E it Accounting

Equity A ti and
d Joint
J i t Arrangements
A t

1. Understand the concept of “significant influence” and “joint control;”

pp
2. Appreciate the different accounting
gppolicies for investment in an associate and
joint venture as reflected in an investor’s separate financial statements and the
consolidated financial statements;
3. Understand the differences between the cost and equity method and
consolidation;
4. Know how to apply the equity method in accounting for investment in an
associate and joint venture in the consolidated financial statements;
5. Perform an analytical check on the balance of the investment in an associate and
joint venture; and
6. Appreciate the nature of joint arrangements and know how to apply the
appropriate accounting treatment.

Lee Kin Wai 1

Significant influence
Significant influence
•Prima facie : >= 20% voting rights of investee  significant influence
•FRS 28.5 - if an entity holds, directly or indirectly (eg through subsidiaries), 20 per
cent or more of the voting power of the investee, it is presumed that the entity has
significant influence, unless it can be clearly demonstrated that this is not the case.
Conversely,y, if the entityy holds,, directlyy or indirectlyy (eg
( g through
g subsidiaries),
), less
than 20 per cent of the voting power of the investee, it is presumed that the entity
does not have significant influence, unless such influence can be clearly
demonstrated A substantial or majority ownership by another investor does not
demonstrated.
necessarily preclude an entity from having significant influence.

•Other
Other indicators of significant influence (besides voting rights):-
rights):
•FRS 28.6 - The existence of significant influence by an entity is usually evidenced
in one or more of the following ways:
(a) representation on the board of directors or equivalent governing body of the
investee;
((b)) Participation
p in p
policy-making
y g processes,
p including
gpparticipation
p in decisions
about dividends or other distributions;
(c) material transactions between the entity and its investee;
(d) interchange of managerial personnel; or
(e) provision of essential technical information.
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 Equity  Method – Overview (FRS 28.3)
• The equity method is a method of accounting whereby
1. the investment is initially recognised at cost
2 investment
2. i t t is
i adjusted
dj t d thereafter
th ft for
f the
th post-acquisition
t i iti change
h iin th
the
investor’s share of the investee’s net assets.
3. The investor’s pprofit or loss includes its share of the investee’s p
profit or
loss and the investor’s other comprehensive income includes its share
of the investee’s other comprehensive income.
• E it method
Equity th d procedures-details
d d t il outlined
tli d iin FRS 28
28. 26 tto FRS 2828.43.
43

• Equity method is a “one-line

one-line proportionate consolidation”
consolidation .
– In Consolidated Balance Sheet, represented by “Investment in
associate”
• Essentially investment cost + share of associate’s post-acquisition
change in net assets – dividends received
– In Consolidated Statement of Comprehensive IncomeIncome,
represented by “Share of associate’s profit”
• Essentially parent’s proportionate share of associate’s profit after
tax.
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Equity Method – Key components of investment in associate

Investment
in associate

Unamortized
Share of book
Fair Value Implicit goodwill
value of net assets
Adjustments

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 Cost Method Versus Equity Method Versus Fair Value
Through Profit or Loss (FVTPL)
Dimensions Cost Method Equity
q y Method FVTPL
Income • Dividend income • Share of profits • Dividend income and
recognition • Emphasizing • Emphasizing the predictive change in fair value,
reliabilityy and value of information of providing timely
realized income unrealized gains information and
emphasizing relevance
over reliability
Asset • Initial cost less • Initial cost; and • Fair value
measurement impairment loss • Share of post acquisition
change in equity
Profit on sale • Large terminal profit • Smaller terminal profit • Zero terminal profit
• Profits are recognized
systematically over holding
period
Nature of the • No economic • Economic interdependence • No economic
economic relationship
p • Investor has “significant
significant relationshipp
relationship
between • Investor is deemed influence” over the • Investment may be held
investor and as a passive holder investee for trading or quantifies
investee of investment for fair value
measurement

Lee Kin Wai 5

E it accounting
Equity ti vs. consolidation
lid ti

• Equity accounting captures the substance of consolidation but not the

form
‒ Individual line items of financial statements of investor and associate
are not consolidated.
‒ Results and net assets of associate are recognized in single line
items:
• Share of profit of associate in the income statement
• Investment in associate account in the statement of financial
position.
position
‒ Consolidation and equity method will achieve the same group
retained earnings and net assets (with minor exceptions for upstream
and downstream sales adjustments)
adjustments).

• Decision rights implicit in “significant influence” are not as strong as in

“
“control”
t l”
‒ Might be misleading to aggregate associate’s individual assets and
liabilities

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 Equity method versus consolidation
Issue Consolidation Equity method

P/L Add each line in S’s P/L to Report

p share of A’s pprofit in
P’s P/L. consolidated P/L. Not line
e.g. Consolidated sales by line addition.
=sales
l P + sales
l S +/- / CJE

NCI ((P/L)) We combine P’s p profit and Recognize

g share of
S’s profit. associate’s profit only.
NCI (P/L) is NCI share of No need to separately
Subsidiary’s profit (as a recognize other investor’s
deduction). share of associate profit.
Assett and
A d Line by
Li b liline addition.
dditi No liline b
N by liline addition
dditi off
liability e.g. Inventory (consolidated) investor’s asset and
= inventory (P)+ inventory (S) associate’s
assoc a e s asset.
asse
Eliminate investment account Investment in associate
shows its share of A’s net
assets (BV + FV excess +
Lee Kin Wai implicit goodwill) 7

Equity method versus consolidation
Issue Consolidation Equity method
Goodwill on Separately shown in Implicit in Investment in
consolidation
lid ti consolidated
lid t d B/S
B/S. associate.
i t
Unamortized Consolidated net asset Implicit in Investment in
balance of = Net
N A Asset (P) + bbook
kNNet associate
associate.
fair value Asset (S) + Fair value
differential differential (S) – amortized
amount
Relationship
p Investor controls investee Investor has significant
g
between influence over investee.
investor- (weaker than control)
investee

Impact on Line by line addition of P and No line by line addition of

financial S results in larger balances. investor and associate.
ratios R ti diff
Ratios differ ffrom equity
it Likely to have lower debt
debt-
method. Lee Kin Wai
equity ratio. 8
 M th d l
Methodology off Equity
E it Accounting
A ti
1. Investment is initially recorded at cost.

2. Investment at cost comprises of:f

a) Share of the book value of the net assets of the
associate;
b) Share of the fair value adjustments of net identifiable
asset of the associate; and
c)) Goodwill.
G d ill

3
3. Goodwill that is implicit in the cost of investment is written
off when impaired.

4
4. Fair
F i value
l adjustment
dj t t iincluded
l d d iin th
the costt off iinvestment
t t iis
amortized or expensed off and adjusted against investor’s
share of profit in the period when amortization take place.
Lee Kin Wai 9

Methodology of Equity Accounting
gy q y g
5. Investor’s share of past and current amortization of fair value
adjustments is adjusted against the investment account and opening
retained earnings and share of profit.

6. Initial investment is adjusted for the post-acquisition change in

investor’s share of net assets of the investee.

7. Post-acquisition change in the investor’s share of net assets is added

to the investment account.
• Include share of profit and tax in each reporting date from
initial recognition to disposal date.

8. Share of current profit of the associate will be adjusted for:

• Unrealized profit arising from current year transfer (downward
adjustment).
• Realized profit in current year arising from previous year
transfer (upward adjustment).
adjustment)
Lee Kin Wai 10
M th d l
Methodology of Equity Accounting
f E it A ti

9. Dividend paid by associate reduce carrying value of investments

Deemed as a repayment of profits
•Deemed
•Since share of profit is recognized by the investors, dividends should not be
recognized as profit
•It will be credited to the investment account as a realization of equity-accounted
profit.
profit

10 Other changes in equity of associate (e

10. (e.g.
g increase in revaluation reserve)
are recognized in accordance with the investor’s interest.
•Share of current revaluation reserves are recognized in the Statement of Profit
or Loss and Other Comprehensive Income.

Lee Kin Wai 11

I
Investment in
i Associate
A i – Analytical
A l i l Check
Ch k or independent
i d d prooff

Investment 
in associate

Share of book Unamortized 
Implicit goodwill
value of net assets FV adjustments

Investor’s share X
Investor s share X 
Investor’s share X Initial cost 
Initial cost – Investor
Investor’ss 
(U
(Unamortized
i d
(Book value of net  share of FV of 
balance of excess FV 
assets –/+ unrealized  identifiable net assets 
over book value of net
over book value of net 
profit/loss at period 
fi /l i d at initial recognition
i ii l ii
identifiable asset on 
end) – impairment loss
Initial recognition)

Lee Kin Wai 12
 Example 1 –
p equity accounting
q y g
1)) Company P acquired 40% of Company A on 
Co pa y acqu ed 0% o Co pa y o
1‐1‐20x5 for $800,000. P classified the 
investment in A using the cost method in P'ss 
investment in A  using the cost method in P
separate financial statements. 
2) There are no changes in the share capital of 
the companies since acquisition date
the companies since acquisition date 
Retained earnings of Company A as at 
acquisition date was $ 600 000
acquisition date  was $ 600,000. 
3) The financial statements of P and A for year 
20x8 are shown below. 

(c) Lee Kin Wai 13

Example 1 –
p equity accounting
q y g

(c) Lee Kin Wai 14
Example 1 – equity accounting

Lee Kin Wai 15

Example 1 – equity accounting

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Example 1 – equity accounting

Lee Kin Wai 17

Example 2 – Amortization of fair value adjustments of identifiable net

assets. See TLK page 332.

• Investor I acquired 20% of Associate A’s share on 1 Jan 20x4.

• Initial investment in A was $6,000,000. Investor carries the investment
at cost in its separate financial statements.
• Excess of fair value over book value of a depreciable
p asset at
acquisition date was $5,000,000.
• Depreciation was over 10 years.
y
• Retained earnings as at acquisition date: $15,000,000.
• Retained earnings
g as at 1 Jan 20x5: $
$20,000,000.
, ,
• Current year net profit before tax for 20x5: $10,000,000 and current
yyear tax expense:
p $2,100,000.
• Tax rate was 20%.
• Prepare equity accounting entries for the year ended 31 Dec 20x5.

Lee Kin Wai 18
Example 2 – Amortization of fair value adjustments of identifiable
net assets. See TLK page 332.

E1
Dr.D IInvestment
t t in associiatte A 1 000 000
1,000,000
Cr.Cr Opening Retained earnings 1 000 000
1,000,000
[ change in post-acquistion retained profits of associate from acquisition date to start of current year. ]
Retained earnings at start of year - A 20,000,000
Less : Retained earnings at acquisitiondate
n date - A 15 000 000
15,000,000
Increase in retained earninggs of A ppost - acquiq sition 5,000,000
, ,
Investor 20% share = 1,000,000
Lee Kin Wai 19

Example 2 – Amortization of fair value adjustments of identifiable net assets.

See TLK page 332
332.

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 Example 2 – Amortization of fair value adjustments of identifiable net
assets. See TLK page 332.

Lee Kin Wai 21

Goodwill and fair value differential are implicit and embedded in the
i
investment
t t in
i associate
i t (i
(i.e. nott separately
t l shown
h as a separate
t line
li it
item))
• FRS 28.32 - An investment is accounted for using the equity method from the date
on which it becomes an associate or a joint venture venture. On acquisition of the
investment, any difference between the cost of the investment and the entity’s
share of the net fair value of the investee’s identifiable assets and liabilities is
accounted for as follows:
• (a) Goodwill relating to an associate or a joint venture is included in the carrying
amount of the investment. Amortisation of that goodwill is not permitted.
• (b) Any excess of the entity’s share of the net fair value of the investee’s
identifiable assets and liabilities over the cost of the investment is included as
income in the determination of the entity’s share of the associate or joint venture’s
profit
fit or lloss iin th
the period
i d iin which
hi h th
the iinvestment
t t iis acquired.
i d [NEGATIVE
GOODWILL OR GAIN ON PURCHASE]
• Appropriate adjustments to the entity’s share of the associate’s or joint venture’s profit or
l
loss after
ft acquisition
i iti are maded iin order
d tto account,t ffor example,
l ffor d
depreciation
i ti off th
the
depreciable assets based on their fair values at the acquisition date. Similarly, appropriate
adjustments to the entity’s share of the associate’s or joint venture’s profit or loss after
acquisition are made for impairment losses such as for goodwill or depreciable assetsassets.
Thus,:-
• Dr. share of associate profit (current year P/L)
• Dr Opening Retained Earnings (prior year)
Dr.
Cr. investment in associates
Lee Kin Wai 22
Goodwill impairment

• Goodwill (in associate) is not recognized as a stand-alone asset in the

investor’s consolidated account but goodwill is implicit in the
investment account
account, hence
hence, not tested for impairment on its own.
own

• Impairment test is performed for investment as a whole

‒ Carrying amount of the investment is compared with recoverable
amount
‒ Recoverable amount is the higher of:
• Value in use, and
• FV less cost to sell

• Impairment losses:
‒ Will reduce the investment account
‒ May be attributed to book value of net assets, fair value
adjustments or goodwill

Lee Kin Wai 23

Example 3 – goodwill impairment.

See TLK page 335

•Assume investor P purchased 20% of the share capital of

A on 1-1-20x1.
1 1 20 1
•On 1-3-20x3, the goodwill impairment of an investment in
an associate was $250,000.
•The current year is 20X5
20X5.
•On 1-5-20x5, the current year goodwill impairment of the
associate os $100,000.
In 20x5, the net profit before tax of the associate is
•In
$10,000,000 and the tax expense is $2,100,000.

Lee Kin Wai 24
 Example 3 – goodwill impairment.
See TLK page 335.

Lee Kin Wai 25

Transfer of Assets between Investor and Associate

FRS 28:28
• Gains and losses resulting from ‘upstream’ and
‘downstream’ transactions between an entity (including its
consolidated subsidiaries) and its associate or joint
venture are recognised in the entity’s financial statements
only to the extent of unrelated investors
investors’ interests in the
associate or joint venture.
p
• ‘Upstream’ transactions are,, for example,
p , sales of assets
from an associate or a joint venture to the investor.
• ‘Downstream’ transactions are,, for example, p , sales or
contributions of assets from the investor to its associate or
its joint venture.
• The investor’s share in the associate’s or joint
venture’s gains or losses resulting from these
transactions is eliminated
eliminated.
Lee Kin Wai 26
 Transfer of Assets between Investor and Associate
Assume Investor owns x % off associate

“Upstream sale” “Downstream sale”

Investor Investor

Sales were 
Sales were Sales were 
Sales were
X % made from  made from 
associate to  X % investor to 
investor associate

A
Associate
i t Associate

In both upstream and downstream sales:

• Investor recognizes profit only to the extent of unrelated investor’s
interest in associate (1 - X%)
• Investor’s share of profit arising from transfers is eliminated (X%)27
Lee Kin Wai

Example 4
Downstream sale by investor to associate
TLK page 340

• Investor (P) owned 20% of Associate (A)

• P sells $200,000 of inventory to A. This a
downstream sale by investor to associate.
associate
• The original
g cost of inventory
y is $140,000.
• 1 / 3 remains unsold in associate A’s
warehouse at the end of the year.
• A
A’ss net profit after tax is $800,000.
$800 000
• Tax rate is 20%.
Lee Kin Wai 28
Example 4
D
Downstream sale
l bby iinvestor to associate
i
TLK page 340

Lee Kin Wai 29

Example 5
U
Upstream sale
l by
b associate
i to investor
i
TLK page 341

• Investor (P) owned 20% of Associate (A)

• A sells $200,000 of inventory to P. This a
upstream sale by associate to investor
investor.
• The original
g cost of inventory
y is $140,000.
• 1 / 3 remains unsold in Investor P’s
warehouse at the end of the year.
• A
A’ss net profit after tax is $800,000.
$800 000
• Tax rate is 20%
Lee Kin Wai 30
Example 5
U
Upstream sale
l by
b associate
i to investor
i
TLK page 340

Lee Kin Wai 31

Joint Arrangement
• FRS 111 Joint Arrangements
• A joint
j i arrangement is
i an arrangement off which
hi h two or more
parties have joint control.
• Joint control is the contractually agreed sharing of control of
an arrangement,
arrangement which exists only when decisions about the
relevant activities require the unanimous consent of the
parties sharing control.
• A jjoint arrangement
g is either a
1. joint operation or
2 joint
2. j i t venture.
t
Lee Kin Wai 32
J i t operation
Joint ti versus Joint
J i t venture
t

• A joint operation is a joint arrangement whereby the

parties that have joint control of the arrangement have
rights to the assets,
assets and obligations for the liabilities,
liabilities
relating to the arrangement. Those parties are called
joint operators.
• A joint venture is a joint arrangement whereby the
parties that have joint control of the arrangement have
rights to the net assets of the arrangement. Those
parties are called joint venturers.
Lee Kin Wai 33

Comparison of Joint operations vs joint venture (Source: FRS 111)

Joint operation
Terms of The contractual arrangement
g The contractual arrangement
contractual provides the parties to the joint
arrangement arrangement with rights to the
assets and obligations for the
assets,
liabilities, relating to the
arrangement.
Joint Venture
g
provides the parties to the joint
arrangement with rights to the net
assets of the arrangement (it is
the separate vehicle, not the
parties, that has rights to the
assets and obligations for the
assets,
liabilities, relating to the
arrangement).

Rights to Parties to the joint Assets brought into the

assets arrangement share all interests
(rights, title or ownership) in
the assets relating to the
arrangement in a specified
proportion.
Lee Kin Wai
arrangement or subsequently
acquired by the joint arrangement
are the arrangement’s assets.
The parties have no interests (i.e.
no rights, or ownership) in the
assets of the arrangement.
34
 Joint operation
Obligations The parties to the joint
For arrangement share all
liabilities liabilities, obligations, costs
andd expenses iin a specified
ifi d
proportion (e.g. in proportion
to the parties’ ownership
interest in the arrangement or
in proportion to the activity
carried out through the
arrangement )
Joint Venture
The joint arrangement is liable
for the debts and obligations of
the arrangement.
P i to the
Parties h jjoint
i arrangement
are liable to the arrangement
only to the extent of their
respective investments in the
arrangement or to their
respective obligations to
contribute additional capital to
the arrangement .

Recourse Yes. No.

by third
parties.

Lee Kin Wai 35

Joint operation Joint Venture

Revenues,  The contractual arrangement  The contractual arrangement 

expenses,  establishes the allocation of  establishes each party’s share in 
profit or loss revenues and expenses on the 
profit or loss  revenues and expenses on the the profit or loss relating to the
the profit or loss relating to the 
basis of the relative performance  activities of the arrangement. 
of each party to the joint 
arrangement. For example, the 
contractual arrangement might 
establish that revenues and 
expenses are allocated on the 
basis of the capacity that each 
party uses in a plant operated
party uses in a plant operated 
jointly, which could differ from 
their ownership interest in the 
joint arrangement In other
joint arrangement. In other 
instances, the parties may agree 
to share the profit or loss 
relating to the arrangement 
l ti t th t
based on the parties’ ownership 
interest in the arrangement. 

Lee Kin Wai 36
 Accounting for Joint Venture
Accounting for Joint Venture
• A joint venturer shall recognise its interest in a joint
venture as an investment and shall account for that
investment using the equity method per FRS 28
“I
“Investments
t t in
i Associates
A i t and
d Joint
J i t Ventures”.
V t ”
• Ap
party
y that p
participates
p in,, but does not have jjoint control
of, a joint venture shall account for its interest in the
arrangement per FRS 39.
• See TLK illustration 6.4
6 4 (page 376) on equity accounting
for joint venture.
Lee Kin Wai 37

Accounting for Joint Operator
g p
• A joint operator recognises its interest in a joint operation:

(a) its assets, including its share of any assets held jointly;

(b) its
it liabilities,
li biliti i l di its
including it share
h off liabilities
li biliti incurred
i d jointly;
j i tl

(c) its revenue from the sale of its share of the output arising from the joint

operation;

(d) its share of the revenue from the sale of the output by the joint

p ; and
operation;

(e) its expenses, including its share of any expenses incurred jointly.

• See TLK illustration 6.5 (p

(page
g 379)) for accounting
g of jjoint operations.
p
Lee Kin Wai 38