What is the equity method

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

Before showing an example of the accounting recognition of the equity method, it’s essential to understand the meaning of significant influence.

 

Let’s assume that company A, is a hospital specializing in cardiac surgery.

On the other hand, company B, carry out developments in robotics.

In this way, the management of entity A, observes that there may be a strategic relationship between both companies.

For this reason, entity A, acquires 30% of company B.

In this way, the entity A, will significantly influence over entity B.

This means that from now on, company A, has representation on the board of directors of the associate entity.

This is important because the company A, will now take part in entity B’s relevant decisions.

At this point, it is necessary to ask the following question.

How to know if exists significant influence of one company over another?

IAS 28 establishes that if an entity directly or indirectly owns more than 20% interest in another company, it is presumed that significant influence exist.

However, an entity own an interest greater than 20%, and still, if in practice the investing entity cannot influence the relevant decisions of the investee entity, we could conclude that such influence does not exist.

Or conversely, an entity may have an interest of less than 20%, and if the investment entity can demonstrate that it can influence certain important decisions of the associate entity, it could be concluded that significant influence exists.

As we can see in our example, company A, acquired a 30% interest in Entity B, showing that significant influence exists.

Thus, company A, must recognize its investment using the equity method.

Besides, it’s important to say that if the interest were not 30% but 60% for example, entity A should no longer use the equity method but carry out a financial statement consolidation process.

Then, how is the accounting recognition of the equity method?

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 profit or loss 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 see the following example to better understand what was said above.

Are you looking to stay ahead in the ever-changing business world and enhance your understanding of International Financial Reporting Standards (IFRS)?

Look no further!

Our IFRS course is designed to provide you with the knowledge and skills you need to succeed in today’s global economy.

Our course is led by industry experts who have years of experience in the field, providing you with the most up-to-date and relevant information.

The course is designed to be interactive, with quizzes, case studies, and practical examples to help you retain the information and apply it in the real world.

The course is also flexible, it’s available online, allowing you to learn at your own pace and on your own schedule.

Plus, we offer a money-back guarantee, meaning that if you are not satisfied with the course, we will refund your money.

Don’t miss this opportunity to stay ahead of the game and gain a competitive edge in the business world.

Sign up for our IFRS course today!

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?

To solve this exercise, we are going to calculate the equity method.

This method says that we should recognize the initial investment at cost.

In other words, recognize the investment of 70,000.

In addition, we must affect the investment for the proportional of 30% of gain or loss recognized in the accounting period of entity B.

As we can see, for year 1, the entity reported a profit of 45,000.

Therefore, we must affect the investment in 13,500, equivalent to 30% of 45,000.

And finally, we must establish the amount of dividends received by entity A.

As we see in the example, company B distributed dividends of 12,000.

In this case we must negatively affect the investment as a consequence of the dividends received equivalent to 30% of 12,000.

That is, an adjustment of 3,600.

In this way, the final balance of the investment increased to 79,900, which is equivalent to the initial balance of 70,000 plus the reported profit minus the dividends received.

For year 2, entity B did not report a profit; on the contrary, it reported a loss of 10,000.

And the other side, this entity does not distribute dividends.

In this way, we must take the carrying amount of the investment at the end of year 1, and affect its balance for the proportional generated loss in year 2.

This gives a carrying amount of the investment at the end of year 2, equivalent to 76,900.

Up to this point, we have only considered that the investment may be affected by the profit or loss generated in an accounting period and the dividends received.

But what happens for example, if an associated entity has a building that presents revaluations due to the increase of fair value of this asset during the accounting period?

Equity method of accounting and the revaluation of assets.

To show the accounting effect of an economic event of this nature, we will review 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 this asset 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?

To solve this exercise, we must first determine the revaluation of the property plant and equipment at the end of year 1.

If you are not very familiar with the revaluation model, in the following post you find an example of revaluation model.

Revaluation model example 

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 interest 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.

In this way in the example, the initial cost of the property plant and equipment equals 40,000.

We also know that the useful life of this asset is ten years.

Therefore, the carrying amount of this asset at the end of year 1 is 36,000.

Now, we must compare this value with the fair value of the building, equivalent to 42,000

Thus, the value the entity must report in other comprehensive income from using the revaluation model is equal to 6,000.

Now we will calculate the carrying amout of the investment using the equity method.

In this way, the profit generated in year one by entity B is 75,000.

On the other hand, the reported dividends are equal to 35,000, and the revaluation generated to 6,000.

This gives a total balance of 46,000.

Now we must obtain the proportion of this balance according to the interest of entity A, in company B.

In other words, 35% of 46,000

This gives a result of 16,000.

And since we know that the initial balance of the investment is 200,000, the carrying amount of the investment at the end of year 1 equals 216,100.

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.

News related to example of equity method

RELATED POST