Accounting for investments in associates | My Assignment Tutor

Lecture 10 : Accounting for investments in associatesHI5020 Corporate AccountingTopics covered in this lecture• How to account for equity investmentswhere the investor does not havecontrol over the investee• Cost method of accounting forinvestment in associate• Equity method of accounting forinvestment in associateHolmes InstituteIntroduction to Accounting for EquityInvestments (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 &reserves▪ An equity investment is deemed to exist where (AASB132):• the investor has acquired an equity instrument, whichcan be defined as:➢any contract that evidences a residual interest in anentity’s assets after deducting all its liabilitiesHolmes InstituteTypes of Investments▪ Equity investments✓Usually shares in an organisation✓Give investor an ownership interest & thereforeshare in profits▪ Bonds✓Instrument that binds one party to repay funds toanother party at a specified time & rate✓For example, debentures & unsecured notes✓Can be issued at face value, discount or premium✓Some can have both debt & equity characteristics,e.g. convertible bondsHolmes InstituteTypes 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 & buildings✓Held to earn rentals &/or capital appreciation✓Can be purchased directly or through a propertytrust✓Also derivative instruments✓Derive their value from other underlying assets✓For example, futures & optionsHolmes InstituteInvestments in AssociatesKey terms:Associate: investee over which the investor hassignificant influenceInvestee: entity in which another entity has anownership interestInvestor: entity/person that has an ownershipinterest in another entitySignificant influence: power to participate ininvestee’s financial & operating policy decisions (butnot control or joint control)Holmes InstituteEquity Method of AccountingAASB 128 requires that:where an investor does significantly influence aninvestee, the investor must adopt the equitymethod of accountingTherefore, while there is a general principle thatequity investments shall be measured at fairvalue, where an investor has significantinfluence then we will use equity accounting tomeasure the equity investmentHolmes InstituteEquity Method of Accounting (cont.)• AASB 128 requires:• use of equity accounting within the financialstatements, &• application of equity accounting to include corporateinvestments & non-corporate investments• Significant influence• Used in determining whether the equity method is tobe applied• Falls short of control• Normally stems from investor’s voting power in theinvestee• Assumed to exist where investor holds 20% or more ofinvestee’s voting powerHolmes InstituteEquity Method of Accounting (cont.)• Significant influence (cont.):• 20% is not intended as an absolute cut-off point &significant influence may exist with an equity holdingbelow this rather arbitrary amount of voting power• Other indicators• representation on board of directors• participation in policy-making processes• material transactions between investor & investee• interchange of managerial personnel• provision of essential technical information• If the investor subsequently ceases to have significantinfluence, they must cease using equity accountingHolmes InstituteApplication of the Equity Method of Accounting✓As with the materiality application in other accountingstandards, if investments are not material, investornot required to comply with AASB 128✓Investment in associate is initially recognised at cost✓Carrying amount of investment is increased ordecreased to recognise investor’s share of investee’spost-acquisition profits✓Investor’s share of investee’s profit or loss to beincluded in investor’s profit or loss✓Distributions (e.g. dividends) from investee reducethe investment’s carrying amountHolmes InstituteApplication of the Equity Method of Accounting (cont.)• Adjustments to carrying amount also for:• changes in investor’s proportionate interest ininvestee from changes in investee’s equity notincluded in investee’s profit or loss• For example, revaluations of property, plant &equipment & foreign exchange translationdifferences• Investor’s share of changes recognised directly ininvestor’s equityHolmes InstituteApplication of the Equity Method of Accounting (cont.)• If investor is required to prepare consolidated financialstatements they should:• recognise investment in associate by applying equitymethod in consolidated financial statements, &• apply cost or fair value methods in own individualfinancial statements• If investor does not prepare consolidated financialreports they should:• apply the equity method to their own ‘separate’financial report• (the above is summarised on the following slide)Holmes InstituteIs the Investor a Parent Entity?Holmes InstituteApplication of the Equity Method of Accounting (cont.)• At acquisition, the difference between investor’s share ofadjusted values of investee’s net assets & cost ofinvestment is regarded as:• goodwill, or• discount on acquisition• Goodwill is not separately disclosed; however, anyimpairment of goodwill is taken into account incalculating the investor’s share of the associate’s profitor loss• When recognising investor’s share of associate’s postacquisition profits:• adjustments are to be made to profit share to take intoaccount depreciation based on fair values ofassociate’s assetHolmes InstituteApplication of the Equity Method of Accounting (cont.)• Rationale for adopting the equity method• Stream of dividend receipts (revenue under the costmethod) might provide inaccurate guide to investee’sperformance & value• Provides a better indication of investment’sunderlying worth• Criticisms by opponents of equity method• Breaches realisation principle tied to notion ofconservatism• Investor reports its share of investee’s profits, evenwithout any dividends• Account balance of investment is neither cost nor fairvalueHolmes InstituteApplication of the Equity Method of Accounting (cont.)Comparison of cost method & equity method ofaccountingCost methodTo recognise initial acquisition of shares Investment in X LtdCash at bankXXXX To recognise receipt of pre-acquisition dividend Cash at bankXXInvestment in X LtdXX Holmes InstituteApplication of the Equity Method of Accounting (cont.)Cost method (cont.)To recognise dividends provided by associate frompost-acquisition profitsDividend receivable XXDividend revenue XXTo recognise receipt of previous dividend provided Cash at bankXXDividend receivableXX Holmes InstituteApplication 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 Investment in X LtdXXShare of associate’s profitXX To recognise investor’s share of dividends Dividend revenueXXInvestment in X LtdXX Holmes InstituteApplication of the Equity Method of Accounting (cont.)In consolidation worksheet (Year 2)Prior period share of profits Investment in X LtdXXRetained earnings (opening)XX To recognise share of associate’s lossesShare of associate’s profit/loss XXInvestment in X Ltd XXHolmes InstituteApplication of the Equity Method of Accounting (cont.)To recognise investor’s share of dividends Dividend revenueInvestment in X LtdXXXX Investor’s share of associate’s increase inrevaluation reserve Investment in X LtdRevaluation surplusXXXX Holmes InstituteApplication of the Equity Method of Accounting (cont.)✓Investor’s share of associate’s profit/loss tobe adjusted for (AASB 128):✓any depreciation differences caused byreassessing values of associate’s assets to fairvalue at date of acquisitionHolmes InstituteWorked Example—Comparison of the cost and equitymethods of accounting• On 1 July 2018, Cassie Ltd acquires a 30 per cent interestin Joy Ltd for a cash consideration of $540 000.• On the date of the acquisition, the assets of Joy Ltd arereported at their fair value. The total share capital andreserves of Joy Ltd as at the date of the acquisition are:Share capital $1 320 000 Retained earningsTotal shareholders’ funds$480 000$1 800 000 Holmes InstituteWorked Example— Comparison of the cost and equitymethods of accounting-continuedAdditional information• For the year ending 30 June 2019, Joy Ltd records an after-tax profitof $100 000. A dividend of $40 000 is declared and ratified by Joy Ltdon 30 June 2019, with the dividend coming from profits earned in the2018–19 financial year.• In October 2019, Joy Ltd pays the $40 000 dividend provided for on30 June 2019.• For the year ending 30 June 2020, Joy Ltd records an after-tax lossof $50 000. On 30 June 2020, Joy Ltd declares dividends of $20 000,to be paid out of the profits earned in the 2019 financial year.• On 30 June 2020, Joy Ltd revalues its land upwards by an amount of$400 000.• Cassie Ltd recognises dividends as revenue when the investeedeclares the dividends (i.e. Cassie Ltd also recognises a dividendreceivable).• The corporate tax rate is 30 per cent.Holmes InstituteWorked Example— Comparison of the cost and equitymethods of accounting-continued(a) Journal entries using the cost method in the accounts of Cassie LtdYear ending 30 June 2019July 2018 Dr Investment in Joy LtdCr Cash at bank540 000540 000 June 2019 Dr Dividend receivableCr Dividend revenue12 00012 000 Year ending 30 June 2020October 2019 Dr Cash at bankCr Dividend receivable12 00012 000 June 2020 Dr Dividend receivableCr Dividend revenue6 0006 000 Holmes InstituteWorked Example— Comparison of the cost and equitymethods of accounting-continued(b) Journal entries using the equity method in the consolidated financial statements of Cassie Ltd(a parent entity)30 June 2019 (in consolidation worksheet) DrInvestment in Joy Ltd30 000CrShare of associate’s profit30 000DrDividend revenue12 000CrInvestment in Joy Ltd12 000 30 June 2020 (in consolidation worksheet) DrInvestment in Joy Ltd18 000CrRetained earnings—30 June 201918 000DrShare of associate’s profit/loss15 000CrInvestment in Joy Ltd15 000DrDividend revenue6 000CrInvestment in Joy Ltd6 000DrInvestment in Joy Ltd84 000CrRevaluation surplus84 000 Holmes InstituteWorked Example— Comparison of the cost and equitymethods of accounting-continuedJournal entries using the equity method in the accounts of Cassie Ltd (not a parententity)Year ending 30 June 2019July 2018 DrInvestment in Joy Ltd540 000CrCash at bank540 000 30 June 2019 DrInvestment in Joy LtdCrShare of associate’s profitDrDividend receivableCrInvestment in Joy Ltd 30 00030 00012 00012 000Holmes InstituteWorked Example— Comparison of the cost and equitymethods of accounting-continuedYear ending 30 June 2020October 2019Dr Cash at bank 12 000Cr Dividend receivable 12 00030 June 2020Dr Share of associate’s profit/loss 15 000Cr Investment in Joy Ltd 15 000Dr Dividend receivable 6 000Cr Investment in Joy Ltd 6 000Dr Investment in Joy Ltd 84 000Cr Revaluation surplus 84 000Holmes InstituteWorked Example —Adoption of equity accounting in the presence of a differencebetween the fair values and carrying amountsOn 1 July 2017, Rankin Ltd, a parent entity, acquires a 25per cent interest in the issued capital of Coombes Ltd for acash consideration of $80 000.At the date of acquisition, the shareholders’ equity ofCoombes Ltd is $225 000, represented by: Share capitalRetained earningsTotal shareholders’ equity$165 000$60 000$225 000 Holmes InstituteWorked Example —Adoption of equity accounting in the presence of adifference between the fair values and carrying amountsAdditional information• On the date of acquisition, land and buildings have carryingamounts in the books of Coombes Ltd of $200 000 and $400 000respectively. The market value of the land at the time is $225 000,and the buildings’ market value is $450 000. The buildings have aremaining expected useful life from 1 July 2017 of 20 years.• For the year ending 30 June 2018, Coombes Ltd reported an aftertax profit of $50 000 from which it declared a dividend of $20 000.• For the year ended 30 June 2019, Coombes Ltd reports an after-taxprofit of $100 000, from which it declared a dividend of $50 000.• Coombes Ltd revalues its land to $250 000 in June 2019.• Rankin Ltd recognises dividends as revenue on receipt of thedividends.• It is assumed that any goodwill acquired has not subsequently beenimpaired.• The tax rate is 30 per cent.Holmes InstituteWorked Example —Adoption of equity accounting in the presence of adifference between the fair values and carrying amountsExtra 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 ofthis is $625 × (1 – 0.30) = $437.50Associate’s profit for the year ending 30 June 2018 $50 000 Rankin Ltd’s equity interest in Coombes Ltd× 25%$12 500(437.50)less Building depreciation adjustment (see above) Rankin Ltd’s share of Coombes Ltd’s adjusted profit $12 062.50As Rankin’s policy is to recognise dividends as revenue only as they are received, thedividend provided by Coombes in the 2018 financial year, but unpaid at year end, willnot be recognised in calculating Rankin’s share of the associate’s profits.June 2018 (in consolidation worksheet) DrInvestment in Coombes Ltd12 062.50CrRetained earnings as at 30 June 201812 062.50 Holmes InstituteWorked Example —Adoption of equity accounting in the presence of adifference between the fair values and carrying amountsJune 2019 (in consolidation worksheet) DrInvestment in Coombes Ltd24 562.50CrShare of associate’s profit24 562.50 DrDividend revenue5 000CrInvestment in Coombes Ltd5 000 We increase the investment account for the share in the postacquisition movement in the revaluation surplus, after tax, which iscalculated as:($250 000 – $225 000) × (1 – tax rate) × 25% = $4375. DrInvestment in Coombes Ltd4 375CrRevaluation surplus4 375 Holmes InstituteInter-entity Transactions✓Carrying amount of investment in associate must beincreased or decreased by:✓amount of investor’s share of associate’s postacquisition profit or loss after adjustments forcertain inter-entity transactions✓Investor required to adjust share of associate’s profitor loss for its share of any unrealised profits or lossesfrom transactions between:✓associate & investor (or any controlled entities), &✓associate & any other associate of the investorHolmes InstituteInter-entity Transactions (cont.)✓Transactions between associate & memberof economic entity✓The proportion of unrealised profits or losses tobe eliminated is investor’s ownership interest inassociate✓Transactions between two associates of theinvestor✓The proportion of unrealised profits or losses tobe eliminated is product of investor’s ownershipinterest in each associateHolmes InstituteInter-entity Transactions (cont.)✓Refer to Figure 32.2—Investor Company &its subsidiaries & associates—on the nextslide✓Investor Company✓Subsidiary A: 100% owned✓Subsidiary B: 80% owned✓Associate A: 40% owned✓Associate B: 30% ownedHolmes InstituteHolmes InstituteInter-entity Transactions (cont.)Figure 32.2 (cont.)✓Transaction 1✓Associate A sells goods to Subsidiary A for aprofit of $10,000✓At reporting date, Subsidiary A still has 50% ofthe goods on hand✓Amount of unrealised gain = 50% of $10,000 =$5000✓Amount to be eliminated = 40% of $5,000 =$2,000Holmes InstituteInter-entity Transactions (cont.)Figure 32.2 (cont.)Transaction 2Same circumstances as Transaction 1, except goodssold by Associate A to Subsidiary BSame amount to be eliminated, even thoughSubsidiary B is only 80% heldTransaction 3Associate A sells goods to Associate B for a $20,000profitAt reporting date, 75% of goods on handAmount of unrealised gain = 75% of $20,000 = $15,000Amount to be eliminated = 12% (0.40 X 0.30) of $15,000= $1,800Holmes InstituteThe following topics have been discussed in this lecture:• Equity investment –investor associate relationship• Cost method of accounting for equity investment• Equity method of accounting for equity investment• Dealing with inter-equity transactionsLecture SummaryHolmes Institute

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