101 Concepts for the Level I Exam
Essential Concept 21: Investments in Associates and Joint Ventures
An investment is considered an “associate company” when the investor has (or can exercise) significant influence, but not control, over the investee’s business activities. Significant influence is presumed with 20 – 50% ownership or voting power of the associate (investee). Significant influence may be evidenced by:
- Representation on the board of directors
- Participation in the policy-making process
- Material transactions between the investor and the investee
- Interchange of managerial personnel
- Technological dependency
Joint ventures are ventures undertaken and controlled by two or more parties. IFRS identifies two characteristics of joint ventures as:
- A contractual arrangement exists between two or more venturers.
- The contractual arrangement establishes joint control.
The equity method is used to account for investments in associates and joint ventures.
Equity method: It’s a one-line consolidation method.
- Investment account reflected as a single line item (non-current asset) on the balance sheet
- Equity investment is initially recorded on the investor’s balance sheet at cost. It has three components:
- Reported value on investee B/S
- Fair value surplus
- Subsequently, the carrying amount of the investment is adjusted to recognize the investor’s proportionate share of the investee’s earnings or losses.
- Value of investment = beginning value + share of profits – share of dividends
- Dividends received from the investee are treated as a return of capital and reduce the carrying amount of the investment. They are not reported on the income statement.
- If the investment costs exceed the book value of the investee, then we amortize the excess purchase price attributable to plant and equipment.
- Value of investment = beginning value + share of profits – share of dividends – amortization of excess purchase price attributable to plant and equipment
- The share of income (not dividends) is recorded in the investor’s income statement
Transactions with the investee:
- Because an investor company can influence the terms and timings of transactions with associates, profits from such transactions cannot be realized until confirmed through use of third-party sale.
- Investor company’s share of any unrealized profit must be deferred by reducing the amount recorded under the equity method.
- This deferred profit is added back to the equity income when confirmed.