Module 14.4 and 14.5: Investment in Associates – Equity Method and Acquisition Method

We use the equity methods for investment ownership of another company between 20-50%. This range is the usually considered influential ownership.

The initial investment is recorded at cost, and put on the balance sheet as a noncurrent asset. Following the acquisition, the investee’s share of earnings increases the investment account on the investor’s B/S and I/S, however dividends reduce the investment account and are not recognized on the I/S.

If the investee reports a loss, the investor’s proportionate share of the loss reduces the investment account and also lowers earnings in the investor’s income statement. If the investee’s losses reduce the investment account to zero, the investor usually discontinues use of the equity method. The equity method is resumed once the proportionate share of the investee’s earnings exceed the share of losses that were not recognized during the suspension period.

U.S. GAAP allows equity method investments to be recorded at fair value. Under IFRS, the fair value option is only available to venture capital firms, mutual funds, and similar entities. The decision to use the fair value option is irrevocable and any changes in value (along with dividends) are recorded in the income statement.

At the acquisition date, the excess purchase price over the proportionate share of the investee’s book value is allocated to the investee’s identifiable assets and liabilities based on their fair values. Any remainder is considered goodwill.

In subsequent periods, the investor recognizes expense based on the excess amounts assigned to the investee’s assets and liabilities.

It is important to note that the purchase price allocation to the investee’s assets and liabilities is included in the investor’s balance sheet, not the investee’s. In addition, the additional expense that results from the assigned amounts is not recognized in the investee’s income statement. Under the equity method of accounting, the investor must adjust its balance sheet investment account and the proportionate share of the income reported from the investee for this additional expense.

Transactions can be described as upstream (investee to the investor) or downstream (investor to the investee). In an upstream sale, the investee has recognized all of the profit in its income statement. However, for profit that is unconfirmed (goods have not been used or sold by the investor), the investor must eliminate its proportionate share of the profit from the equity income of the investee.

In a downstream sale, the investor has recognized all of the profit in its income statement. Like the upstream sale, the investor must eliminate the proportionate share of the profit that is unconfirmed.

Under the acquisition method, all of the assets, liabilities, revenues, and expenses of the subsidiary are combined with the parent. (Consolidate purchased assets at fair value). Inter-company transactions are excluded.

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