRS 102. Loss should only be recognised to the extent that the investment is written down to nil. Where a long term investment is treated as a net investment in an associate (i.e. a long term loan where settlement is neither likely nor planned in the foreseeable future) the loss would be netted against this investment also.

Where profits are made in the future, these profits will not be recognised until the associate comes back into a net asset position.

Example 7: loss in excess of investment

Company A has a 35% associate. The cost was CU100,000. At the end of year 1 the associate made a loss of CU150,000. In this instance the CU100,000 would be credited against the investment but the CU50,000 would not be recognised as there is no obligation on Company A with regard to these losses.

If in year 2 a profit of CU40,000 was recognised by the associate, this CU40,000 would not be recognised as a loss of CU50,000 has went unrecognised previously. Only when another CU10,000 of profits are made can the entity recognise the profit in the parent company consolidated accounts.

If there was a loan which met the definition of a long term investment then CU50,000 of the loss above would be taken off that loan.

14.5.2.8 Deferred tax on unremitted earning in the consolidated financial statements

14.5.2.8.1 Overview

As detailed in Section 29 of FRS 102, deferred tax may be required to be recognised on unremitted earnings as the parent cannot control the timing of the reversal. The reason why there is deferred tax is due to the Group’s share of the associate’s results being posted in the consolidated profit and loss but the income/expenses were not taxable/tax deductible for tax purposes in that year for the group as no dividend was actually received for all of the amounts recognised.

Determining the deferred tax rate to use will depend on how management expect the investment to be settled i.e. by sale or through the receipt of dividends.

14.5.2.8.2 Timing difference to reverse through sale

If it is expected to be sold, then the capital gains tax rate should be utilised to measure the deferred tax. The timing difference will be the difference between the carrying amount of the investment and the tax base cost. Note the participation relief from GGT may apply which may exempt any gain from tax. If no tax would be payable from sale then no deferred tax would need to be recognised.

14.5.2.8.3 Timing difference to reverse through receipt of dividends

Where it is expected that the asset will be settled through receipt of dividends, then the tax rate applicable to the receipt of dividends should be used. However it is likely that any dividends where it is from Irish Companies will not be taxable in the parent’s hands at all when it is received and in that case no deferred tax arises as they are permanent differences.

14.5.2.8.4 Example of deferred tax on unremitted earnings

Example 8: Deferred tax on unremitted earnings

Company A invested CU500,000 to acquire 35% of Company B as detailed in example 3 at 14.5.2.2.2. The movement recognised under consolidated financial statements the equit method was CU10,100 split CU11,850 credit into the P8C and CU1,750 debt in OCI as detailed at 14.5.2.2.2. Assume that the dividend when made to Company A by Company B is taxable in the hands of Company A at a rate of 10%. Assume the entity does not have control over when it will be distributed. The transition adjustments required on transition are:

Dr deferred Tax in P8L (11,185×10%)

Cr Deferred Tax in OCI (1 (1,750X10%)

1,185

175

Cr Deferred Tax balance sheet

1,010

Being journal to reflect deferred tax

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