Accounting for investments in associates

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Jim Rohn stated the following: “It doesn’t matter which side of the fence you get off on sometimes. What matters most is getting off. You cannot make progress without making decisions.”

Similar to various decisions we have to make in life, accounting contains numerous policy choices that will have an impact on the line items presented in the financial statements.

This article will take a closer look at the impact of an accounting policy choice in the separate financial statements of an investor when that investor accounts for its investments in associates.

Paragraph 14.2 of the IFRS for SMEs states the following: “An associate is an entity, including an unincorporated entity such as a partnership, over which the investor has significant influence and that is neither a subsidiary nor an interest in a joint venture.”

Significant influence is defined in paragraph 14.3 of the IFRS for SMEs as “the power to participate in the financial and operating policy decisions of the associate but is not control or joint control over those policies.”

In accordance with paragraph 9.26 of the IFRS for SMEs, an investor can account for its investments in associates in its separate financial statements either at cost less impairment, at fair value or using the equity method. One of these three options should be selected by the investor. The main differences between these three options will be demonstrated through the use of the following example:

Scenario:

On 30 April 20.17, Winter Ltd (“Winter”) acquired a 25% interest in the ordinary share capital of Coffee Ltd (“Coffee”) for R88 000 in cash. On that date Coffee’s credit balance on its share capital and retained earnings amounted to R100 000 and R215 000 respectively.

On 30 April 20.17 all the identifiable assets and liabilities of Coffee were fairly valued. Since 30 April 20.17 Winter exercised significant influence over the financial and operating policy decisions of Coffee.

Coffee made a profit for the period 1 May 20.17 to 31 December 20.17 of R92 000.

On 30 June 20.17, Coffee revalued its plant for the first time by R30 000.

Coffee declared an ordinary dividend of R10 000 at 20 December 20.17.

The fair value of the 25% investment in Coffee was R99 000 at 31 December 20.17.

The reporting date of Winter and Coffee is 31 December 20.17.

Ignore any tax implications for the purpose of this scenario.

The following journal entries will be made in the separate financial statements of Winter, depending on the accounting policy elected, to account for its investment in the associate, Coffee:

 

COST MODEL
DEBIT

R

CREDIT

R

 

30 April 20.17

Investment in associate (SFP)

Bank (SFP)

 

20 December 20.17

Bank (SFP)

Dividend income (P/L) (10 000 x 25%)

 

 

88 000

 

 

 

2 500

 

 

 

 

88 000

 

 

 

2 500

EQUITY METHOD
  DEBIT

R

CREDIT

R

 

30 April 20.17

Investment in associate (SFP) (1)

Bank (SFP)

 

30 June 20.17

Investment in associate (SFP) (2)

Share of OCI of associate (OCI) (30 000 x 25%)

 

20 December 20.17

Bank (SFP)

Investment in associate (SFP) (10 000 x 25%) (2), (3)

 

31 December 20.17

Investment in associate (SFP) (1)

Share of profit of associate (P/L) (92 000 x 25%)

 

 

 

88 000

 

 

 

7 500

 

 

 

2 500

 

 

 

23 000

 

 

 

 

88 000

 

 

 

7 500

 

 

 

2 500

 

 

 

23 000

 

Guidance in the IFRS for SMEs on the equity method:

(1)

Paragraph 14.8 of the IFRS for SMEs states the following: “Under the equity method of accounting, an equity investment is initially recognised at the transaction price (including transaction costs) and is subsequently adjusted to reflect the investor’s share of the profit or loss and other comprehensive income of the associate”.

 (2)

Paragraph 14.8 (a) of the IFRS for SMEs states the following: “Distributions received from the associate reduce the carrying amount of the investment. Adjustments to the carrying amount may also be required as a consequence of changes in the associate’s equity arising from items of other comprehensive income.”

(3)

A different approach could have been followed by the investor to account for the dividend received from the associate. The investor could have recorded the dividend received initially in the line item “Other income” through the following journal entry:

 Dr Bank (SFP)                                      R2 500

Cr Dividend income (P/L)                                   R2 500

 Then the journal entry required to account for the investment in the associate in accordance with the equity method and paragraph 14.8 (a) of the IFRS for SMEs will be:

Dr Dividend income (P/L)                 R2 500

Cr Investment in associate (SFP)                      R2 500

 

FAIR VALUE MODEL
  DEBIT

R

CREDIT

R

 

30 April 20.17

Investment in associate (SFP)

Bank (SFP)

 

20 December 20.17

Bank (SFP)

Dividend income (P/L) (10 000 x 25%)

 

31 December 20.17

Investment in associate (SFP)

Fair value adjustment (P/L) (99 000 – 88 000)

 

 

 

88 000

 

 

 

2 500

 

 

 

11 000

 

 

 

 

88 000

 

 

 

2 500

 

 

 

11 000

The following is a summary of the impact of the investment in Coffee on the various line items in the separate financial statements of Winter, depending on the accounting policy choice, for the year ended 31 December 20.17 (the impact was determined by adding all the journal entries above to the relevant line item):

LINE ITEM COST MODEL EQUITY METHOD FAIR VALUE MODEL
  DEBIT/ (CREDIT)

R

DEBIT/ (CREDIT)

R

DEBIT/ (CREDIT)

R

 

Investment in associate (SFP)

 

Bank (SFP)

 

Other income (P/L)

 

Share of profit of associate (P/L)

 

Share of OCI of associate (OCI)

 

 

88 000

 

(85 500)

 

(2 500)

 

 

 

116 000

 

(85 500)

 

 

(23 000)

 

(7 500)

 

99 000

 

(85 500)

 

(13 500)

 

 

As can be seen from the example above, the election of an accounting policy will have an impact on various line items in the financial statements. Before getting off the fence and electing an accounting policy, make an informed decision and consider the impact of the accounting policy choice on the various line items in the entity’s financial statements.

Ms Celesté Brittz CA(SA) is a lecturer in Financial Accounting at the School of Accountancy, University of the Free State