Advanced Accounting — Associates and Joint Ventures: The Equity Method

An investment that gives no control but allows participation in the investee’s financial and operating policies is accounted for neither at fair value nor by consolidation, but by the equity method. The standard is K-IFRS 1028 Investments in Associates and Joint Ventures (IAS 28). The equity method is sometimes called “one-line consolidation”, because it puts the investor’s share of the investee’s net assets and profit into a single investment account.

1. Significant influence and joint control

An associate is an entity over which the investor has significant influence. Holding directly or indirectly 20% or more of the voting power is presumed to give significant influence, though the presumption can be rebutted. Even below 20%, significant influence may exist where there is:

representation on the board of directors or equivalent governing body
participation in policy-making, including decisions on dividends
material transactions between investor and investee
interchange of managerial personnel
provision of essential technical information

A joint venture is an arrangement in which the parties jointly control it and have rights to its net assets (K-IFRS 1111, IFRS 11). The equity method applies to joint ventures too. In a joint operation, where the parties have direct rights to assets and obligations for liabilities, each recognizes its own share of assets, liabilities, income and expenses.

2. Measurement under the equity method

The investment is initially recognized at cost. Afterwards, the investor’s share of the investee’s profit or loss and OCI is added to the carrying amount, and dividends received reduce it. A dividend is not income but a return of the investment.

Share of profit and carrying amount of the investment

\begin{aligned}\text{Share of profit} &= (\text{Investee's profit} - \text{Amortization of FV differences}) \times \text{Ownership \%} - \text{Unrealized intragroup profit (investor's share)} \\ \text{Closing investment} &= \text{Opening investment} + \text{Share of profit} + \text{Share of OCI} - \text{Dividends received}\end{aligned}

The difference between cost and the investor's share of the fair value of the investee's net assets is goodwill, included within the investment. It is not amortized separately; the investment as a whole is tested for impairment as a single asset.

3. Worked example

At the beginning of 20X1 company A bought 30% of B for ₩9 million. At the acquisition date B’s net assets had a carrying amount of ₩23 million, and a building had a fair value ₩2 million above its carrying amount (remaining useful life ten years).

Share of the fair value of net assets: $(2{,}300 + 200) \times 30\% = 750$ (₩10,000)
Goodwill within the investment: $900 - 750 = 150$

In 20X1 B’s profit is ₩4 million and its dividends ₩1 million. In addition, ₩500,000 of profit on goods A sold to B remains in B’s closing inventory (downstream sale).

Equity method for 20X1 (unit: ₩10,000)
Item	Working	Amount
B's adjusted profit	400 − 200 ÷ 10	380
A's share	380 × 30%	114
Eliminate downstream unrealized profit	50 × 30%	(15)
Share of profit		99
Dividends received	100 × 30%	(30)
Closing carrying amount of the investment	900 + 99 − 30	969

Unlike consolidation, the equity method eliminates unrealized intragroup profit only to the extent of the investor’s interest, for both downstream and upstream transactions, because the remaining 70% is regarded as a transaction with outside shareholders.

4. Losses and other issues

Loss limit: when the investor’s share of losses exceeds the carrying amount of the investment, the investment stops at zero and further losses are not recognized. Items that are in substance part of the net investment, such as long-term loans, absorb further losses, and a liability is recognized if the investor has an obligation to pay on the investee’s behalf. When profits return, unrecognized losses are made good first before profit is recognized again.
Bargain purchase: if the share of the fair value of net assets exceeds cost, the difference is included in the share of profit in the year of acquisition.
Uniform policies and reporting dates: the associate’s accounting policies are aligned with the investor’s, and any difference in reporting dates must be no more than three months.
Disposal: when significant influence is lost, the retained interest is measured at fair value and the difference is recognized in profit or loss. OCI recognized for the associate is treated as if the associate had disposed of the related assets directly.

Check your understanding

At the beginning of 20X1 company C bought 25% of D for ₩5 million; the fair value (= carrying amount) of D’s net assets at the acquisition date is ₩20 million. D made losses of ₩16 million in 20X1 and ₩8 million in 20X2, and profit of ₩10 million in 20X3. There are no dividends, and C has no other net investment in D or obligation to pay. What are the carrying amount of the investment and the share of profit or loss at the end of each year?

The share of loss for 20X1 is $1{,}600 \times 25\% = 400$ (₩10,000), leaving an investment of ₩1 million. Of the ₩2 million share of loss for 20X2, only ₩1 million is recognized, bringing the investment to zero and leaving ₩1 million of unrecognized loss. Of the ₩2.5 million share of profit for 20X3, the ₩1 million of unrecognized loss is made good first, and only ₩1.5 million is recognized as share of profit, so the investment becomes ₩1.5 million.

References

Korea Accounting Standards Board, K-IFRS 1028 Investments in Associates and Joint Ventures
Korea Accounting Standards Board, K-IFRS 1111 Joint Arrangements
Joe Hoyle, Thomas Schaefer and Timothy Doupnik, Advanced Accounting, ch. 1