Question

The accountant of Chocolate Ltd, Ms Fraser, has been advised by her auditors that the entity’s investment in Corio Milk Ltd should be accounted for using the equity method of accounting. Chocolate Ltd holds only 20.2% of the voting shares currently issued by Corio Milk Ltd. Since the investment was undertaken purely for cash flow reasons based on the potential dividend stream from the investment, Ms Fraser does not believe that Chocolate Ltd exerts significant influence over the investee. Required Discuss the factors that Ms Fraser should investigate in determining whether an investor–associate relationship exists, and what avenues are available so that the equity method of accounting does not have to be applied.

Answer 1

Answer:

The equity method is a type of accounting used for intercorporate investments. This method is used when the investor holds significant influence over the investee but does not exercise full control over it, as in the relationship between a parent company and its subsidiary. In this case, the terminology of “parent” and “subsidiary” are not used, unlike in the consolidation method where the investor exerts full control over its investee. Instead, in instances where it’s appropriate to use the equity method of accounting, the investee is often referred to as an “associate” or “affiliate”.

IAS 28 Investments in Associates outlines the accounting for investments in associates. An associate is an entity over which an investor has significant influence, being the power to participate in the financial and operating policy decisions of the investee (but not control or joint control), and investments in associates are, with limited exceptions, required to be accounted for using the equity method.

Key definitions [IAS 28]

Associate: an entity in which an investor has significant influence but not control or joint control.

Significant influence: power to participate in the financial and operating policy decisions but not control them.

Equity method: a method of accounting by which an equity investment is initially recorded at cost and subsequently adjusted to reflect the investor's share of the net assets of the associate (investee).

Identification of associates

A holding of 20% or more of the voting power (directly or through subsidiaries) will indicate significant influence unless it can be clearly demonstrated otherwise. If the holding is less than 20%, the investor will be presumed not to have significant influence unless such influence can be clearly demonstrated. [IAS 28]

The existence of significant influence by an investor is usually evidenced in one or more of the following ways: [IAS 28]

• representation on the board of directors or equivalent governing body of the investee
• participation in the policy-making process
• material transactions between the investor and the investee
• interchange of managerial personnel
• provision of essential technical information
• Potential voting rights are a factor to be considered in deciding whether significant influence exists.

Since in the given problem, Chocolate Ltd holds only 20.2% of the voting shares the contention of the auditor is valid and justified.