Investment in Associates

Question 1

Explain the mechanism of “Equity Method”

Answer 1

Balance Sheet:

Initial Investment is recorded at cost as a non-current asset (Investment Account)

In Subsequent periods:

On Balance Sheet:

If Investee’s earnings increase, Investment Account increases proportionately (% share holding of investor in investee) and vice versa

On Income Statement:

Proportionate Increase/Decrease in Investor’s earnings is recorded

DIVIDENDS ARE TREATED AS ROC, THUS REDUCES INVESTMENT ACCOUNT AND ARE NOT RECORDED ON INCOME STATEMENT

Question 2

What happens when Investee’s losses reduce the investment account to zero under “Equity method”?

Answer 2

• Discontinue use of Equity method
• When proportionate share of investee’s earnings
  exceed the amount of losses that were not
  recognized during the suspension period, resume
  “Equity method” again.

Question 3

Can Fair Value method be used for Equity Method Investments?

Answer 3

Yes, only under US GAAP
IFRS allows FV option only to Venture Capital Firms, mutual funds and similar entities

IF FV OPTION IS USED, THE OPTION IS IRREVOCABLE

Question 4

How does FV Option word for Equity method investments?

Answer 4

• Record Equities at FV
• Any change in FV along with dividends are recorded
  on Income Statement

Question 5

Why does Allocation of Purchase price over book value acquired exist?

Answer 5

Rarely, BV of net assets = FV of net assets as book value of many assets and liabilities is based on historical cost.

Hence upon acquisition, the purchase price could be greater than the proportionate book value of net assets of the investee

Question 6

How is Excess of purchase price over Book Value allocated?

Answer 6

• Assign Purchase price to the proportionate book
  value of net assets of the investee
• Calculate the difference of FV-BV for all the assets of
  the investee, if it exists
• Assign the excess of purchase price over book value
  from Step 1 to the difference proportionately
• Any remainder is GOODWILL

THIS ALLOCATION ONLY REFLECTS IN INVESTOR’S BALANCE SHEET, NOT ON INVESTEE’S

Question 7

What impact does allocation of excess of purchase price over book value to investee’s net assets have on investor’s income?

Answer 7

• Investor must recognize additional depreciation expense that resulted from the purchase price allocation RESULTING INTO REDUCED INCOME
• Once allocated, in subsequent periods, investor recognizes expense based on the excess amounts assigned to the investee’s net assets
  Eg., Depreciation expense
• Take the excess amount allocated and calculate depreciation expense for the year and deduct it from Investor’s income

THIS ADDITIONAL EXPENSE IS ONLY RECORDED ON INVESTOR’S INCOME STATEMENT AND NOT ON INVESTEE’S