Investment in Associates, Part 2

Impairments of Investments in Associates

Equity method investments must be tested for impairment. Under U.S. GAAP, if the fair value of the investment falls below the carrying value (investment account on the balance sheet) and the decline is considered other than temporary, the investment is written down to fair value and a loss is recognized on the income statement. Under IFRS, impairment needs to be evidenced by one or more loss events.

While U.S. GAAP prohibits reversal of impairment losses, IFRS allows reversal to the extent the net recoverable amount subsequently increases.

Transactions With the Investee

So far, our discussion has ignored transactions between the investor and investee. Because of its ownership interest, the investor may be able to influence transactions with the investee. Thus, profit from these transactions must be deferred until the profit is confirmed through use or sale to a third party.

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.

For example, suppose that Investor owns 30% of Investee. During the year, Investee sold goods to Investor and recognized $15,000 of profit from the sale. At year end, half of the goods purchased from Investee remained in Investor’s inventory.

All of the profit is included in Investee’s net income. Investor must reduce its equity income of Investee by Investor’s proportionate share of the unconfirmed profit. Since half of the goods remain, half of the profit is unconfirmed.

Thus, Investor must reduce its equity income by $2,250 [($15,000 total profit × 50% unconfirmed) × 30% ownership interest]. Once the inventory is sold by Investor, $2,250 of equity income will be recognized.

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.

For example, imagine again that Investor owns 30% of Investee. During the year, Investor sold $40,000 of goods to Investee for $50,000. Investee sold 90% of the goods by year end.

In this case, Investor’s profit is $10,000 ($50,000 sales − $40,000 COGS). Investee has sold 90% of the goods; thus, 10% of the profit remains in Investee’s inventory. Investor must reduce its equity income by the proportionate share of the unconfirmed profit: $10,000 profit × 10% unconfirmed amount × 30% ownership interest = $300.

Once Investee sells the remaining inventory, Investor can recognize $300 of profit.

Analytical Issues for Investments in Associates

When an investee is profitable, and its dividend payout ratio is less than 100%, the equity method usually results in higher earnings as compared to the accounting methods used for minority passive investments. Thus, the analyst should consider if the equity method is appropriate for the investor. For example, an investor could use the equity method in order to report the proportionate share of the investee’s earnings, when it cannot actually influence the investee.

Also, the investee’s individual assets and liabilities are not reported on the investor’s balance sheet. The investor simply reports its proportionate share of the investee’s equity in one line on the balance sheet. By ignoring the investee’s debt, leverage is lower.

In addition, the margin ratios are higher since the investee’s revenues are ignored.

Finally, the proportionate share of the investee’s earnings is recognized in the investor’s income statement, but the earnings may not be available to the investor in the form of cash flow (dividends). That is, the investee’s earnings may be permanently reinvested.

Under the acquisition method, all of the assets, liabilities, revenues, and expenses of the subsidiary are combined with the parent. Intercompany transactions are excluded.

In the case where the parent owns less than 100% of the subsidiary, it is necessary to create a noncontrolling (minority) interest account for the proportionate share of the subsidiary’s net assets that are not owned by the parent.