9.3 Investments in Associates and Joint Ventures: The Equity Method (PAS 28)

Investments in Associates and Joint Ventures: The Equity Method (PAS 28)

The equity method links FAR topic 3.2.4 and AFAR's separate and consolidated statements. This section covers significant influence and its indicators, equity method mechanics including excess cost allocation and amortization, dividends, losses beyond the investment, impairment, discontinuance, and the partial elimination of unrealized intercompany profits, ending with a full schedule.

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1. PAS 28: Investments in Associates & Significant Influence

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

Significant Influence

Significant influence is the power to participate in the financial and operating policy decisions of the investee, but is not control or joint control over those policies.

• Rebuttable Presumption:
  • 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 otherwise.
  • If an investor holds less than 20% of the voting power, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated.

Qualitative Indicators of Significant Influence (PAS 28 par. 6)

Even with less than 20% voting power, significant influence is evidenced by one or more of the following:

1. Representation on the board of directors or equivalent governing body 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;
4. Interchange of managerial personnel; or
5. Provision of essential technical information.

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2. Equity Method Accounting Mechanics

Under the equity method, the investment is initially recorded at cost (including transaction costs, unlike PFRS 3 business combinations where transaction costs are expensed). The carrying amount is subsequently adjusted to reflect the investor's share of post-acquisition changes in the investee's equity:

Initial Cost of Investment (Purchase Price + Transaction Costs)   PHP XXX,XXX
Adjustments:
  Plus: Investor's share of investee's profit or loss                 XXX,XXX
  Less: Investor's share of investee's losses                        (XXX,XXX)
  Plus/Less: Investor's share of investee's OCI movements            XXX,XXX
  Less: Dividends received or receivable from investee               (XXX,XXX)
  Less: Amortization of acquisition-date fair value increments       (XXX,XXX)
  Plus: Realization of acquisition-date fair value decrements         XXX,XXX
  Less: Elimination of investor's share of unrealized profit        (XXX,XXX)
Ending Carrying Amount of Investment in Associate / JV           PHP XXX,XXX

Journal Entries Summary:

1. Initial Acquisition:
   Investment in Associate                     XXX,XXX
       Cash                                                XXX,XXX

2. Share of Investee Net Income:
   Investment in Associate                     XXX,XXX
       Investment Income (Profit or Loss)                  XXX,XXX

3. Receipt of Dividends:
   Cash / Dividends Receivable                 XXX,XXX
       Investment in Associate                             XXX,XXX
   (Dividends reduce the carrying amount; NEVER recognized as dividend income!)

4. Amortization of Fair Value Increment (e.g., Undervalued Equipment):
   Investment Income (Profit or Loss)          XXX,XXX
       Investment in Associate                             XXX,XXX

Discontinuation of the Equity Method

An entity discontinues the equity method from the date when its investment ceases to be an associate or a joint venture:

• If the investment becomes a subsidiary, the entity applies PFRS 3 and PFRS 10.
• If the retained interest is a financial asset, it is measured at fair value under PFRS 9. The difference between the fair value of any retained interest plus proceeds from disposing of the partial interest and the carrying amount of the investment at the date the equity method was discontinued is recognized in profit or loss.

Loss Absorption Limit

If an investor's share of losses of an associate equals or exceeds its interest in the associate, the investor discontinues recognizing its share of further losses. The interest in an associate includes the carrying amount of the investment under the equity method together with any long-term interests that, in substance, form part of the entity's net investment (e.g., preferred shares or unsecured long-term loans). Additional losses are recognized as a provision only to the extent that the investor has incurred legal or constructive obligations or made payments on behalf of the associate.

Impairment Testing under PAS 36

Goodwill forming part of the carrying amount of an investment in an associate or joint venture is not separately recognized and therefore is not tested for impairment separately under PAS 36. Instead, the entire carrying amount of the investment is tested for impairment as a single asset whenever application of the requirements in PAS 28 indicates that the investment may be impaired.

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3. Intercompany Transactions with Associates: Proportionate Elimination

A critical distinction between PFRS 10 consolidation and PAS 28 equity accounting lies in the treatment of intercompany profits:

$\text{Unrealized Profit Eliminated} = \text{Total Unrealized Intercompany Profit} \times \text{Investor's Ownership \%}$

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4. Comprehensive Worked Example: Equity Method Accounting Schedule

On January 1, 2026, Makati Capital Corp. purchased 30% of the outstanding voting common shares of Taguig Technologies Inc. for PHP 2,400,000 cash, incurring direct transaction fees of PHP 100,000. Makati determined that it exercises significant influence over Taguig.

Acquiree Data as of January 1, 2026:

• Taguig's reported net assets (Share Capital + Retained Earnings): PHP 6,000,000.
• Fair value adjustments on January 1, 2026:
  • Inventory: Fair value exceeds carrying amount by PHP 300,000 (all sold by Taguig to external customers during 2026).
  • Equipment: Fair value exceeds carrying amount by PHP 1,000,000 (remaining useful life of 5 years, straight-line).
  • Buildings: Fair value equals carrying amount.
  • All other assets and liabilities have carrying amounts equal to fair values.

Taguig's Operating Results for 2026:

• Reported Net Income: PHP 1,500,000.
• Cash Dividends declared and paid: PHP 500,000.
• Other Comprehensive Income (gain on FVOCI financial assets): PHP 200,000.

Intercompany Transactions during 2026:

1. Downstream Transaction (Makati to Taguig): Makati sold inventory costing PHP 400,000 to Taguig for PHP 600,000 (markup PHP 200,000). At year-end, Taguig still holds 40% of this inventory.
   • Total unrealized ending downstream profit: $40\% \times \text{PHP }200{,}000 = \text{PHP }80{,}000$.
   • Makati's 30% share to eliminate: $30\% \times \text{PHP }80{,}000 = \text{PHP }24{,}000$.
2. Upstream Transaction (Taguig to Makati): Taguig sold merchandise costing PHP 250,000 to Makati for PHP 350,000 (markup PHP 100,000). At year-end, Makati holds 50% of these goods in ending inventory.
   • Total unrealized ending upstream profit: $50\% \times \text{PHP }100{,}000 = \text{PHP }50{,}000$.
   • Makati's 30% share to eliminate: $30\% \times \text{PHP }50{,}000 = \text{PHP }15{,}000$.

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Step 1: Initial Cost and Goodwill Analysis

Initial Purchase Price:                                       PHP 2,400,000
Add: Directly attributable transaction costs:                       100,000
Total Initial Cost of Investment in Associate:                PHP 2,500,000

Less: Makati's share of Book Value of Taguig Net Assets:
      30% × PHP 6,000,000:                                   (1,800,000)
Excess of Cost over Book Value:                               PHP   700,000

Allocation of Excess:
  Inventory: 30% × PHP 300,000 =                              PHP    90,000
  Equipment: 30% × PHP 1,000,000 =                                  300,000
  Total Fair Value Differential Allocated:                    PHP   390,000
Implied Goodwill (embedded in investment carrying amount):    PHP   310,000

Step 2: Calculate Investment Income Recognized in Profit or Loss for 2026

Share of Taguig's Reported Net Income (30% × PHP 1,500,000):   PHP 450,000
Less: Amortization of Inventory increment (100% sold):             (90,000)
Less: Depreciation of Equipment increment (PHP 300,000 / 5 yrs):    (60,000)
Less: Elimination of Downstream unrealized profit (30% × 80,000):   (24,000)
Less: Elimination of Upstream unrealized profit (30% × 50,000):     (15,000)
Net Investment Income recognized in Profit or Loss:            PHP 261,000

Step 3: Calculate Ending Carrying Amount of Investment at December 31, 2026

Initial Cost of Investment (including transaction fees):      PHP 2,500,000
Add: Investment Income recognized in Profit or Loss:                261,000
Add: Share of Other Comprehensive Income (30% × PHP 200,000):        60,000
Less: Cash dividends received (30% × PHP 500,000):                 (150,000)
Ending Carrying Amount of Investment in Associate:            PHP 2,671,000

Accounting Note on Upstream vs. Downstream Entry Placement: In the separate/consolidated statements of Makati, the downstream elimination of PHP 24,000 reduces the Investment in Associate account directly, whereas the upstream elimination of PHP 15,000 reduces Makati's own ending Inventory asset balance. Both adjustments debit Investment Income in profit or loss.