Investments in associates are those in which the investor has significant influence, but not control, over the investee's business activities.

Significant influence is presumed at ownership levels of at least 20%, but is determined based on the facts for each investment. For example, significant influence may be present for ownership levels of less than 20% if the investor licenses technology that is important to the investee company. Alternatively, lack of significant influence may be present for ownership levels above 20% if prohibited by contracts.

The FASB has provided examples of cases in which significant influence may NOT exist:

• Investee opposes investor's acquisition of stock.
• Investor surrenders significant shareholder rights.
• Investor is unable to obtain needed financial information from investee.
• Investor is unable to obtain representation on investee's board of directors.

The determining factor is the amount of influence. There are situations where 10% ownership has been enough to confer "significant influence"� and others where more than 20% was not.

The equity method is generally employed when the investor has significant influence over the investee. Both the U.S. GAAP and IFRS require this method because it provides a more objective basis for reporting investment income. It is a method of accounting by which an equity investment is initially recorded at cost and subsequently adjusted to reflect the investor's share of the net assets of the associate (investee).

Equity Method: Basic Principles

For any company: ending retained earnings (RE) = beginning RE + Net Income - Dividends. Following the same logic:

• In the year of acquisition, the investor company reports its investment in the investee at the acquisition cost.
• The value that the investor company reports the investment in subsequent years will depend on both the dividends paid and the earnings of the investee.
  • If the investee in Year 2 has positive net income, the investor will increase its reported investment by % of ownership in the investee x the investee's net income.
  • If the investee has a loss, then the investor will reduce its investment by its ratable amount of the loss. If the balance is reduced to zero, equity method accounting is discontinued until the cumulative balance is positive.
  • Dividends received by the investor from the investee will not be included in the investor's net income. Instead, the dividends will be deducted from the investment in the investee, on the rationale that the investee's payment of dividends reduces its equity by the amount paid, and the investor will share ratably in that reduction. Therefore, dividends are treated as a return of investment.

The equity investment is reported as a single line item on the balance sheet and on the income statement.

Example

Rings & More acquired 45% of the equity securities of Diamonds Galore for $1,350,000. On the acquisition date, Diamonds Galore's net assets had a fair value of $3,000,000. During the year, Diamonds Galore paid dividends of $150,000 and net income of $1,750,000.

The journal entries are as follows:

To record the purchase of the investment:

To record percentage share of investee company earnings (45% of earnings of $1,750,000):

To record dividends received (45% of dividends of $150,000):

If the subsidiary had a loss, the investment account would have been reduced.

During the year, the investor will report $787,500 as equity income on investment in its income statement.

Equity Method: Other Issues

Implicit Goodwill

On acquisition of the investment in an associate, any difference between the cost of acquisition and the investor's share of the fair values of the net identifiable assets of the associate is accounted for like goodwill, which is part of the one-line item (the investment) on the investor's balance sheet.

• The US. GAAP requires the use of net book values, not fair values, of net identifiable assets.
• The IFRS allows the use of either net book values or fair values.

The goodwill is simply the residual excess not allocated to identifiable assets or liabilities.

Appropriate adjustments to the investor's share of the profits or losses after acquisition are made to account for additional depreciation or amortization of the associate's depreciable or amortizable assets based on the excess of their fair values over their carrying amounts at the time the investment was acquired.

Example

Purchase price: $500.
20% of shares.
Book value: $2,000.
Net identifiable assets of the investee: net book value $1,000, fair market value: $1,200.

The investor pays $500 for $400 ($2,000 x 20%) worth of assets. Assign $40 [(1,200 - 1,000) x 20%] to net identifiable assets, the goodwill is then $60. In subsequent accounting periods the $40 will be amortized and the $60 worth of goodwill is not amortized.

Impairment

If impairment is indicated, the amount is calculated. The entire carrying amount of the investment is tested for impairment as a single asset, that is, goodwill is not tested separately. The impairment loss is recognized on the income statement and the carrying amount of the investment on the balance sheet is reduced to its fair value.

The reversal of impairment losses is not allowed.

Transactions with Associates

Any inter-company transactions between the investor and investee (upstream or downstream) should be eliminated.

Effects on Financial Statements

Balance sheet effect. The investment account is reported on the balance sheet as a single amount. It is reported at cost, adjusted for dividends received and proportionate earnings, not at fair market value.

Income statement effect. The investor's share of the investee's earnings is reported as a single item on the investor's income statement. Compared with the previous subject, the equity method will result in the investor company reporting higher income than if it used classifications such as available-for-sale or trading securities.

Financial ratios. The equity method recognizes income in excess of dividends received.

• Whenever the investee has earnings and a dividend payout ratio of less than 100%, use of the equity method will increase the earnings of the investor relative to those using the cost method.
• When the investee has positive net income, the investor's ratios of interest coverage and return on investment will improve, but this is a two-edged sword, because the investor could find those ratios reduced if the investee starts to experience losses.
• As only assets and equity are affected, without any recognition of the investee's debt, the investor's debt-to-equity and debt-to-total capital ratios improve under the equity method.

Issues for Analysts

• The criteria of "significant influence" can be subjective. If the investee is profitable, the investor will want to purchase enough (i.e., 20%) to use the equity method. If the investee is not profitable, then the investor will purchase less than 20% so that it can avoid having to report its proportionate share of the losses.
• The one-line consolidation can hide lots of details.
• The premise of the equity method is that the investor has access to the investee's earnings. If the reality proves otherwise, then use of the equity method may not be indicated, and the investment should be considered as an investment in marketable securities and evaluated on a mark-to-market basis.