Accounting for an Investment in an Associate

When a company invests in another, the accounting treatment hinges on the level of influence the investor can exert over the investee’s operations. This relationship can range from passive ownership with no influence to complete control. An investment in an associate represents a middle ground, where the investor does not have control but holds a degree of sway over the investee’s financial and operating policies.

The accounting standards provide a specific framework for these situations, designed to reflect the economic substance of the relationship. This approach ensures that the investor’s financial statements provide a clear picture of the performance of its investment.

Criteria for an Investment in an Associate

The determination of an investment in an associate is guided by the principle of “significant influence.” U.S. Generally Accepted Accounting Principles (GAAP), under Accounting Standards Codification (ASC) Topic 323, establish the framework for this assessment. A common starting point is the quantitative threshold, where ownership of 20% to 50% of the investee’s voting stock creates a presumption of significant influence.

This 20% to 50% guideline is a rebuttable presumption, not an absolute rule. The conclusion rests on a qualitative assessment of various indicators. An investor might hold less than 20% of the stock but still exercise significant influence, or conversely, hold more than 20% and lack it.

Several qualitative factors provide evidence of significant influence. Representation on the investee’s board of directors gives the investor a direct role in governance and strategic oversight. Participation in the policy-making process, such as decisions about dividends or operations, also demonstrates influence beyond that of a passive investor.

Other indicators involve the operational relationship between the two entities. Material transactions between the investor and the investee can signal a dependency that gives the investor leverage. The interchange of managerial personnel suggests a close working relationship, and technological dependency is another indicator of significant influence.

The Equity Method of Accounting

Once an investment is classified as an associate, it is accounted for using the equity method. This method reflects the investor’s ongoing share in the associate’s financial results. At the date of acquisition, the investment is recorded on the investor’s balance sheet at its purchase cost, which includes the purchase price and any direct transaction costs.

Following the initial recognition, the carrying value of the investment is adjusted each reporting period. If the associate reports net income, the investor increases the carrying value of its investment by its proportionate share. For instance, if an associate earns $100,000 in a year, a 25% investor would increase its investment account by $25,000 and recognize that amount as revenue on its income statement.

Conversely, if the associate incurs a net loss, the investor decreases its investment account. A $40,000 loss for the associate would require a 25% investor to record a $10,000 loss and decrease the investment account by the same amount. The investor discontinues applying the equity method if the investment’s carrying amount is reduced to zero due to the associate’s losses.

When the investor receives a dividend from the associate, it is not recognized as income. Instead, it is treated as a return of the investment, reducing the carrying value of the investment account on the balance sheet. For example, a $5,000 dividend would be recorded as cash and a corresponding $5,000 reduction to the investment’s balance.

An additional complexity arises if the purchase price of the investment differs from the investor’s share of the book value of the associate’s net assets. This “basis difference” must be accounted for over time. For example, if part of the excess cost is attributable to undervalued equipment of the associate, the investor must recognize additional depreciation expense over the equipment’s remaining life, which reduces the equity in earnings recognized from the associate.

Presentation and Disclosure Requirements

On the balance sheet, the investment in the associate is presented as a single line item within non-current assets. This amount represents the initial cost, adjusted for the cumulative share of the associate’s profits or losses and reduced by any dividends received.

On the income statement, the investor’s share of the associate’s net income or loss is also presented as a single line item. This line, often labeled “Equity in earnings,” is usually found after gross profit but before income tax expense. This presentation separates the earnings from the investor’s primary operating income.

Beyond the primary financial statements, specific disclosures in the accompanying notes provide more detail about the investment. Companies must disclose:

• The name of each investee and the percentage of ownership.
• The accounting policies for such investments.
• The difference, if any, between the carrying amount of the investment and the share of the underlying equity in the investee’s net assets.
• The accounting policy for this basis difference.
• The quoted market price for the investment, if available.
• Summarized financial information of the associate—such as total assets, liabilities, revenues, and net income—for investments that are material to the investor.

Impairment Testing for the Investment

An investment accounted for under the equity method must be periodically evaluated for impairment. An impairment loss is recognized when there is evidence that a decline in the investment’s value is “other-than-temporary.” This is triggered by specific events or changes in circumstances that suggest the investor may not be able to recover the carrying amount of its investment.

Triggers for an impairment test include:

• A series of operating losses at the associate.
• Significant financial difficulties faced by the investee.
• Adverse changes in the legal, economic, or technological environment in which the associate operates.
• A situation where the fair value of the investment is significantly below its carrying amount for an extended period.

The impairment test involves comparing the fair value of the investment with its carrying amount. If the fair value is less than the carrying amount, the investor must determine if this decline is other-than-temporary. If it is, an impairment loss must be recognized, calculated as the difference between the investment’s carrying amount and its fair value.

This impairment charge reduces the carrying value of the investment on the balance sheet to its new, lower fair value. The impairment is assessed at the overall investment level, not on the underlying assets of the associate. Once an impairment loss is recognized, it establishes a new cost basis for the investment, and any subsequent reversal of that impairment loss is not permitted.