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27/08/2015

Chapter 32
Accounting for equity
investments, including
investments in associates

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-1

Objectives of this lecture


Be aware of how to account for equity
investments
Be aware that investments in associates (defined
as investees over which the investor has
significant influence) must be accounted for by
using the equity method of accounting, and know
how to apply this method of accounting

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-2

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Objectives of this lecture (cont.)


Understand that if the investor is a parent entity
(that is, it has at least one subsidiary) then the
cost or fair value methods of accounting is to be
used in its own individual financial statements
and the equity method in the consolidation
worksheet to account for the investments in
associates
Understand that if an investor is not a parent
entity (it has no subsidiaries) the equity method
of accounting is to be used in its own accounts
to account for investments in associates.

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-3

Objectives (cont.)
Be aware of tests that can be applied to determine the
existence of significant influence
Be aware of the disclosure requirements of
AASB 128 Disclosure of Interests in Other entities

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PPTs to accompany Deegan, Australian Financial Accounting 7e

32-4

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Introduction to accounting for equity


investments
The lecture considers how to account for equity
investments where the investor does not have
control over the investee
To determine the correct accounting treatment for
equity investments a number of factors should be
considered:
What is the nature of the investors operations?
Is the investment held for trading purposes?
What degree of control or influence can the investor
exert over the investee?
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 7e

32-5

Introduction to accounting for equity


investments (cont.)
If the investor has significant influence over the
investee, the equity method of accounting must be
applied
Investment in an associate is increased by any postacquisition movements in the associates earnings and
reserves

An equity investment is deemed to exist where


(AASB 132):
the investor has acquired an equity instrument, which
can be defined as:
any contract that evidences a residual interest in an
entitys assets after deducting all its liabilities
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 7e

32-6

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Why do firms make equity investments?


Instead of leaving cash in low interest bank deposits
To have ready access to funds for dividend
payments, taxes and periodic capital works
When sources of cash are needed in the short term,
firms invest in marketable securities readily
convertible to cash
Disclosed as current assets

Marketable securities:
are debentures, shares, options or bonds that are
readily sold at reasonably short notice
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 7e

32-7

Why do firms make equity investments?


(cont.)
Long-term investments
Shares in listed companies to yield income from
dividends and increases in market value
Diversified portfolio of shares to reduce overall risk
exposure
Larger stake in a specific company in anticipation of a
takeover bid or to gain representation on the board

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PPTs to accompany Deegan, Australian Financial Accounting 7e

32-8

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Types of investments (cont.)

Equity investments
Usually shares in an organisation
Give investor an ownership interest and therefore share in
profits
Cash investments
Can be converted to cash at short notice
For example, interest-bearing deposits
Property investments
Various investments in physical property
For example, land and buildings
Held to earn rentals and/or capital appreciation
Can be purchased directly or through a property trust

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-9

Measurement of equity instruments at


fair value
If an equity instrument is acquired for trading purposes
then AASB 9 requires the subsequent changes in fair
value to be included in profit or loss, subject to limited
exceptions.

However, and as indicated at (b) above, if an


investment in an equity instrument is not held for
trading, then the gains or losses can be included in
other comprehensive income rather than in profit or
loss.

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-10

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Example: change in fair value

For example, the share price of an investment in XYZ Ltd


increases from $11.00 to $12.50 and the reporting entity has
10 000 shares in XYZ. (see p.1092)

If the reporting entity has elected to treat the investment in XYZ as


trading stock, a gain of $15 000 will be recognised in the Profit and
Loss. The accounting entry would be :

Dr
Cr

Investment in XYZ
Gain on equity investments

15 000
15 000

If the reporting entity has elected to treat the investment in XYZ as


non-trading stock, a gain of $15 000 will be disclosed as part of the
Other Comprehensive Income and the credit entry could be to an
equity account entitled: Investment revaluation reserve. The
accounting entry would be:

Dr
Cr

Investment in XYZ
Investment revaluation reserve

15 000
15 000

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-11

Investments in associates
Key terms:
Associate: investee over which the investor has
significant influence
Investee: entity in which another entity has an
ownership interest
Investor: entity/person that has an ownership interest
in another entity
Significant influence: power to participate in
investees financial and operating policy decisions
(but not control or joint control)

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-12

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Equity method of accounting


AASB 128 Investments in Associates and
Joint Ventures requires that:
where an investor does significantly influence an
investee, the investor must adopt the equity
method of accounting
therefore, whilst there is a general principle that
equity investments shall be measured at fair value
(as we discussed earlier), where an investor has
significant influence then we will use equity
accounting to measure the equity investment

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-13

Equity method of accounting (cont.)


AASB 128 requires:
use of equity accounting within the financial
statements, and
application of equity accounting to include corporate
investments and non-corporate investments

Significant influence
Used in determining whether the equity method is to be
applied
Falls short of control
Normally stems from investors voting power in the
investee
Assumed to exist where investor holds 20% or more of
investees voting power
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 7e

32-14

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Equity method of accounting (cont.)


Significant influence (cont.):
20% is not intended as an absolute cut-off point and
significant influence may exist with an equity holding below
this rather arbitrary amount of voting power
Other indicators
representation on board of directors
participation in policy-making processes
material transactions between investor and investee
interchange of managerial personnel
provision of essential technical information
If the investor subsequently ceases to have significant
influence, they must cease using equity accounting
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 7e

32-15

Application of the equity method of


accounting
As with the materiality application in other accounting
standards, if investments are not material, investor not
required to comply with AASB 128
Investment in associate is initially recognised at cost
Carrying amount of investment is increased or decreased
to recognise investors share of investees postacquisition profits
Investors share of investees profit or loss to be included
in investors profit or loss
Distributions (e.g. dividends) from investee reduce the
investments carrying amount
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 7e

32-16

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Application of the equity method of


accounting (cont.)
Adjustments to carrying amount also for:
changes in investors proportionate interest in
investee from changes in investees equity not
included in investees profit or loss
For example, revaluations of property, plant and
equipment and foreign exchange translation
differences
Investors share of changes recognised directly in
investors equity

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-17

Application of the equity method of


accounting (cont.)
If investor is required to prepare consolidated
financial statements they should:
recognise investment in associate by applying equity
method in consolidated financial statements, and
apply cost or fair value methods in own individual
financial statements
As paragraph 10 of AASB 127 Separate Financial
Statements states:
When an entity prepares separate financial statements, it shall
account for investments in subsidiaries, joint ventures and
associates either:
(a) at cost, or
(b) in accordance with AASB 9.
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 7e

32-18

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Application of the equity method of


accounting (cont.)
If investor does not prepare consolidated
financial reports they should:
apply the equity method to their own separate
financial report
(the above is summarised on the following slide)

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-19

Is the investor a parent entity?

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-20

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Application of the equity method of


accounting (cont.)
At acquisition, the difference between investors share of
adjusted values of investees net assets and cost of
investment is regarded as:
goodwill, or
discount on acquisition

Goodwill is not separately disclosed; however, any


impairment of goodwill is taken into account in calculating
the investors share of the associates profit or loss
When recognising investors share of associates postacquisition profits:
adjustments are to be made to profit share to take into
account depreciation based on fair values of associates asset
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 7e

32-21

Application of the equity method of


accounting (cont.)
Rationale for adopting the equity method
Stream of dividend receipts (revenue under the cost
method) might provide inaccurate guide to investees
performance and value
Provides a better indication of investments underlying worth

Criticisms by opponents of equity method


Breaches realisation principle tied to notion of conservatism
Investor reports its share of investees profits, even without
any dividends
Account balance of investment is neither cost nor fair value
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 7e

32-22

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Application of the equity method of


accounting (cont.)
Refer to Worked Example 32.1 (p. 1096)
Comparison of cost method and equity method of
accounting
Cost method
To recognise initial acquisition of shares
Dr Investment in X Ltd
Cr Cash at bank

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-23

Application of the equity method of


accounting (cont.)
Cost method (cont.)
To recognise dividends provided by associate from
post-acquisition profits
Dr Dividend receivable
x
Cr Dividend revenue
x
To recognise receipt of previous dividend provided
Dr Cash at bank
x
Cr Dividend receivable
x

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-24

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Application of the equity method of


accounting (cont.)
Equity method (where investor is a parent)
In consolidation worksheet (Year 1)
To record investors share of associates profit
Dr Investment in X Ltd
x
Cr Share of associates profit

To recognise investors share of dividends


Dr Dividend revenue
x
Cr Investment in X Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-25

Application of the equity method of


accounting (cont.)
In consolidation worksheet (Year 2)
Prior period share of profits
Dr Investment in X Ltd
Cr Retained earnings (opening)

To recognise share of associates losses


Dr Share of associates profit/loss
Cr Investment in X Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-26

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Application of the equity method of


accounting (cont.)
To recognise investors share of dividends
Dr Dividend revenue
x
Cr Investment in X Ltd

Investors share of associates increase in revaluation


reserve
Dr Investment in X Ltd
x
Cr Revaluation surplus
x

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-27

Application of the equity method of


accounting (cont.)
Equity method (where investor is not a parent)
In investors accounts (Year 1)
Initial acquisition
Dr Investment in X Ltd
Cr Cash at bank

Dividends from associates pre-acquisition earnings


Dr Cash at bank
Cr Investment in X Ltd

Share of associates profit


Dr Investment in X Ltd
Cr Share of associates profit

Investors share of associates declared dividends


Dr Dividend receivable
Cr Investment in X Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-28

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Application of the equity method of


accounting (cont.)
In investors accounts (Year 2)
Receipt of dividend declared in previous period
Dr Cash at bank
Cr Dividend receivable

Investors share of current loss of associate


Dr Share of associates profit/loss
Cr Investment in X Ltd

Investors share of dividend declared by associate


Dr Dividend receivable
Cr Investment in X Ltd

Investors share of increase in associates revaluation surplus


Dr Investment in X Ltd
x
Cr Revaluation surplus
x
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 7e

32-29

Application of the equity method of


accounting (cont.)
Carrying amount of investment to be adjusted by
(AASB 128):
post-acquisition increments or decrements in
associates total reserves except to the extent that
movements have already been reflected in associates
or in carrying amount of investment

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-30

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Worked Example 32.1Comparison of the cost


method and equity method of accounting
On 1 July 2014 Cassie Ltd acquires a 30% interest in Joy Ltd for a
cash consideration of $540 000
On the date of the acquisition, the assets of Joy Ltd are reported at
their fair value. The total share capital and reserves of Joy Ltd as at
the date of the acquisition are:
Share capital
$1 320 000
Retained earnings
$480 000
Total shareholders funds
$1 800 000

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-31

Worked Example 32.1Comparison of the cost


method and equity method of accounting (cont.)
Additional information
For the year ending 30 June 2015, Joy Ltd records an after-tax
profit of $100 000. A dividend of $40 000 is declared and
ratified by Joy Ltd on 30 June 2015, with the dividend coming
from profits earned in the 201415 financial year
In October 2015 Joy Ltd pays the $40 000 dividend provided for
on 30 June 2015
For the year ending 30 June 2016, Joy Ltd records an after-tax
loss of $50 000. On 30 June 2016 Joy Ltd declares dividends of
$20 000, to be paid out of the profits earned in the 2015
financial year
On 30 June 2016 Joy Ltd revalues its land upwards by an
amount of $400 000
Cassie Ltd recognises dividends as revenue when the investee
declares the dividends (that is, Cassie Ltd also recognises a
dividend receivable)
The corporate tax rate is 30%
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 7e

32-32

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Worked Example 32.1Solution


(a) Journal entries using the cost method in the accounts of Cassie Ltd
Year ending 30 June 2015
July 2014
Dr Investment in Joy Ltd
540 000
Cr Cash at bank
540 000
June 2015
Dr Dividend receivable
Cr Dividend revenue
Year ending 30 June 2016
October 2015
Dr Cash at bank
Cr Dividend receivable
June 2016
Dr Dividend receivable
Cr Dividend revenue

12 000
12 000

12 000
12 000

6 000
6 000

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-33

Worked Example 32.1Solution (cont.)


(b) Journal entries using the equity method in the consolidated financial
statements of Cassie Ltd (a parent entity)
30 June 2015 (in consolidation worksheet)
Dr Investment in Joy Ltd
30 000
Cr Share of associates profit
Dr Dividend revenue
12 000
Cr Investment in Joy Ltd
30 June 2016 (in consolidation worksheet)
Dr Investment in Joy Ltd
Cr Retained earnings30 June 2015
Dr Share of associates profit/loss
Cr Investment in Joy Ltd
Dr Dividend revenue
Cr Investment in Joy Ltd
Dr Investment in Joy Ltd
Cr Revaluation surplus
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 7e

30 000
12 000

18 000
18 000
15 000
15 000
6 000
6 000
84 000
84 000

32-34

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Worked Example 32.1Solution (cont.)


Journal entries using the equity method in the accounts of Cassie
Ltd (not a parent entity)
Year ending 30 June 2015
July 2014
Dr Investment in Joy Ltd
Cr Cash at bank
30 June 2015
Dr Investment in Joy Ltd
Cr Share of associates profit
Dr Dividend receivable
Cr Investment in Joy Ltd

540 000
540 000

30 000
30 000
12 000
12 000

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-35

Worked Example 32.1Solution (cont.)


Year ending 30 June 2016
October 2015
Dr Cash at bank
Cr Dividend receivable
30 June 2016
Dr Share of associates profit/loss
Cr Investment in Joy Ltd

12 000
12 000

15 000
15 000

Dr Dividend receivable
Cr Investment in Joy Ltd

6 000

Dr Investment in Joy Ltd


Cr Revaluation surplus

84 000

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PPTs to accompany Deegan, Australian Financial Accounting 7e

6 000

84 000

32-36

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Losses incurred by an associate


Equity method to be discontinued when:
effect of equity-accounting losses or revaluation
decrements causes investment carrying amount to fall
below zero

When it is possible that associate will generate


accounting profits or recognise revaluation
increments in a subsequent period:
investment in associate to be increased only by
investors share of profits or revaluation increments
when such increases offset losses and revaluation
decrements not recognised following suspension of
the equity method

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-37

Summary
The lecture considers issues relating to the valuation and
disclosure of equity investments
If investor has significant influence over investee (i.e. an
associate), equity accounting must be used to account for
investors interest in associate
Equity accounting will be undertaken in the consolidated
accounts if the investor has subsidiaries

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Deegan, Australian Financial Accounting 7e

32-38

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