Q8: How do we account for long-term investments that involve investing in the shares of other companies that are associated companies.

A:

The equity method is used when a long-term investment involves investing in an associated company. An associated company is where the investing company has significant influence over, but not control of, the investee company:

“An associate is an entity over which the investor has significant influence.”

AASB 128 Investments in Associates and Joint Ventures para 3

AASB 128 prescribes the accounting for investments in associates (and joint ventures) and sets out the requirements for the application of the equity method for these investments. Where the investing company holds 20% or more of the shares in an investee company, the existence of significant influence by the investee company over the investee company will be presumed, unless there is clear evidence to the contrary:

“If an entity holds … 20 per cent or more of the voting power of the investee, it is presumed that the entity has significant influence, unless it can be clearly demonstrated that this is not the case.

AASB 128 para 5

Also, where the investing company holds less than 20% of the shares in an investee company, it is presumed there is no significant influence by the investee company over the investee company, unless there is clear evidence to the contrary:

“Conversely, if the entity holds … less than 20 per cent of the voting power of the investee, it is presumed that the entity does not have significant influence, unless such influence can be clearly demonstrated.”

AASB 128 para 5

AASB 128 goes on to give examples of common types of evidence of having significant influence:

“The existence of significant influence by an entity is usually evidenced in one or more of the following ways:

(a) representation on the board of directors or equivalent governing body of the investee;

(b) participation in policy-making processes, including participation in decisions about dividends or other distributions;

(c)  material transactions between the entity and its investee;

(d) interchange of managerial personnel; or

(e) provision of essential technical information.”

AASB 128 para 6

Where the equity method is used, the investment is initially recorded at cost in the Balance sheet. When the associated company makes a profit (including Other comprehensive income), the investor company increases the value of its assets by their percentage share of the profit (including Other comprehensive income) of the associated company. And when an associated company pays a dividend, the investor company deducts the percentage share of the dividend from the value of its investment. This is set out in AASB 128 para 10:

“Under the equity method, on initial recognition the investment in an associate or a joint venture is recognised at cost, and the carrying amount is increased or decreased to recognise the investor’s share of the profit or loss of the investee after the date of acquisition. The investor’s share of the investee’s profit or loss is recognised in the investor’s profit or loss. Distributions received from an investee reduce the carrying amount of the investment. Adjustments to the carrying amount may also be necessary for changes in the investor’s proportionate interest in the investee arising from changes in the investee’s other comprehensive income. Such changes include those arising from the revaluation of property, plant and equipment and from foreign exchange translation differences. The investor’s share of those changes is recognised in the investor’s other comprehensive income.”

In this way, under the equity method, long-term investments are included in the investor company’s Balance sheet as a non-current asset; and it is originally valued at cost. Each year, the value of long-term investments are increased by the investor company’s share of profits (including Other comprehensive income) of the long-term investment; and reduced by the dividends received. Also, each year the value of long-term investments are reviewed for any impairment losses:

“After application of the equity method … the entity applies paragraphs 41A–41C to determine whether there is any objective evidence that its net investment in the associate … is impaired.”

AASB 128 para 40

 

Also, see Martin’s videos Equity Method – Associated Companies