Investment in associates

This chapter explains how to identify associates and account for them using the equity method in consolidated financial statements. This matters in group accounting because not every investment creates a subsidiary relationship. When an investor holds a significant but non-controlling interest in another entity, the equity method is used instead of full consolidation.

To classify investments correctly, you need to distinguish between:

• control
• significant influence
• joint control

Learning objectives

By the end of this chapter, you should be able to:

• Define and identify an associate and significant influence, and identify situations where significant influence exists.
• Describe the key features of a parent-associate relationship and identify an associate within a group structure.
• Describe the principle of the equity method of accounting for associate entities.

Definitions

Associates

These are entities over which an investor has significant influence but not control or joint control. Significant influence

It represents the power to participate in the financial and operating policy decisions of an investee without having control or joint control over those policies.

It helps to separate the three levels of influence an investor may have over another entity:

• Control (typically more than 50% of voting rights) creates a subsidiary relationship. The investee’s financial statements are fully consolidated line by line into the group accounts.
• Joint control exists when control is shared under a contractual arrangement, creating a joint arrangement.
• Significant influence sits between control and joint control. The investor can participate meaningfully in decisions, but can’t dominate them.

Under IAS 28, significant influence is generally presumed to exist when an investor holds 20% or more of the voting power of the investee. However, this is only a presumption:

• Significant influence can exist with less than 20% ownership.
• Significant influence may not exist even with more than 20% ownership.

For example, an investor holding 25% of the voting rights would normally be presumed to have significant influence. However, if another shareholder holds 75% and makes decisions without any meaningful input from the 25% holder, significant influence may not exist in practice. Conversely, an investor with only 15% ownership might still have significant influence if it holds a seat on the board of directors and actively participates in policy decisions.

The existence of significant influence is usually evidenced in one or more of the following ways:

1. representation on the board of directors or equivalent governing body of the investee;
2. participation in policy-making processes, including participation in decisions about dividends or other distributions;
3. material transactions between the entity and its investee;
4. interchange of managerial personnel; or
5. provision of essential technical information

These indicators are assessed together rather than one by one. A single strong indicator (such as board representation) may be enough to establish significant influence. On the other hand, if none of the indicators are present, the 20% presumption may be rebutted.

This assessment requires professional judgement and should be based on the substance of the relationship, not only its legal form.

Where an entity has significant influence, the investment is accounted for using the equity method in the financial statements, just as an investment in a subsidiary is accounted for using the acquisition method.

Equity method

The equity method is used in the group (consolidated) financial statements for investments in associates. Instead of recognising income only when dividends are received, the investment is:

• initially recorded at cost, and
• subsequently adjusted to reflect the group’s share of the associate’s profit (or loss).

The rationale behind the equity method is straightforward. Because the investor has significant influence over the associate, it can participate in decisions that affect the associate’s profitability, including decisions about reinvesting profits rather than distributing them as dividends. If you recognised income only when dividends are received, you would ignore the investor’s share of profits retained within the associate. The equity method avoids this by recognising the investor’s share of the associate’s profit as it is earned, whether or not it is distributed.

The consolidated statement of profit or loss

In the consolidated statement of profit or loss, the group’s share of the associate’s post-tax profit (i.e., profit after tax), after adjusting for intra-group sales (such as unrealised profit), is presented as a single line item: “share of profit of associate.” This amount is included within the consolidated profit for the year.

The adjustment for unrealised profit arises when there are trading transactions between the group and the associate. For example, if the associate sells goods to the parent at a mark-up and some of those goods remain unsold at the year-end, the unrealised profit must be eliminated to the extent of the group’s share in the associate.

The consolidated statement of financial position

At the end of the year, the group’s share of the associate’s profit is added to the cost/carrying amount of the investment. The investment is presented as an investment in associate under non-current assets in the consolidated statement of financial position.

If the associate reports a loss, the carrying amount of the investment is reduced by the group’s share of that loss. Dividends received from the associate also reduce the carrying amount of the investment. This is because dividends are a return of value that has already been recognised through the equity method; recognising the dividend as income again would be a double-count.

The carrying amount of the investment in an associate at any point in time is therefore:

Carrying amount = Cost of investment + Group’s share of post-acquisition profits − Group’s share of post-acquisition losses − Dividends received from the associate

The equity method is sometimes described as a single-line consolidation. Unlike a subsidiary, the associate’s individual revenues, expenses, assets, and liabilities are not added line by line into the group financial statements. Instead, the group’s interest in the associate is shown using two figures:

• a single line in the statement of profit or loss (share of associate’s profit), and
• a single line in the statement of financial position (investment in associate).

This reflects the fact that the group does not control the associate and therefore can’t treat the associate’s individual assets and liabilities as if they were the group’s.

Note, the financial statements of the associate company are not consolidated (i.e. adding) as part of the group statements.