Explaining the Equity Method of Accounting for Investments With Examples
In its 15 years of existence, Hames Company records its equity investments using the cost method. Currently, the company’s accountant, Miss Vanuela, suggests that it is time to shift from the cost to equity method of accounting for investments. CEO Darwin Stevans is not very keen on adapting changes when there is no need to. However, during its closed door conference, Mr. Stevans, together with Mr. Uy, a consultant, and the company’s two assistant vice presidents, succumb to the idea of changing the method. Miss Vanuela, the proponent, is present to answer questions.
Mr. Stevans highlights the reasons uttered by Miss Vanuela, which are the following: Current investments are above 20% of the investees’ equities, investments’ profitability monitoring, and increases or decreases in the investment accounts due to dividends and income sharing. The meeting is adjourned with the CEO satisfied with the accountant’s presentation.
How is the Equity Method Applied to Equity Securities?
When the shares of stock held by an entity investor give such entity significant influence over the entity investee, the investee is called an associate. Significant influence is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies. An associate, however, is not limited to an incorporated entity. It may also include an unincorporated entity such as a partnership or a joint venture.
The existence of significant influence by an investor is usually evidenced in one or more of the following ways:
- Representation on the board of directors or equivalent governing body of the investee.
- Participation in policy-making processes, including participation in decisions about dividends or other distributions.
- Material transactions between the investor and the investee.
- Interchange of managerial personnel.
- Provision of essential technical information.
The existence of significant influence over the investee may be judgmental such that if an investor holds directly or indirectly 20 percent or more of he voting power of the investee, influence is present unless it can be clearly demonstrated that this is not the case.
Conversely, if the investor holds directly or indirectly less than 20 percent of the voting power of the investee, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated.
When the investment in associate is not held exclusively for disposal within twelve months from the acquisition date, the investment should be accounted for using the equity method, unless the investor is a subsidiary of another entity, or the investor’s debt or equity instruments are not traded in a public market.
The discussion below describes how the use of an equity method of accounting for investments is applied to a company’s investment in an associate:
If a company invests in an associate, the investment is initially recogniized at cost, and an account called “Investment in Associate” is created. The decrease in cash or any appropriate asset given away in exchange is also recorded.
The carrying amount of the investment increases or decreases in recognizing the investor’s share of the profit or loss of the investee after the date of acquisition. The investor’s share of the profit or loss of the investee is recognized in the investor’s profit or loss income statement. Therefore, if the investee obtains profit during the period and the investor gets its share, the investment in associate account of the investment increases and it decreases if the investee suffers a loss.
Any difference between the cost of the investment and the investor’s share of the fair values in net identifiable assets of the associate is treated as goodwill. Goodwill is not amortized but is subject to annual impairment loss. Share in impairment loss attributed to goodwill adjusts the investor’s share in profits and losses. In this case, if there is any impairment loss, the income amounts from the associate account and the investment account are both decreased.
Appropriate adjustments to the investor’s share of the profits or losses after acquisition are made to the investment account–for example, the depreciation of the depreciable assets, based on their fair value at date of acquisition. Thus, to amortize the excess of cost attributable to a depreciable asset, a reduction to the income from the associate and the investment account is created.
If there are distributions of dividends, received or receivable from an investee, the carrying amount of the investment is reduced.
Changes in the investee’s equity that have not been recognized in the investee’s profit or loss (such as those arising from revaluation of property, plant, or equipment, and from foreign exchange translation differences) are considered as adjustments to the carrying amounts of the investment.
These changes are recognized directly in equity of the investor. In this case, the investment account is increased while a revaluation surplus-associate is created.
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An Illustration on How Hames Company Applies Equity Method to its Investments in Associates
The following transactions are those of Hames Company for the year 2010 pertaining to its equity investment in Vanch Company, an affiliate:
Purchased 25,000 at $150 per share of Vanch’s ordinary shares representing 25% of the voting rights in Vanch. The net assets of the Vanch on this date have carrying value of $14,000,000
Utilizing the equity method of accounting for investments, Miss Vanuela creates an account Investment in Associate with the amount of $3.750,000, decreasing the cash account of the same amount, $3,750,000.
Sometime during the year, Hames Company receives cash dividends of $10 per share from Vanch. Cash is increased by $250,000 (25,000 units of shares multiplied by $10) and a corresponding decrease in the Investment In Associate of $250,000.
Note: When an affiliate company declares a dividend and the investing company receives its share, the investment account is decreased.
At the end of the year, when Vanch Company reports a net income of $2,000,000, Hames receives its share of $500,000, or $2,000,000 mulitplied by 25%.
As a result of this transaction, Investment in Affiliate account increases by $30,000. A new account called Income from Associate is created with the same amount of $30,000.
The carrying amount of the identifiable assets equals their fair values, except for land which has fair value in excess of the carrying amount of $200,000 and the building which has fair value in excess of carrying amount of $400,000. The building, on January 1, 2010, has an estimated useful life of 10 years. There is no indication of impairment of goodwill.
Because of this transaction, the “Income from Associate” and the “Investment from Associate” accounts decreases with the same amount, $150,000, computed below:
Cost of investment $3,750,000
Underlying equity in carrying value of net assets 25% of $18,000,000 $3,500,000
Excess of Cost $250,000
Attributable to land 25% of $200,000 ($50,000)
Attributable to building 25% of $400,000 ($100,000)
Goodwill $100,000
Applicable depreciation on building is $10,000 - $100,000 / 10 years.
There is no adjustment applicable to land, even if its fair value differs from its carrying amount in the books of Vanch because land is not subject to depreciation or amortization. Neither is there any adjustment on the goodwill, as goodwill is not impaired. If goodwill is evaluated to be impaired, a proportionate share in impairment loss should be taken up by Hames by debiting income from associate and crediting the investment account.
On the face of the balance sheet, the Investment in Associate account should be shown in a separate line presentation as required by standard in presenting the financial statements. Likewise, Income from Associate account shall be presented as a separate line item on the face of the income statement. The investment in associate is valued on the balance sheet at its carrying amount under the non-current asset classifcation.
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Summary of the Application of the Equity Method: Hames and Vanch Company
As a summary of the above equity method of accounting for investments:
The Investment in Associates account is increased by the following:
- Investment
- Income share
The account is decreased, on the other hand, if there are dividends received from the associate.
Any adjustments to the fair values of the assets are also adjusted. In the above example, since there are increases in the values of the land and building, the depreciation of the building is also adjusted wherein the net income is also adjusted.
As a summary, I would like to repeat these two paragraphs stated in the preceding section:
There is no adjustment applicable to land, even if its fair value differs from its carrying amount in the books of Vanch because land is not subject to depreciation or amortization. Neither is there any adjustment on the goodwill, as goodwill is not impaired. If goodwill is evaluated to be impaired, a proportionate share in impairment loss should be taken up by Hames by debiting income from associate and crediting the investment account.
On the face of the balance sheet, the Investment in Associate account should be shown in a separate line presentation as required by standard in presenting the financial statements. Likewise, the Income from Associate account shall be presented as a separate line item on the face of the income statement. The Investment in Associate is valued on the balance sheet at its carrying amount under the non-current asset classifcation.
Conclusion: The Benefit of Using the Equity Method of Accounting for Investments
As we can read in the first section of this article, the accountant suggests the change of recording investments, from cost to equity method, because the profitability of investments (through its current balance) cannot be monitored by cost method. The account “Investment in Associate” is only used at its initial recognition but not when the company receives dividends or income. Any change in the value of the assets is reflected when the equity method is used. Cost method might be practical if the company has only one investment but if the company has more than one investment, it will be hard to monitor them one by one. Equity method is a practical method to account the investments of a company.
Books and Image Credits:
Valix, Conrado T; Peralta, Jose F; and Valix, Christian Aris M. Financial accounting volume, 2009 edition.
