When to stop equity accounting

When to stop equity accounting your associates for loss making associates

‍Equity accounted associates

Often, an investor holds between 20% - 49% of the shareholding in a company. This range of shareholding usually indicates that the investor has what is called “significant influence” over the operations and the policies of the said company.

In the presence of significant influence, we cannot merely account for this shareholding as an ordinary investment. In other words we’re sitting somewhere between a regular investment accounted for at cost and a full blown consolidated subsidiary.

Such significant influence results in the investment being classified as an associate and as such will need to be “equity accounted” which in layman’s terms is how we “consolidate” an associate.

What does equity accounting mean and how does it differ from other forms of accounting such as consolidation or IFRS 9 fair value financial instruments?

Initial acquisition of investment in associate

The investor initially recognises the investment in associate at cost in its separate financial statements when the investment is made.

The cost of this investment is determined as the cost incurred in acquiring this investment. IAS 28 also allows for different measurement basis such as fair value in accordance to IFRS 9. But for now, let us work with the former, i.e. recognizing the investment at cost.

Dr: Investment in associate                 $1000

Cr: Bank                                                                                       $1000

(accounting for the initial investment in associate…)

Receiving dividends from the associate

Ordinarily, the investor will also receive distributions from the company (associate) and will record the following journal entry in its own financial records:

Dr: Bank/Asset                                           $1000

Cr: Dividend Income (SPL)                                                 $1000

(accounting for dividends actually received from the associate…)

Post acquisition (equity accounting)

Equity accounting is the process in which the investor rather recognizes its share of the earnings from associate  in its accounting records instead of just the dividend it receives from the company (associate).You may agree that simply accounting for dividends received might not be the best measure of taking the associates results into account.

But what do we mean by this?

The equity accounting method requires that were move the dividend income and rather replace it with the investors share of the earnings from associate. As such the following proforma journal entry would need to be prepared and processed:

Dr: Dividend Income (SPL)                                  R1 000

Cr: Investment (SFP)                                                                            R 1000

(removing the dividend recognized….)

Dr: Investment in associate (SFP)                   R1500

Cr: Earnings from Associate (SPL)                                                R1 500

(and accounting for our share of the earnings instead)

The purpose of the equity accounting method is that it enhances the decision usefulness of the financial statements by providing more informative financial information relating to the investor’s interest in net assets and profit or loss of the company (associate). The investment in associate is now reflected at the cost of the purchased equity PLUS share of the increases in equity LESS the distributions of equity received by the investor from the company.

What about associates held at fair value

IF the investment is measured in accordance of IFRS 9 fair value (instead of cost as in my previous example), all prior fair value adjustments need to be reversed so that the investment is reflected at cost before the equity accounting method can be applied. This is done using the following proforma journal entry.

Dr: Retained Earnings (SCE) *                            R2 000

Dr: Fair value (OCI) / (SPL)**                                                            R500

Cr: Investment in Associate (SFP)                                                 R2500

(reversing *prior year and **current year fair value adjustments to bring back to cost)

What happens if the associate makes losses?

Just like the profits from the associate, the losses of the associate also need to be equity accounted. The losses of the associate will reduce the carrying amount of the investment. If the associate continues to make losses, the carrying amount of the investment could even end up being a negative balance.

In these instances, the associate is equity accounted until the carrying amount of the investment is zero. If the losses continue, the losses are provided for as a liability ONLY if the investor has a legal or constructive obligation to make payments on behalf of the associate. If no such obligation exists, these losses are NOT recognized– a record is maintained outside of the financial statements. However, in the years when the associate eventually becomes profitable, the earnings from associate can ONLY be recognized when the share of cumulative profits equals the share of losses not recognized.

Loss making associate example

P Limited purchased  30% of A Limited on 1 January 2023 for $60000 and exercised significant influence from this date. During the 2023financial year A Limited earned a profit of $40 000. Due to the political climate A Limited made a loss of $300 000 during the 2024 financial year. All companies have 31 December reporting dates.

The investment is recognized at $60 000 in the separate financial statements of P Limited

Equity accounting of prior year (2023) profits:

Dr: Investment in associate (SFP)                                  $12 000

Cr: Retained Earnings (SCE)                                                                            $12 000

$40 000 x 30%

Carrying amount of the investment: $60 000 + $12 000= $72 000

Equity accounting of current year (2024) loss:

Dr: Earnings from associate (SFP)                                  $72 000

Cr: Investment in Associate (SPL)                                                                $72 000

$300 000 x 30% = $90 000

Limited to $72 000

The remaining $90 000 – $72 000 = $18 000 loss will not be recognized unless P Limited has a legal or contractual obligation to make payments on behalf of the A Ltd.

IF: P Limited has a legal or constructive obligation to make payments on behalf of the associate the following journal entry would be processed

Dr: Earnings from associate (SFP)                                  $18 000

Cr: Liability (SFP)                                                                                                  $18 000

In the subsequent year, A Limited earns a profit of $500 000:

The proforma journal provided above would be repeated, however last year’s profit would be recognized in retained earnings.

Dr: Investment in Associate (SFP)                                  $132 000

Cr: Earnings from Associate (SPL)                                                               $132 000

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$500 000 x 30% = $150 000

The amount recognized: $150 000 – $18 000 = $132000

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