Accounting recognition of equity method

The equity method of accounting is used in international financial reporting standards to recognize an investment in an entity that has significant influence over another company.

The accounting recognition, when the equity method is used, consists of the initial recognition of an investment at cost and the subsequent adjustment to show the increases or decreases in the proportional part of the result of an associate.

In addition, the investment may be affected by distributions made by the associate.

In other words, these distributions will reduce the carrying amount of the investment.

Let’s look at an example to understand what we saw above.

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Example of accounting recognition using the equity method of accounting

At the beginning of year 1, company A acquires 30% of the interest of entity B, for 70,000.

At the end of year 1, entity B record a profit of 45,000, and distributed dividends of 12,000.

And on the other hand, in year 2, entity B presented a loss of 10,000, and no dividend distribution was made.

What is the accounting recognition that company A must carry out, in years 1 and 2?

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Exercise solution:

Calculation of the equity method, year 1.

Profit reported by entity B = 45,000

Participation 30%

Increase in investment = 13,500 (45,000×30%)

Dividend distribution = 12,000

Participation 30%

Decrease in investment = -3,600 (12,000×30%)

Carrying amount Investment value year 1:

Investment cost: 70,000

Profit Share: 13,500

Share of dividends: -3,600

Carrying amount at end of year 1: 79,900

Equity method calculation, year 2.

Profit reported by entity B = -10,000

Participation 30%

Decrease in investment = -3,000 (10,000×30%)

Carrying amount of investment, year 2

Initial investment balance, year 2: 79,900

Decrease in investment: -3,000

Final balance carrying amount investment year 2: 82,900

Requirements to use the equity method.

It is necessary to have significant influence to recognize an inversion using the equity method of accounting.

Exist significant influence occurs when an entity has the power to intervene in an investee’s financial and operating policy decisions without actually having control.

To understand this concept, let’s see the following scheme:

Requirements to use the equity method.

If an entity has an interest between 20% to 50%, it must recognize its investment using the equity method because there is a significant influence.

On the other hand, if there is a share greater than 50%, and in addition, it can be shown that there is control of one entity over another, it will be necessary to carry out a consolidation of financial statements.

And finally, if the share of one entity over another is less than 20%, the investment must be recognized as a financial instrument.

Equity method of accounting , and the revaluation of assets.

Under paragraph 10 of IAS 28, it will be necessary for an entity that recognizes its investment using the equity method to make a series of adjustments for changes in the investor’s proportional participation in the investee; these changes could arise as the result of other comprehensive income changes of an investee.

For example, suppose an associate uses the revaluation model for the subsequent measurement of its property, plant, and equipment.

In this case, the values recorded in the other comprehensive income account will affect the investment recognized when an entity uses the equity method of accounting.

Let’s look at the following example:

At the beginning of year 1, entity B acquires a building for 40,000 with a useful life of 10 years.

The entity uses the revaluation model for the subsequent measurement of this asset.

At the end of this year, the fair value of the build amounts to 42,000.

In addition, entity B reported profits of 75,000 and distributed dividends of 35,000.

On the other hand, at the beginning of year 1, company A acquires 35% of the interest of entity B for 200,000.

According to the above information, what is the investment carrying amount recognized by company A at the end of year 1?

Exercise solution:

We must first determine the revaluation of the property, plant, and equipment at the end of year 1.

For this, we will determine the carrying amount of the building at the end of this year.

Asset cost: 40,000

Accumulated depreciation: 4,000

Carrying amount: 36,000

Carrying amount vs. fair value = revaluation:

Revaluation: 42,000 – 36,000 = 6,000

Earnings reported by entity B: 75,000

Reported dividends: -35,000

ORI adjustments: 6,000

Net: 46,000

Share: 35%

Investment increase: 16,100

Investment cost: 200,000

Increase in investment: 16,100

Carrying amount Investment at year 1: 216,100

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