Equity Method

What is the Equity Method?

The equity method is an accounting method companies use when they have significant influence over another company they have invested in.

One of the primary investment sources for an organization is an intercompany investment. In other words, a company either invests in or takes control of another company’s operations.

To understand the equity method, knowing how accounting standards advise companies to account for their investments is important. Accounting standards classify intercorporate investments into three categories.

1. Financial Assets: When a company’s ownership in another company is less than 20%, it is classified as a financial asset. The investor is said not to influence the investee’s operations. IFRS 9 deals with the accounting of a financial asset.
2. Associate Investments: These are investments where the investor’s control is between 20% to 50%. When ownership exceeds 20%, the investor is said to have significant influence. This is when we use the equity method to account for intercompany investments.
   This article explores associate accounting in detail.
3. Subsidiaries: These are established when the investor owns more than 50% of an entity. In this case, the investor is deemed to have control over the investee’s operations. When the investor is said to have control, we use business combination accounting.

Which accounting treatment should a company adopt? Let us say that company A owns 60% of company B. But, it is not involved in making any operational or managerial decisions. In such a situation, company B may be considered an associate or financial asset.

Therefore, it makes more sense that a company looks at its degree of control rather than its percentage of ownership.

When Is Significant Influence Established?

As discussed before, determining the presence of significant influence is highly subjective, and this is usually done at the discretion of the investing company. However, accounting standards usually advise companies to answer the following questions:

How Do Companies Account For Excess Purchase Prices Under The Equity Method?

Before we look at how financial statements are prepared under the equity method, let us discuss some factors that affect the company’s accounting practices. One of these factors is the excess purchase price when investing in an associate.

A company’s assets are of two types - those that can be identified and those that cannot. Identifiable assets can be measured reliably and assigned a specific value. Non-identifiable assets (like goodwill) cannot be measured or valued accurately.

When we talk about the excess purchase price, net identifiable assets are an important metric.

Net identifiable assets = Total identifiable assets - Total liabilities

To understand the accounting for the excess purchase price, let us take an example. Let us say that INV Inc. (the investor) is investing $1.5 million to acquire 35% of another company called ASC Ltd. (the associate).

Here is the balance sheet of ASC Ltd. All figures are displayed in ‘000s of dollars.

For the most part, liabilities are fixed, and fair value fluctuations will not impact the company’s contractual obligations. Accounts receivable is an obligation that the company is owed. This, too, is fixed.

Fluctuations in fair value come primarily through inventory, PP&E, and land. How these fluctuations are treated differs based on the type of asset of concern.

1. Inventory: Since inventory is not depreciated, we will expense the excess of fair value through the profit and loss statement.
2. PP&E: PP&E is a depreciating asset. When the investor invests in the associate, he will first capitalize the excess PP&E and then depreciate this excess over the asset’s remaining useful life.
3. Land: Since land is not a depreciable asset, we will report it at fair value on the investment date.

In the above example, there is no goodwill, so net identifiable assets will be the difference between total assets and total liabilities, which is reflected in shareholders’ equity. The fair value of net identifiable assets is $3,020,000.

Since INV Inc. is acquiring 35%, the purchase price should logically be:

35% * 3,020,000 = $1,057,000

But INV Inc. has paid $1.5 million. What does the excess of $443,000 represent? This is the “premium” or the goodwill component the investor will pay to acquire the associate. 

Treatment Of Goodwill And Impairment Loss Under Equity Method

Impairment loss is another factor that affects the financial statements when accounting for associates. Now that we have calculated goodwill, we must also look at how it is treated under the equity method.

Since goodwill does not have a definite life, it is not amortized like other intangible assets. When the company is dealing with subsidiaries, goodwill must be tested for impairment at least once a year.

However, the equity method does not require companies to test goodwill for impairment. Unlike subsidiary accounting, goodwill does not have to be shown in the investor’s balance sheet under the equity method.

Under the equity method, the equity investment in the associate as a whole is tested for impairment. Both IFRS and GAAP have different rules for impairment testing and accounting. Let us take an example to understand the impairment testing process.

Let us say that the carrying value of company A, the associate, is $2 million on the balance sheet of B, the investor. We will deal with the calculation of carrying value in upcoming sections. For now, think of carrying value as the value of the investment in the investor’s balance sheet.

We will discuss each of these terms in detail in the next few sections and how they impact the calculation of impairment loss under the two accounting standards - International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP).

Impairment Loss Under IFRS

Under IFRS, the calculation of impairment loss is based on two factors - the fair value of the associate and the value in use.

1. The fair value of the associate

The fair value of the associate is the price of the associate company in the market. This can also be seen as the associate's enterprise value.

However, the associate may also incur some costs while selling the company. These costs must be accounted for. Therefore, the costs to sell the associate are deducted from the fair value of the associate.

2. Value in use

The value in use is the present value of all cash flows the associate will generate for the investor. To determine the value in use, the discount rate used to bring cash flows to their present value is an appropriate rate that reflects the risk of investing in the associate.

Under IFRS, the carrying value of the associate is measured against its “recoverable amount.” The recoverable amount is higher than the associate’s fair value and value in use. There is an impairment loss if the carrying value is higher than the recoverable amount.

In our example, the fair value is $1.1 million after it has been adjusted for selling costs. The value in use is given as $1.5 million. Since the value in use is higher, this is the recoverable amount the carrying amount must be compared against.

There is an impairment loss since the carrying value is $2 million.

Impairment loss = Carrying value of associate - Recoverable amount

The investor, B, will record an impairment loss of $500,000 on his income statement.

Impairment loss under GAAP

The process of determining impairment loss is slightly different under US GAAP. A company using GAAP measures will have to adopt a two-step approach to account for impairment loss.

While impairment loss is directly calculated through the recoverable amount under IFRS, US GAAP does not use the concept of recoverable amount. Instead, it asks the investors to conduct an impairment test of the associate before calculating impairment loss.

To answer the question, “Is the asset impaired?” the associate’s fair value must be compared with its carrying value to test for impairment. If the carrying value exceeds the fair value, the asset is considered impaired.

The investor must recognize an impairment loss if the impairment test returns positive. We know that the associate's carrying value is $2 million, and its fair value is $1.3 million.

Impairment loss = Carrying value of associate - Fair value of associate

An impairment loss of $700,000 is recorded on the income statement of B, the investor.

Reversal of impairment losses under IFRS and GAAP

There is a key distinction to be made between the treatment of impairment losses under IFRS and GAAP. This is with respect to the treatment of impairment reversals. Let us continue our example.

The value of the associate on B's balance sheet has been written down to $1.3 million. B will also record an impairment loss of $700,000 on its income statement. For our example, we will assume that impairment loss is the same under IFRS and GAAP.

Suppose that the fair value of the associate after a year is $1.8 million. This is higher than the investor's value on its balance sheet.

Under IFRS, B is allowed to report an impairment reversal gain of $500,000 on its income statement and report the associate’s value at $1.8 million.

Under US GAAP, impairment reversals are strictly prohibited. It is irreversible once the company records an impairment loss on the income statement.

Effect of Transactions With the Associate

The next factor to be considered when the company is preparing its books of accounts under the equity method is the effect of transactions with the associate. Associate transactions are of two types.

1. Upstream Sales

These are sales where the investee (associate) sells goods to the investor company. Since the associate is the seller, it will record a profit on sale in its books of account. But the investor is entitled to a proportion of these profits to the extent of his holding.

In the case of both upstream and downstream sales, the profits are considered to be unrealized since the goods are flowing within the company, and there is no value addition in the form of sales to a third party.

Therefore, the investor will deduct these unrealized profits from his net income and recognize them once he can sell the goods in stock to a third party.

2. Downstream Sales

As the name suggests, downstream sales flow “down”, i.e., from the investor to the associate. In this case, the investor is the seller and will have unrealized profit in its books. Once the associate is able to resell these goods to a third party, the investor will recognize a profit.

Impact of Upstream and Downstream Sales With an Example

Now that we have understood how upstream and downstream sales work, let us take an example of two companies - INV (the investor) and ASC (the associate). INV holds a 40% stake in ASC. We have the following figures from INV’s books at the end of the year.

During the year, there were two transactions between the investor and the associate.

1. ASC sold goods for $200,000 to INV. This included a profit of $60,000. At the end of the year, INV had not resold these goods to a third party.
2. INV sold goods for $400,000 to ASC, making a profit of $100,000 in the process. ASC has sold $80,000 worth of goods to third parties as of the reporting date.

Before calculating realized and unrealized profit, we must calculate the percentage of goods that both INV and ASC have in stock.

In the case of INV, no goods were sold. Therefore, 100% of the goods are still in stock. However, ASC sold goods worth $80,000 out of the $400,000 in stock. Therefore, it has only 80% of its goods under inventory.

The unrealized profit from the downstream transaction will be $80,000 since 80% of the stock lies unsold. As for the upstream transaction, no profits have been realized since no goods have been sold.

Since INV owns 40% of ASC, it is entitled to a proportionate amount of these profits. INV will deduct an amount of $56,000 from its net income. Furthermore, the carrying value of ASC in its balance sheet will also reduce by $56,000.

After the adjustment, we will have the following figures.

Financial Statement Preparation Under The Equity Method

After having analyzed the impact of various factors on the financial statements under the equity method, we can finally jump into actually seeing how the financial statements are prepared. Unlike a subsidiary, the associate is considered a fairly independent entity.

Therefore, the investor will report associate investments like any other non-current investment, i.e., as a single line item in the income statement and the balance sheet. We will use everything we have learned so far to plug a figure into the income statement and balance sheet.

Let us take a new example of two companies - INV (the investor) and ASC (the associate). INV owns 35% of ASC shares, for which it paid $500 million. All relevant figures are given below (in $000s).

Since we have already studied the calculation method for each of these items in previous sections, we will not delve into them in detail. The figures are already given to us, so we will directly calculate the impact on the investor’s (INV) income statement and balance sheet.

Below is the calculation for the figure that will go into INV’s income statement. We will calculate both the consolidated figure and the investor’s profit share.

INV will record this profit share as a single line item in its income statement after gross profit and before “earnings before tax”.

Let us now calculate the figures for the balance sheet.

The carrying value of the associate will be recorded as a single line item under non-current assets in the balance sheet.

Summary

Let us recap everything we have learned in this article. We began by discussing the various classes of investments subject to specific accounting treatments.

Through this, we concluded that where the investor has a stake of 20%-50% in another company, we use the equity method to account for such investments.

We then learned about the components that make up the equity method's income statement and balance sheet calculations.

The first component was the excess of fair value over book value over the associate’s depreciable assets. This amount is capitalized and depreciated over the asset’s remaining useful life.

Secondly, we learned how impairment of associate investments is recognized and recorded under both IFRS and GAAP standards. While the reversal of such impairments is prohibited under GAAP, IFRS allows it to the extent of the original loss.

The final component of our income statement calculation was the effect of upstream and downstream transactions with the associate. Both types of transactions will have unrealized profits, which will be deducted from the investor’s net income until these profits are realized.

Dividends from the associate are treated as withdrawals and reduce the associate’s carrying value. Impairment losses also reduce the carrying value of the associate. Finally, we used all these components to prepare our income statement and balance sheet figures.

Under the equity method, the investment value of the associate is reported as a single line item under non-current assets on the investor's balance sheet. The share of associate profits belonging to the investing company is recorded in the income statement of that company.

Researched and written by Sathyanarayana Sairam | LinkedIn

Reviewed and edited by Alexander Bellucci | LinkedIn

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