Accounting For Investment In Associates In Consolidated Financial Statements – AS 23

Introduction – Consolidated Financial Statements

Consolidated Financial Statements refer to integrating the financial results of subsidiaries and associates into the parent entity’s statements. This process is typically handled by the investor who has substantial control or notable influence over these secondary entities. Accounting Standard (AS) 23 provides a comprehensive guide on accounting for associates’ investments within the context of a group’s consolidated financial statements, outlining fundamental principles and procedural rules to follow.

Who is an Associate?

An associate is an entity where an investor has significant influence but not control, and it’s neither a subsidiary nor a joint venture of the investor. This influence, allowing participation in financial or operating decisions, can be acquired through share ownership, statute, or agreement.

An investor is presumed to have significant influence over an investee if they hold 20% or more of the voting power, directly or indirectly, unless proven otherwise. On the contrary, if the investor owns less than 20% of the voting power, they’re typically deemed not to have significant influence unless they can prove it. Regardless, even if another investor holds substantial or majority ownership, it doesn’t automatically prevent an investor from having significant influence.

Significant influence by an investor over an investee is usually demonstrated through one or more methods: 

1. representation on the board of directors or equivalent governing body, 
2. involvement in policy-making processes, 
3. substantial transactions between the investor and investee, 
4. exchange of management staff, or 
5. supply of critical technical information.

3. Standalone Financial Statements

In the standalone financial statements, the investor must acknowledge and quantify investments in associates following the guidelines outlined in Accounting Standard 13, which pertains to Accounting for Investments.

4. Accounting of investments in associates in consolidated financial statements of the investor

In the consolidated financial statements, the investment in an associate is typically recorded using the equity method. 

However, there are exceptions: 

1. If the investment is purchased and held solely for near-future disposal, or 
2. If the associate operates under stringent long-term restrictions that notably hamper its ability to transfer funds to the investor. 

In these two scenarios, the accounting for investments in associates should follow the principles outlined in Accounting Standard 13

1. What is Equity Method?

An equity method is an accounting approach in which the initial recording of an investment in an associate is at its cost, acknowledging (but not formally recognizing) any goodwill or capital reserve that emerges at the time of acquisition. After this initial recording, the investment’s carrying value is modified to reflect post-acquisition changes in the investor’s portion of the investee’s net assets.

2. Equity Method – Application

Using the equity method, the associate investment is initially documented at cost, marking any goodwill or capital reserve that arises at the acquisition stage. However, this goodwill or capital reserve isn’t officially recognized in the accounting records; it’s identified purely for disclosure in the consolidated financial statements. Subsequently, the carrying value of the investment is updated to account for any changes in the investor’s share of the investee’s net assets post-acquisition. Additionally, the consolidated income statement includes the investor’s portion of the investee’s operational results.

Example: 

Let’s consider an example where X Ltd. holds 30% voting power in another company, Y Ltd. Since the shareholding percentage exceeds 20%, Y Ltd. is an associate of X Ltd. The carrying amount of the investment in Y Ltd. is Rs. 80,00,000. The current year’s profits of Y Ltd. amount to Rs. 20,00,000. In the consolidated financial statements, the following items would be recognized as follows:

Investment in Y Ltd. = 80,00,000 + (20,00,000*30%) = 86,00,000

The consolidated profit would also increase by Rs. 6,00,000 (20,00,000*30%)

In this scenario, the associate’s profit is calculated after adjusting the dividend amount for cumulative preference shareholders, regardless of whether the dividends have been declared.

Under the equity method, if an investor’s proportion of an associate’s losses meets or exceeds the investment’s carrying value, the investor usually stops accounting for further losses, bringing the investment’s reported value to zero. Additional losses are accounted for if the investor has taken on obligations or made payments to cover the associate’s liabilities, either because the investor has guaranteed them or is otherwise committed to them. If the associate later records profits, the investor only restarts including their share of those profits once this share equals the proportion of net losses that haven’t been accounted for.

Example: 

Continuing with the prior example, let’s assume that Y Ltd. incurs a loss of Rs. 3,00,00,000 during the current year. In this case, X Ltd.’s share of this loss would amount to Rs. 90,00,000. This would lead to a negative investment value in X Ltd.’s consolidated financial statements. Therefore, in these statements, the investment in Y Ltd. would be recorded as zero. Furthermore, the consolidated profit would also decrease by Rs. 80,00,000.

When employing the equity method for investment accounting in an associate, any unrealized profits or losses resulting from transactions between the investor (or its consolidated subsidiaries) and the associate should be removed, proportional to the investor’s interest in the associate. However, unrealized losses should not be eliminated if, and to the extent, the transfer cost of the asset is irrecoverable.

3. Discontinuation of equity method

The use of the equity method should be terminated from the date when:

(a) the investor no longer holds significant influence over an associate but still maintains all or part of its investment; or

(b) the application of the equity method becomes unsuitable due to severe long-term restrictions on the associate that greatly hinder its capacity to transfer funds to the investor.

From the date the equity method is stopped, the accounting for such investments in associates should comply with Accounting Standard (AS) 13, Accounting for Investments. The investment’s carrying value at that date should be considered its cost.

5. Disclosure requirements

Investment disclosure requirements mandate the following information in an entity’s financial statements:

(a) If the equity method has not been used for accounting investments in associates in the consolidated financial statements, the reasons for this must be given.

(b) Goodwill or capital reserve originating from an associate’s acquisition should be separately disclosed.

(c) Investments in associates accounted for using the equity method should be classified as long-term investments and separately disclosed in the consolidated balance sheet.

(d) The investor’s share of the profits or losses of investments in associates should be separately disclosed in the consolidated profit and loss statement. Any extraordinary or prior period items should also be announced separately.

(e) The names of associates whose reporting date differs from the investors and the differences in reporting dates should be disclosed in the consolidated financial statements.

(f) If an associate employs different accounting policies for similar transactions and events, and it’s not practical to make suitable adjustments to the associate’s financial statements, this fact and a brief description of the policy differences should be disclosed.

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