11.3 IAS 28 Investments in Associates & The Equity Method

11.3 IAS 28 Investments in Associates & The Equity Method

Core Principle: Under IAS 28 Investments in Associates and Joint Ventures, an associate is an entity over which the investor has significant influence—defined as the power to participate in the financial and operating policy decisions of the investee, but not control or joint control over those policies. Because the investor lacks control, line-by-line consolidation is strictly prohibited. Instead, associates are accounted for using the equity method (often characterized as "one-line consolidation"): the investor recognizes its share of the associate's post-tax profit as a single line item in the Consolidated Statement of Profit or Loss (within the Investing category under IFRS 18) and reports its net investment as a single non-current asset in the Consolidated Statement of Financial Position.

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1. Definition of an Associate & Indicators of Significant Influence

In financial reporting, investments in equity shares fall into three primary categories depending on the degree of influence exercised:

                         The Spectrum of Corporate Influence
  ┌────────────────────────┬─────────────────────────┬──────────────────────────┐
  │ PASSIVE INVESTMENT     │ ASSOCIATE               │ SUBSIDIARY               │
  │ (0% to <20% Voting)    │ (20% to 50% Voting)     │ (>50% Voting or Control) │
  ├────────────────────────┼─────────────────────────┼──────────────────────────┤
  │ • No significant       │ • Significant Influence │ • Control (IFRS 10)      │
  │   influence            │ • IAS 28 Equity Method  │ • Full Line-by-Line      │
  │ • IFRS 9: FVTPL /      │ • Single-line net asset │   Consolidation          │
  │   FVTOCI               │   and profit line       │ • 100% revenues & costs  │
  └────────────────────────┴─────────────────────────┴──────────────────────────┘

The Rebuttable Presumption

Under IAS 28 paragraph 5:

• 20% to 50% Voting Power: If an investor holds, directly or indirectly, 20% or more of the voting power of the investee, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case.
• Less than 20% Voting Power: If the investor holds less than 20%, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated.

Qualitative Indicators of Significant Influence (IAS 28.6)

The existence of significant influence is usually evidenced in one or more of the following ways, regardless of the precise shareholding percentage:

1. Representation on the Board of Directors or equivalent governing organ of the investee;
2. Participation in Policy-Making Processes, including participation in decisions about dividends or other distributions;
3. Material Transactions between the investor and the investee (such as major supply agreements);
4. Interchange of Managerial Personnel (seconding senior executives to the investee);
5. Provision of Essential Technical Information or critical intellectual property on which the investee relies.

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2. The Conceptual Foundation: Why Line-by-Line Consolidation is Forbidden

A common misunderstanding among students is to ask why a 30% or 40% associate cannot be consolidated proportionally or line-by-line. Under the IASB Conceptual Framework, an asset is an economic resource controlled by the entity. When an investor owns 30% of an associate, the remaining 70% is held by outside parties who control the board.

The investor cannot direct the associate's employees, cannot mandate sales volumes, cannot deploy its equipment, and cannot access its bank accounts at will. If the investor added 30% (or 100%) of the associate's revenue and operating costs to group revenue and expenses:

• Group revenue and operational scale would be severely distorted;
• Key operational ratios—such as operating profit margin, asset turnover, and return on capital employed (ROCE)—would be contaminated by figures the parent does not control;
• Users of the financial statements would be misled regarding the cash-generating resources under group command.

Therefore, IFRS strictly mandates the equity method, which confines the group's presentation to the net economic capital invested and the net post-tax return earned.

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3. The Equity Method in the Statement of Financial Position (CSFP)

In the Consolidated Statement of Financial Position, the investment in associate is presented as a single line item within Non-Current Assets.

The Standard Investment in Associate Working Template

  Working: Investment in Associate (CSFP Non-Current Assets)            $
  Cost of initial investment at acquisition date                       XXX
  Add: Group share of post-acquisition retained earnings               XXX
       [Group % x (Associate Closing RE - Associate Acquisition RE)]
  Add: Group share of post-acquisition other reserves (e.g. OCI)       XXX
  Less: Cumulative impairment losses recognized to date (IAS 36)      (XXX)
  Less: Group share of unrealised profit on DOWNSTREAM sales (PUP)    (XXX)
  ─────────────────────────────────────────────────────────────────────────
  CARRYING AMOUNT OF INVESTMENT IN ASSOCIATE IN CSFP                   XXX
  ═════════════════════════════════════════════════════════════════════════

The Goodwill Rule for Associates

Unlike a subsidiary, goodwill relating to an associate is not recognized as a separate asset. It is implicitly embedded within the carrying amount of the investment in associate. Consequently, there is no separate "Goodwill" balance on the face of the balance sheet for an associate, nor is there an amortization charge.

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4. The Equity Method in the Statement of Profit or Loss (CSPL) under IFRS 18

In the Consolidated Statement of Profit or Loss, the investor recognizes its share of the associate's operating results in a single line entry:

Share of Profit of Associate = Group Ownership % x Associate Profit After Tax (PAT)

Presentation under IFRS 18 Presentation and Disclosure in Financial Statements

Under IFRS 18 (which replaces IAS 1), financial statements are categorized into Operating, Investing, and Financing categories. Because investments in associates represent financial assets that generate returns largely independently of the entity's core operational resources, the Share of profit of associates and joint ventures accounted for using the equity method must be classified within the Investing Category.

             IFRS 18 Statement of Profit or Loss Presentation Position
  ─────────────────────────────────────────────────────────────────────────────
  Gross profit                                                          XXX
  Operating expenses                                                   (XXX)
  ─────────────────────────────────────────────────────────────────────────────
  OPERATING PROFIT (Mandatory Subtotal 1)                               XXX
  Investing Category:
    Share of profit of associate (IAS 28 Equity Method)                  XX  <-- HERE
    Dividend income from financial assets                                XX
    Interest income on cash equivalents                                  XX
  ─────────────────────────────────────────────────────────────────────────────
  PROFIT BEFORE FINANCING AND INCOME TAXES (Mandatory Subtotal 2)       XXX
  Financing category (interest expense)                                (XX)
  ─────────────────────────────────────────────────────────────────────────────
  PROFIT BEFORE TAX                                                     XXX
  ═════════════════════════════════════════════════════════════════════════════

Note on Other Comprehensive Income: If the associate recognizes items in Other Comprehensive Income (such as an IAS 16 revaluation surplus), the group's share is recognized as a separate line item within group OCI: "Group share of other comprehensive income of associate".

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5. Impairment Testing under IAS 36

Because goodwill is embedded within the carrying amount of the investment in associate and not separately recognized, it is not tested separately under IAS 36.

Instead, whenever there is an objective indication that the investment may be impaired (such as significant financial difficulty of the associate, adverse changes in the technological or market environment, or default on debt covenants), the entire carrying amount of the investment in associate is tested for impairment as a single asset:

1. Determine Carrying Amount: The carrying amount under the equity method (Cost + post-acquisition profit share - downstream PUP).
2. Determine Recoverable Amount: The higher of:
   • Fair Value Less Costs of Disposal (e.g., quoted market price on an exchange minus selling fees); and
   • Value in Use (the present value of estimated future cash flows expected to be generated by the associate, including dividends received from the associate and the ultimate disposal proceeds).
3. Accounting for Impairment Loss: Impairment Loss = Carrying Amount - Recoverable Amount
   • Debit: Profit or Loss (charged against Share of Profit of Associate or as an Impairment Expense in the Investing category)
   • Credit: Investment in Associate (CSFP)

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6. Intra-Group Trading with Associates & Provision for Unrealised Profit (PUP)

Accounting for unrealised profit on transactions between a group and an associate introduces one of the most intellectually challenging and frequently examined areas of ACCA Financial Reporting.

The Fundamental Difference: Subsidiaries vs. Associates

• Subsidiaries: The group controls 100% of the subsidiary. Therefore, 100% of the unrealised profit is eliminated, regardless of the parent's ownership percentage.
• Associates: The group does not control the associate; outside shareholders own the remainder (e.g., 70% or 60%). The profit earned on the outside shareholders' portion represents a genuine, realized third-party commercial transaction. Therefore, the group only eliminates its own proportionate share of the unrealised profit:

Eliminated PUP = Total Unrealised Profit x Group Ownership %

Upstream vs. Downstream Accounting Entries

              Intra-Group Inventory Flow with Associates: Accounting Architecture

       DOWNSTREAM SALE (Parent Sells Goods to Associate)             UPSTREAM SALE (Associate Sells Goods to Parent)
  ┌─────────────────────────────────────────────────────────┐  ┌─────────────────────────────────────────────────────────┐
  │ Seller: Parent Company                                  │  │ Seller: Associate Company                               │
  │ Inventory Holder: Associate                             │  │ Inventory Holder: Parent (Consolidated Group)           │
  ├─────────────────────────────────────────────────────────┤  ├─────────────────────────────────────────────────────────┤
  │ • Parent recognized the full profit in its ledger.      │  │ • Associate recognized the profit in its ledger.        │
  │ • Associate holds the closing inventory.                │  │ • Parent holds the closing inventory in group warehouse.│
  │ • BUT Associate's inventory is NOT in group accounts!   │  │ • Group inventory in CSFP is overstated by group share. │
  ├─────────────────────────────────────────────────────────┤  ├─────────────────────────────────────────────────────────┤
  │ REQUIRED ADJUSTMENT:                                    │  │ REQUIRED ADJUSTMENT:                                    │
  │ Dr Consolidated Cost of Sales (or Group RE)             │  │ Dr Share of Profit of Associate (P&L)                   │
  │    (Group % x Total PUP)                                │  │    (Group % x Total PUP)                                │
  │ Cr Investment in Associate (CSFP)                       │  │ Cr Consolidated Inventory (CSFP)                        │
  │    (Group % x Total PUP)                                │  │    (Group % x Total PUP)                                │
  └─────────────────────────────────────────────────────────┘  └─────────────────────────────────────────────────────────┘

Why is Investment in Associate Credited on Downstream Sales?

On a downstream sale, the parent sold goods to the associate. The profit is in the parent's accounts, but the inventory is sitting in the associate's warehouse. Because the associate's individual assets are not combined line-by-line, the group balance sheet contains no inventory line item for the associate. Therefore, the group cannot credit inventory! The only asset representing the associate on the consolidated balance sheet is the Investment in Associate. The credit is applied against the carrying amount of the investment.

Why is Group Inventory Credited on Upstream Sales?

On an upstream sale, the associate sold goods to the parent. The parent holds the inventory at year-end. Because the parent's inventory is included line-by-line on the consolidated balance sheet, group closing inventory is overstated by the unrealised margin. Therefore, the credit is applied directly against Consolidated Inventory on the balance sheet, and the debit reduces the Share of Profit of Associate in the statement of profit or loss.

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7. Comprehensive Worked Numerical Example: Equity Accounting

Scenario Data

Polaris plc owns 30% of the ordinary voting shares of Vega Ltd, acquired on 1 January 20X4 for $400,000, when the retained earnings of Vega were $250,000. Polaris exercises significant influence through board representation. Both entities prepare accounts to 31 December 20X6.

For the year ended 31 December 20X6:

• Vega reported a profit after tax of $120,000.
• Vega's retained earnings at 31 December 20X6 stand at $700,000.
• Polaris's draft cost of sales for the year is $1,500,000.

Intra-Group Trading Transactions during 20X6:

1. Transaction A (Downstream): During the year, Polaris sold goods to Vega for $100,000 at a profit mark-up of 25% on cost. At 31 December 20X6, Vega still held $30,000 of these goods in its warehouse.
2. Transaction B (Upstream): During the year, Vega sold goods to Polaris for $50,000 at a gross profit margin of 20% on selling price. At 31 December 20X6, Polaris still held $20,000 of these goods in its inventory.
3. Impairment Review: At 31 December 20X6, an impairment review conducted under IAS 36 determined that the recoverable amount of the investment in Vega is $510,000.

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Step-by-Step Calculations & Workings

Working 1: Downstream PUP (Polaris sells to Vega)

• Vega closing inventory of transferred goods: $30,000
• Mark-up on cost: 25%
• Total unrealised profit: $30,000 x (25 / 125) = $6,000
• Group Share to Eliminate (30%): 30% x $6,000 = $1,800
• Journal Entry:
  • Debit: Consolidated Cost of Sales (P&L) $1,800
  • Credit: Investment in Associate (CSFP) $1,800

Working 2: Upstream PUP (Vega sells to Polaris)

• Polaris closing inventory of transferred goods: $20,000
• Gross margin on selling price: 20%
• Total unrealised profit: $20,000 x 20% = $4,000
• Group Share to Eliminate (30%): 30% x $4,000 = $1,200
• Journal Entry:
  • Debit: Share of Profit of Associate (CSPL) $1,200
  • Credit: Consolidated Inventory (CSFP) $1,200

Working 3: Share of Profit of Associate in Consolidated P&L (IFRS 18 Investing Category)

• Base share of Vega profit after tax: 30% x $120,000 = $36,000
• Less: Upstream PUP adjustment (W2): ($1,200)
• Net Share of Profit of Associate before Impairment = $36,000 - $1,200 = $34,800

Working 4: Carrying Amount of Investment in Associate (CSFP) before Impairment

• Cost of original investment: $400,000
• Add: Group share of post-acquisition retained earnings:
  • Post-Acquisition RE: $700,000 - $250,000 = $450,000
  • Group Share (30%): 30% x $450,000 = $135,000
• Less: Downstream PUP adjustment (W1): ($1,800)
• Pre-Impairment Carrying Amount = $400,000 + $135,000 - $1,800 = $533,200

Working 5: Impairment Loss Calculation (IAS 36)

• Carrying amount before impairment: $533,200
• Recoverable amount: $510,000
• Impairment Loss = $533,200 - $510,000 = $23,200
• Journal Entry:
  • Debit: Impairment Loss on Associate (P&L — Investing Category) $23,200
  • Credit: Investment in Associate (CSFP) $23,200
• Final Carrying Amount in CSFP Non-Current Assets = $510,000

Summary of Financial Statement Presentation:

• Consolidated Statement of Profit or Loss (Investing Category):
  • Share of profit of associate: $34,800
  • Less: Impairment of investment in associate: ($23,200)
  • Net Income from Associate in Investing Category = $11,600
• Consolidated Cost of Sales: Draft $1,500,000 + Downstream PUP $1,800 = $1,501,800
• Consolidated Statement of Financial Position:
  • Non-Current Assets: Investment in Associate = $510,000
  • Current Assets: Inventory reduced by upstream PUP of $1,200

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8. Summary Comparison: Subsidiaries vs. Associates vs. Simple Investments

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9. Common Exam Traps & ACCA Examiner Tips

[!WARNING] ACCA Examiner Trap 1: Attempting Line-by-Line Consolidation for Associates In Section C, candidates sometimes mistakenly add the associate's revenue and expenses into the consolidation pro-forma (either at 100% or at 30%). This is a catastrophic conceptual error that invalidates the entire Statement of Profit or Loss. An associate must appear only as a single line item.

[!WARNING] ACCA Examiner Trap 2: Eliminating 100% of Associate PUP Candidates frequently treat associates like subsidiaries and eliminate 100% of the unrealised profit. You must eliminate only the group's ownership percentage (e.g., 30% x Total PUP). Outside investors have made a realized transaction.

[!WARNING] ACCA Examiner Trap 3: Crediting Inventory on Downstream Sales When the parent sells to the associate, candidates instinctively credit Inventory. But the associate's inventory is not on the group balance sheet! The credit must be applied against the Investment in Associate.

[!TIP] ACCA Examiner Tip: IFRS 18 Placement Marks Under the new IFRS 18 presentation standard, ensure that "Share of profit of associates" is clearly positioned within the Investing Category on the face of the Statement of Profit or Loss, between Operating Profit and Profit Before Financing and Income Taxes.