what is the equity method of accounting

Summary

This video explains the equity method of accounting, used when a company has significant influence over another, typically by owning 20% or more of its shares. The method involves initial investment recognition, followed by adjustments based on the company’s share of the investee’s profit, loss, and dividends. Two practical examples illustrate these concepts: one where a company invests 30% in an entity and another dealing with revaluation of assets. The video also emphasizes the importance of recognizing other comprehensive income and the changes in the investment balance, helping users understand the application of IFRS in real-world scenarios.

Takeaways

• 😀 The equity method is used in IFRS to recognize investments where a company has significant influence over another entity.
• 😀 Significant influence is presumed when a company owns more than 20% of another company's interest, but this can be overridden if the company cannot influence the investee's decisions.
• 😀 A company with less than 20% ownership can still be considered to have significant influence if it can demonstrate the ability to affect important decisions of the associate.
• 😀 When a company has significant influence, it must use the equity method to account for its investment, which includes adjusting for proportional gains and losses of the associate.
• 😀 If a company owns more than 50% of another company, it should consolidate its financial statements rather than using the equity method.
• 😀 The equity method involves initially recording the investment at cost and adjusting the carrying amount for the company’s share of the profit or loss of the associate.
• 😀 Dividends received from an associate reduce the carrying amount of the investment in the equity method.
• 😀 In the example provided, Company A acquires 30% of Company B, and the investment value increases or decreases based on Company B's profits or losses and dividends distributed.
• 😀 The equity method also accounts for changes in the associate's assets, such as property revaluation, under other comprehensive income.
• 😀 In the example, when Company B revalued its building, the revaluation increase affects Company A's investment carrying amount, showing how changes in asset values are incorporated into the equity method.

Q & A

What is the equity method in international financial reporting standards?

The equity method is used to recognize an investment when a company has significant influence over another entity, typically when it owns more than 20% of the entity's shares.

How is 'significant influence' defined under IAS 28?

Significant influence is presumed if an entity owns more than 20% of another entity. However, if the investing entity cannot influence the investee's relevant decisions, significant influence does not exist. Conversely, an entity may have less than 20% but still have significant influence if it can demonstrate the ability to affect important decisions.

What happens when a company owns more than 50% of another entity?

If a company owns more than 50% of another entity, it must use financial statement consolidation rather than the equity method.

How should Company A recognize its investment using the equity method?

Company A should initially recognize its investment at cost and subsequently adjust it based on its share of the investee's profit or loss, as well as any distributions (such as dividends) received from the associate.

What is the impact of dividends on the carrying amount of an investment using the equity method?

Dividends received by the investor reduce the carrying amount of the investment, as they are considered a return of investment.

How would Company A account for a profit of 45,000 and a dividend distribution of 12,000 in year one?

In year one, Company A would recognize 30% of the 45,000 profit, which is 13,500, as an increase in the investment. The 30% of the 12,000 dividend, which is 3,600, would reduce the investment's carrying amount, resulting in a final balance of 79,900.

What adjustments should be made when an associate reports a loss?

When an associate reports a loss, the investor must reduce the carrying amount of the investment by its proportional share of the loss. If no dividends are distributed, the investment is reduced only by the loss.

How is the equity method affected by revaluation of an asset, such as property, plant, and equipment?

If an associate uses the revaluation model for its property, plant, and equipment, the revaluation increase is recorded in other comprehensive income. This affects the carrying amount of the investment under the equity method.

How is the carrying amount of an investment calculated when there is a revaluation increase in an asset?

To calculate the carrying amount of the investment, the investor needs to account for its proportional share of the revaluation increase in other comprehensive income, along with any profits or losses and dividends from the associate.

What is the final carrying amount of Company A’s investment in Entity B at the end of year one in the given example?

At the end of year one, the carrying amount of Company A’s investment in Entity B is 216,100, which is calculated by adding 35% of the total adjustments (including profits, dividends, and revaluation increases) to the initial investment.