The equity method is an accounting approach in which an investment is initially recognized at cost and subsequently increased by an amount equal to the proportionate share of the investor in any change in the investee’s net assets and decreased by amounts/dividends received from the investee.
Under IFRS, the equity method is used to account for an investment in which a company has either a joint control or significant influence.
Significant influence means the power to participate in the financing and operating policy decisions of the investee without control or joint control. It is presumed to exist if an investor owns greater than 20% but less than 50% of the voting shares of the investee.
The application of equity method involves the following procedures:
- Recognizing the investment at cost.
- Increasing or decreasing the carrying amount of the investment by proportionate share of the investor in the profit or loss of the investee, and in the other comprehensive income. This involves removing any proportionate unrealized profits from the profit or loss.
- Decreasing the carrying amount by the amount of dividends received from investee.
Company A purchased 25,000 of the 100,000 outstanding shares of Company B at $10 per share on 1 Jan 20X1. The cost of investment equals $250,000 (i.e. 25,000 shares at $10 per share). Company B recognizes this using the following journal entry:
|Investment in Company B||$250,000|
If the fair value of the proportionate net assets is $200,000, the difference of $50,000 relates to goodwill which is not amortized. If the proportionate fair value of net assets were $280,000, the difference of $30,000 would be recognized in income statement.
If during 20X1, the Company B's profit or loss is $100,000 and other comprehensive income is $20,000, Company would pass the following journal entry:
|Investment in Company B||$30,000|
|Share in profit or loss of associate||$25,000|
|Share in OCI of associate||$5,000|
Any dividends received from the associate is subtracted from the carrying amount of investment. If Company B declared dividends of $60,000 in the financial year ended 31 December 20X1, Company A would subtract $15,000 (its share in the dividend) from the carrying amount of its investment.
|Investment in Company B||$15,000|
The investment in associates is reported as a non-current asset on the statement of financial position. Investment in Company B would appear on the statement of financial position of Company A at $260,000 calculated as follows:
|Investment in Company B as at 1 Jan 20X1||$250,000|
|Add: share in profit and OCI of Company B for FY 20X1||$30,000|
|Less: dividends received from Company B in FY 20X1||($15,000)|
|Investment in Company B as at 31 Dec 20X1||$265,000|